Protecting Against COVID-19 Litigation Risks – Part 1: Commercial Contract Non-Performance
March 31, 2020
We know that many companies are working hard to respond to COVID-19 in the workplace, faced with disruptions or closures and other effects of the pandemic on business and relationships. As businesses are coping with the myriad of issues that have arisen, consideration should be given to the potential long-term effect of immediate decisions. In this three-part series, we look at some of the litigation risks facing businesses responding to the COVID-19 pandemic, and how to manage those risks. This article addresses Commercial Contract Non-Performance. Part 2 and part 3 deal with Potential Disputes between Employers and Employees, and Pandemic Public Disclosure Obligations and Insurance Coverage, respectively.
For most of us, these are unchartered waters and there is little existing case law to provide guidance on how the courts will respond to conflicts that will inevitably arise out of businesses’ response to the pandemic. In most cases, parties will benefit from a reasonable, pragmatic approach to cooperation and negotiating disputes as they arise.
Commercial Contract Non-Performance
With disruptions to the supply chains, business closures and changed consumer habits, among other effects of the response to the COVID-19 pandemic, many businesses may find themselves unable to fulfil contractual obligations or responding to a contracting counter-party who is unable to hold up their end of the bargain. Whether and to what extent COVID-19 may excuse a party’s non-performance depends on the specific terms of our contract. Below I discuss some provisions that may be invoked.
Force Majeure: Many commercial contracts include a provision that absolves the non-performance of one or more contracting parties caused by circumstances beyond the parties’ control. Because of the serious consequences of relying on force majeure, including discharge of some or all contractual obligations temporarily or permanently depending on the wording of the contract, courts are likely to interpret a force majeure clause narrowly. When considering whether your force majeure provision is triggered, parties should look to three things in particular:
1. What types of events are covered?
Some force majeure provisions set out a list of events that fall within the scope of circumstances covered by the clause, whereas others define triggering events more broadly as an “Act of God” or “circumstances beyond a party’s reasonable control”. COVID-19 is more likely to constitute a force majeure event where the provision specifically includes wording pertaining to “pandemic” or “endemic” or “disease outbreak” or “quarantine”. There is very little case law on what constitutes an “Act of God”, but courts generally require a force majeure event to be beyond the scope of normal, foreseeable business risks. What the parties could reasonably have foreseen may be considered in light of the 2003 SARS pandemic, and the spread of other serious viruses since. That said, because the magnitude of the COVID-19 pandemic and its impact of business operations has already exceeded that of SARS, it may be arguable that COVID-19 triggers even the more broadly-worded force majeure provisions.
2. To what extent has COVID-19 impacted the ability to comply with contractual obligations?
The party seeking to rely on a force majeure provision must also establish that the event sufficiently impacted its ability to perform its obligations under the contract. Most force majeure clauses set out the degree to which the triggering event must impact performance: ranging from lower standards of hinderance or delay to higher standards of prevention. Where the contract does not specify, courts are more likely to apply a more onerous standard to excuse non-performance only where the event renders performance impossible, or virtually impossible. The fact that an event has made performance more expensive or less profitable – even dramatically so – is unlikely to trigger a force majeure clause.
3. What is the notice requirement?
Many force majeure provisions set out strict notice requirements. The party seeking to rely on a force majeure provision should ensure that it complies with the notice requirement, otherwise you risk being barred from relying on the force majeure provision.
Don’t forget about your duty to mitigate. The party seeking to rely on the force majeure provision should take reasonable steps to try and avoid the impact of the event on its obligations. The party responding to a force majeure notice should take reasonable steps to mitigate its loss as a result of the other party’s non-performance.
Frustration: Parties to a contract with no force majeure provision may be able to rely on the doctrine of frustration to excuse non-performance. Once established, frustration discharges both parties from their contractual obligations. The doctrine of frustration is meant to be flexible and is not restrictive to any specific formula or type of contract. But flexible does not mean easy to establish. As with force majeure, there is a high bar to establishing contractual frustration.
Frustration takes place when an unforeseeable event supervenes, through no fault of either party, that changes the nature of the parties’ bargain so significantly from what they could reasonably have contemplated when executing the contract that it would be unjust to hold them to the contract in the new circumstances. The fact that a supervening and unforeseeable event renders performance more costly or less profitable is, again, generally not sufficient to establish frustration.
Material Adverse Change: Where force majeure or frustration are not options, a contract’s “material adverse change” or “material adverse effect” provision may allow for termination of the contract or adjustment of the price or other obligations. A “material adverse change” provision is generally included in certain types of contracts – typically purchase and sale or financing agreements – to address situations or events that impact the value of the thing contracted for. These provisions do not typically set out a list of specific triggering events, but rather often rely define a material adverse change or effect more broadly and without defining the threshold for materiality. Materiality is a fact-driven analysis, but courts will consider materiality from an objective point of view to ask whether the adverse change or effect would have induced a reasonable party not to enter into the contract.
Conditions of Contract: In certain types of agreements, such as agreements of purchase and sale, there may be an issue with one party meeting a condition precedent of the agreement. For example, the contract may be conditional of obtaining financing that the purchaser can no longer obtain, or the working capital requirements are not longer attainable. The inability to meet a condition of the contract may affect the enforceability of the entire contract.