Is Coronavirus Infecting Your Commercial Contracts? Excusing and Enforcing Performance Amidst Worldwide Uncertainties
Panic over the new coronavirus (COVID-19) is continuing to cause significant disruptions in the global supply chain. During uncertain times, suppliers seek to escape existing contractual obligations they can no longer timely fulfill, and customers seek to secure commitments from their suppliers. As the virus continues to spread, contracting parties are seeking to excuse or delay performance under contracts based on force majeure or common-law doctrines that could arguably justify what would otherwise constitute breach.
Regardless of which side of the pandemic impact you find yourself, below are items you should consider.
Force Majeure
Many contracting parties anticipated unforeseeable impacts on a party’s ability to perform by including an express force majeure provision in their contract. A force majeure provision typically dictates that a contracting party is not responsible for its violations of the contract, including delayed performance, to the extent due to circumstances or events not within the reasonable control of the party. How broad or narrow the force majeure provision is drafted will determine whether COVID-19 or the impacts thereof amount to force majeure. Depending on that determination, a force majeure provision may be dispositive of issues relating to liability for delay or other inability to perform. Many force majeure clauses include broad catch-all provisions, but even a broadly worded provision may not excuse performance unless the force majeure clause makes some specific reference to the event at issue. See Team Mktg. USA Corp. v. Power Pact, LLC, 839 N.Y.S.2d 242 (2007) (stating that if “the event that prevents performance is not enumerated, but the clause contains an expansive catchall phrase in addition to specific events, the precept of ejusdem generis as a construction guide is appropriate—that is, words constituting general language of excuse are not to be given the most expansive meaning possible, but are held to apply only to the same general kind or class as those specifically mentioned.”) Some force majeure provisions also track common law principles and only exculpate an obligated party to the extent the force majeure event or circumstance was “unforeseeable.” Each party should carefully review the force majeure provisions to ensure that COVID-19 is included within the events for which a party may be excused. As a drafting note, force majeure provisions in contracts entered into currently should specifically include “pandemic, worldwide illness, epidemic, outbreak, quarantine, etc.” since COVID-19 is clearly known and may not otherwise be included as an unforeseeable event.
Many state courts construe force majeure provisions narrowly, and “[o]rdinarily, only if the force majeure clause specifically includes the event that actually prevents a party's performance will that party be excused.” See Kel Kim Corp. v. Central Markets, Inc., 70 N.Y.2d 900, 902–03 (1987); see also Constellation Energy Servs. of New York, Inc. v. New Water St. Corp., 46 N.Y.S.3d 25, 27 (N.Y. App. Div. 2017) (“[W]hen the parties have themselves defined the contours of force majeure in their agreement, those contours dictate the application, effect, and scope of force majeure.”)
Buyers and sellers alike should pay special attention to any notice requirements associated with the occurrence of a force majeure event as failure to comply with such requirements in some states will preclude the avoidance of contractual obligations under the guise of force majeure, even if no damages from such failed notice are actually shown. Upon the occurrence of a force majeure event, some contracts may entitle one or both parties to suspend performance until the event ceases and may further entitle one or both parties to terminate the agreement or applicable purchase order where such event continues beyond a specified period of time. On the other hand, some force majeure provisions specifically exclude certain obligations, including shipping obligations, or specifically require the obligated party to overcome the force majeure event rather than extending relief.
In any case, in connection with any decision to suspend or terminate performance, buyers and sellers should critically analyze the risk of improperly invoking the right to avoid performance and the responsibility for mitigating damages despite an entitlement to avoid performance.
Exclusions and Limitations of Damages
Contractual provisions excusing a party from liability for consequential damages and capping the liability of a party are common in commercial contracts and are especially important to consider here. Consequential damages typically include, without limitation, lost profits and lost revenues – each of which can quickly accumulate over an extended delay. Even if such damages stem directly from failures of performance related to COVID-19, exclusions of consequential damages will generally be enforced to prohibit the imposition of such damages against the non-performing party. While these provisions don’t allow you to avoid performance, they may allow you to avoid some of the liability associated with your failure to perform.
Liquidated Damages
Another place to look for contract language limiting your exposure to liability for delay are liquidated damages provisions. While many sellers typically reject the imposition of liquidated damages as a benefit, in scenarios where damages from delays are uncertain, especially where no consequential damages are excluded, liquidated damages provisions work to strictly limit liability for delay to the amount of designated liquidated damages. On the buyer side, liquidated damages provisions are generally easier (and cheaper) to enforce than bringing an action for actual damages suffered as a result of delay (especially with respect to continuing delays). Depending on the reasonableness of the designated damages (noting that unreasonable amounts will not be enforced) these provisions can serve to benefit both sides of the supply chain simultaneously.
Insurance
Some lines of insurance such as health, workers’ compensation and life will most likely have covered claims with respect to COVID-19. The same may not be true with respect to business interruption and travel insurance. Whether on business or personal travel, temporary or extended, all insureds should review their coverages with a risk management specialist to determine whether claims associated with COVID-19 are covered.
Non-Contractual Considerations
While courts will typically enforce the express terms of the contract negotiated between the contracting parties, consideration should also be given to common law and non-contractual principles which may impact or serves as a defense to a party’s performance obligations. Courts have traditionally been sympathetic to parties whose performance has been made impossible or impractical by intervening and unforeseeable events such as catastrophic events which are extraordinary and beyond their control. These common law defenses to breach of contract claims are known as “Impossibility,” “Commercial Impracticability” and “Frustration of Purpose.”
The “impossibility of performance” doctrine applies when a party cannot execute their obligations under a contract because doing so has become effectively impossible. In addition to applicable case law, the Restatement (Second) of Contracts and Article 2 of the Uniform Commercial Code related to the sale of goods also address impossibility of performance. As explained by the New York Court of Appeals, “the excuse of impossibility of performance is limited to the destruction of the means of performance by an act of God, vis major, or by law.” See Kel Kim Corp. v. Central Markets, 70 N.Y.2d 900 (1987). Thus, if one party to the contract cannot perform due to an event that the parties could not have foreseen when negotiating their contract, the other party cannot recover for breach of contract. See 407 E. 61st Garage v. Savoy Fifth Ave. Corp., 23 N.Y.2d 275, 282 (1968). In other words, if one party no longer has the means of carrying out the contract due to some event that the parties could not have foreseen when making their contract, the other party cannot recover for breach of contract.
Where performance is not impossible per se, two other doctrines known as “commercial impracticability” or the “frustration of purpose” may come into play.
“Commercial Impracticability” is a quasi-impossible defense to performance of a contract. In many cases, proving that the ability to proceed is outright impossible is too high of a burden. More realistically, performance may be technically possible, but nevertheless commercially impractical. In those situations, courts have found that a failure to perform should be excused under this doctrine. The Restatement (Second) of Contracts § 261 defines impracticability as “Where, after a contract is made, a party’s performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary.” For performance to be impractical, the triggering event must be unforeseeable and not be caused by the party charged with performance. Courts have held that a small shift in the degree of difficulty or expense does not amount to impracticability unless it goes way beyond and can be performed only at an excessive and unreasonable costs.
A related but different defense to impracticability is “frustration of purpose.” Whereas the impossibility and impracticability defenses focus on the inability of a party to perform, the frustration of purpose defense focuses on the reasons the parties entered into the contract. The Restatement (Second) of Contracts § 265 defines frustration as “Where, after a contract is made, a party's principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his remaining duties to render performance are discharged, unless the language or circumstances [of the contract] indicate the contrary.” In such situations, performance is not rendered impossible or impracticable, but the basic bargained for exchange between the parties cannot be accomplished. Frustration of purpose is often seen where the primary purpose of the party’s obligations is rendered moot based on unexpected events, such as the services of a service provider being no longer necessary because the overall project being canceled or delayed. Like impracticability, the frustration must be significant, unforeseen and not caused by the party charged with performance.
Courts look at whether a risk was foreseeable and whether the risk was assumed by the parties when making determinations about the impossibility, impracticability, or frustration. The party seeking to avoid the contract will most often be a defendant in a claim for damages brought by the party seeking to enforce the contractual obligations. In other words, these are defenses-to-defenses. One party argues breach, the opposing party argues impossibility (or impracticability or frustration), then the original party argues that the risk was assumed and/or foreseeable.
Moving Forward
In conclusion, all supply chain participants should carefully review their contracts with the assistance of legal counsel to determine whether and how liability for failure of performance related to COVID-19 may be avoided. In addition, both buyers and sellers might also consider revisiting their contracts to more fairly allocate the risk associated with COVID-19 to the extent their supply chain allows. The extension of goodwill in a period of disarray may ultimately lead to unexpected windfalls.
Should you wish to discuss any of these concepts further and how they apply specifically to your situation, please contact any attorney listed in this advisory.