The Force May Be With You: COVID-19 and Force Majeure Provisions
Client Alerts | March 31, 2020 | Securities and Corporate Finance | Commercial and Corporate Litigation
COVID-19 has caused major disruption to businesses, commerce and the financial markets. With the CDC and WHO projecting that the coronavirus is only in its early stages in the United States, businesses and individuals may feel the burden of the effects of COVID-19 for the foreseeable future. As the flow of goods and services continues to become more constricted, many businesses may find themselves unable to discharge some of their contractual obligations under existing commercial agreements. In order to avoid breaching these agreements, parties should consider exploring the invocation of any force majeure provisions under the agreements, and should review their other available options under law.
Force Majeure Provisions
A force majeure provision is intended to allocate risk between or among the parties in the event that unanticipated events render the contract’s performance impossible or impracticable. This provision excuses a party’s nonperformance of obligations under a contract when an extraordinary, supervening event beyond the control of the parties prevents the party from fulfilling its contractual obligations. It is important to note that the interpretation of what constitutes a force majeure event will vary on a case-by-case basis depending on (1) the specific language of the provision, and (2) the case law of the jurisdiction governing the contract. If a force majeure provision is successfully invoked, the affected party is excused from the nonperformance of its obligations for as long as the event continues, and, if the event continues for an extended period, it is possible that the contract may be terminated.
Most force majeure provisions include an enumerated list of events that constitute a force majeure, which may include floods, tornadoes, earthquakes, hurricanes, terrorism, riots, strikes, wars or (as applicable here) epidemics and pandemics. Depending on the governing jurisdiction, it may be easier to successfully invoke a force majeure provision where the provision specifically lists the event in question as a force majeure event. Under New York law, for example, courts narrowly interpret force majeure clauses, so that only the occurrence of events expressly identified in the clause will excuse a party’s nonperformance. When the parties themselves have defined the contours of force majeure in their agreement, those contours dictate the application, effect and scope of force majeure.
However, force majeure provisions may be drafted with catchall language to be non-exclusive, meaning that the provision does not have to specifically list the event in order for the event to qualify as a force majeure. But New York courts will ascribe force majeure effect only to events that are of the same general kind or nature as those specifically listed. Notwithstanding the courts’ default position of giving effect only to like-kind force majeure events, parties, to some extent, are nevertheless free to negotiate more broadly defined catchall terms, such as “for any reason, whether similar or dissimilar to the foregoing.”
In most jurisdictions, courts will interpret a force majeure provision by determining whether (1) the event qualifies as a force majeure event under the applicable force majeure provision, (2) the event was unforeseeable at the time that the contract was executed, and (3) performance under the contract was rendered impossible. Depending on the jurisdiction and the text of the clause, courts may also require that there is a causal link between the force majeure event and the affected party’s failure to perform.
It is important to note that certain formulations of force majeure provisions have been interpreted to require that performance was actually impossible, while other formulations have been interpreted to require that performance was merely impracticable or unreasonable.
Many force majeure provisions contain conditions to be satisfied before the affected party can rely on the provision. For instance, some force majeure provisions require that the affected party (1) invoke the force majeure provision within a certain amount of time after the occurrence of the event, (2) provide the counterparty with notice, and/or (3) make a reasonable effort to mitigate the effects of the event. The failure to observe these requirements may prevent the affected party from successfully invoking the provision.
Common Law Force Majeure Equivalents
In the event that a contract does not contain an express force majeure provision, there are still ways that a party may seek to excuse its nonperformance or avoid its contractual obligations under common law, including impossibility/impracticability and frustration of purpose. The fundamental difference between these doctrines is that impossibility and impracticability excuse nonperformance where the performance of a party’s obligations is rendered impossible or impracticable, respectively, by a supervening event. Frustration of purpose excuses nonperformance where the supervening event has rendered unattainable the primary reason for which the parties entered into the contract.
Impossibility and Impracticability
The common law doctrines of impossibility or, in some jurisdictions, impracticability, may excuse nonperformance where a party establishes that (1) an unexpected intervening event occurred, (2) the parties’ agreement assumed such an event would not occur, and (3) the unexpected event made contractual performance impossible or impracticable.
The common law definition of foreseeability requires that, at the time the contract was executed, the event preventing performance was not expected or foreseeable, and that the nonoccurrence of the event was a basic assumption on which the contract was made. Generally speaking, dramatic shifts in market conditions and the financial health of the parties are not considered basic assumptions on which contracts are made, and are therefore insufficient to excuse nonperformance. Under New York law, a party to a contract generally must perform or respond in damages for its failure, even when unforeseen circumstances make performance burdensome.
Impossibility and impracticability are objective tests, and the subjective opinion of the individual party is irrelevant. Instead, the court looks to whether a reasonable person under the same facts and circumstances would consider the performance impossible or impracticable. Jurisdictions are split on the standard of impossibility, with some jurisdictions requiring not mere impracticability but true impossibility. Impossibility is a high standard that ordinarily requires that the subject matter of the contract or the means of performance has been destroyed by an unanticipated event. In contrast, other jurisdictions require only that the performance be impracticable, such that performance of the party’s obligations would require excessive or unreasonable expense. In all events, the party asserting the impossibility defense must demonstrate that it took virtually every action within the party’s powers to perform its duties. And, at least in New York, the event presenting the impossibility must not be temporary in nature. When contemplating impossibility, permanent impossibility of performance or at least impossibility which may reasonably be expected to continue for a substantial period of time, is required; mere temporary supervening impossibility of brief duration typically is inadequate to excuse a party from performance.
Frustration of Purpose
The doctrine of frustration of purpose requires that (1) an event substantially frustrates a party’s principal purpose for entering into the contract, (2) the nonoccurrence of the event was a basic assumption of the contract, and (3) the event was not the fault of the party asserting the defense. Whereas the focus of impossibility is the ability of the parties to perform, frustration of purpose instead deals with the fact that one of the parties will not receive the benefit of the bargain even if the other side performs.
The primary inquiry in proving frustration of purpose is whether the unforeseeable event has significantly altered the circumstances of an agreement such that performance would no longer fulfill any aspect of its original purpose. In addressing this question, courts generally interpret a contract’s purpose broadly, and the mere fact that an event has prevented a party from taking advantage of the agreement in an expected manner may be insufficient; therefore, for example, it is not enough that a transaction was previously expected to be profitable, but is now unprofitable.
In New York, the “frustration” must be sufficiently substantial to assert successfully the frustration of purpose defense. To be clear, the frustrated purpose must be so completely the basis of the contract that, as both parties understood, without it, the transaction would have made little sense. It is also well settled that the doctrine of frustration of purpose is not available where the event which prevented performance was foreseeable and provision could have been made for its occurrence.
Recommendations in Light of COVID-19
For contracts including a force majeure clause, and even for those that do not, it is very possible that the COVID-19 pandemic or the governmental response may qualify as a force majeure event or otherwise trigger the common law doctrines of impossibility, impracticability or frustration of purpose. Because of the dramatic variation in the interpretation of force majeure clauses, the determination of whether these events will qualify as a force majeure event for a specific contract (or the equivalent) will depend largely on the governing law of the contract and the specific language of any force majeure provision.
Parties entering into new contracts may not be able to rely on the COVID-19 pandemic given that its risks are well known already. But if you are a party to commercial contracts that have been, or may be, affected by the pandemic, Kleinberg Kaplan recommends that you consult counsel to review each contract in detail to determine the governing law and the existence of a force majeure provision, identify any timing restrictions on when a force majeure claim can be made, and confirm any notice obligations or any duty to mitigate, and other applicable issues.
Regardless of whether you previously entered into a contract or are doing so now, and regardless of whether you are the party invoking the force majeure clause or the party against whom it is invoked, it is important to review all indemnity, termination, liquidated damages and dispute resolution provisions, and other provisions that may affect your ability to assert claims under the contract. It is equally critical to consider whether nonperformance by one party may have knock-on effects on the other party’s ability to discharge its ongoing obligations under commercial agreements, such as finance agreements, acquisition agreements, investment contracts and countless other types of agreements.