Contractual Disruptions: How They Arise and How to Prepare

ith
the recent spread of the novel coronavirus COVID-19 and its unprecedented precipitation
of social-distancing, work-from-home policies, shelter-in-place orders, and
limitations on foreign travel, many individuals may be questioning whether certain
contractual obligations are excused. This article provides a primer on the
contract concepts of force majeure,
impossibility and impracticability, and related provisions that affect, and may
in certain instances excuse, performance of contractual duties owing to changed
circumstances outside any signatory’s control.

Force
Majeure

A
force majeure clause is a contract
provision that excuses a party’s performance of its obligations under a
contract when events beyond the party’s control make performance impossible. To
invoke a contract’s force majeure
clause, a party must typically demonstrate that (1) a disruptive event
enumerated by the force majeure clause
has occurred; (2) the risk of nonperformance was not foreseeable; and (3) that
the event has rendered the party’s performance impossible.

A party looking to invoke a force majeure clause must follow several steps:

First,
a party must examine the contract’s definition of what constitutes a “force majeure” event and demonstrate
that the change in circumstances was included within the definition. Force majeure events will have been enumerated
within a force majeure clause and
generally include: Acts of God; severe acts of nature or weather events
including floods, fires, earthquakes, hurricanes, or explosions; war; acts of
terrorism; epidemics; acts of governmental authorities such as expropriation or
condemnation; changes in laws and regulations; and strikes and labor disputes.

Determining
whether a force majeure clause
applies is a highly fact-intensive exercise, because whether a party is excused
for non-performance stems from the specific contractual language used within an
agreement. For example, some contracts’ force
majeure provisions may specify disease, epidemics, or pandemics as cause
for non-performance, while others may only refer to disease-related disruptions
by reference to “Acts of God” or catch-all phrases such as “any event or
circumstance beyond the reasonable control of the affected party.”

Where
disease-related occurrences have been specifically enumerated, a party may find
it easier to invoke its force majeure
clause in the context of COVID-19. It may be more challenging where, instead,
there is only catch-all language in place; however, a catch-all phrase, or
similarly broad language (such as a force
majeure clause that begins its list with “including, but not limited to”),
may provide some protection, particularly if courts relax their traditional preference
for excusing performance solely based on clearly enumerated circumstances, in
response to an onslaught of COVID-19 related contract disputes. Additionally,
where a party can point to a governmental restriction in place because of
COVID-19, it may have additional grounds to defend nonperformance. 

Second, an affected party must demonstrate a causal link between the force majeure event and its failure to perform. In other words, a party’s performance must be impossible because of the changed circumstances surrounding the contract. For example, in light of COVID-19, the owner of a performing arts venue may successfully argue that recent government orders in his or her state have made it impossible to continue under contract with scheduled performances and obligations to performers, considering the widespread uptick in closures of non-essential businesses. On the other hand, should both parties to a contract be capable of conducting transactions online and/or having a history of remote online transactions, it may be more difficult to argue that COVID-19 has rendered performance impossible (at least without demonstrating other exigent circumstances).

Upon successfully invoking
a force majeure provision, a party may either suspend performance or
terminate the contract outright, depending on the scope of its force majeure
clause. It is thus important to verify the terms of the clause, which may also
dictate that force majeure coverage will only kick in after a certain
period has elapsed, such as 90 days.

If
the contract does not contain a force
majeure clause, a party may turn to the common law defenses of
impossibility or impracticability to excuse performance (though note that New
York only recognizes impracticability in rare circumstances, such as in
connection with sales of goods under the Uniform Commercial Code). A party may also
invoke additional contract provisions where present, such as the “Material
Adverse Effect” provision common to many commercial contracts.

Impossibility
& Impracticability

Impossibility and impracticability exist where circumstances extraneous to a contract render a party’s performance either impossible or impractical. Although the contract itself was adequately formed and would otherwise maintain its binding effect, these defenses recognize that a post-formation change in circumstances has fundamentally altered the ability of the parties to perform under it. A party’s performance will be excused if the following elements are met:

• An
  unforeseen event has occurred. Akin to the events
  enumerated in force majeure clauses, these may include natural disasters, strikes, and other
  major events.

• The nonoccurrence of this event was a basic assumption of the contract. At the time of contracting, the parties did not foresee the event that has since occurred, regardless of whether it was theoretically “foreseeable”. This assumption of nonoccurrence need not be explicitly outlined within the contract, but must be generally apparent from the nature, terms, and purpose of the contract. Under the Uniform Commercial Code, which governs sales of goods, a “[d]elay in delivery or non-delivery in whole or in part by a seller . . . is not a breach of his duty under a contract for sale if performance as agreed has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made.” U.C.C. § 2-615. For example, this provision may apply in the event of a labor dispute where striking workers fail to deliver a shipment of the seller’s goods. In such cases, a seller must seasonably notify the buyer of the delay or non-delivery, and, where a seller may still partially perform, must allocate production and deliveries among customers in a “fair and reasonable” manner.

• The
  effect of the event has rendered the party’s performance impossible or
  impracticable. The
  changed circumstance must be extreme, such that it is unduly burdensome or
  impossible for the party to comply as originally planned; where impossibility
  is concerned, under New York law, the subject matter of the contract must have
  been destroyed or the means of performance must have been rendered objectively
  impossible. The party seeking relief from its obligations under the existing
  contract must also show that it was not at fault in causing the event. The
  reasoning behind this requirement is clear: a party should not be able to take
  advantage of his or her own misconduct. Here, it is also important to determine
  how risk has been allocated between the parties under the contract. Even where
  the other requirements are met, if the adversely affected party assumed the
  risk of the occurrence of the changed circumstances during contract formation
  (impliedly or explicitly), it will not be able to invoke impossibility or
  impracticability. To gauge risk allocation, a party should examine the express
  language of the contract (i.e., what
  disruptive events the parties contemplated, and which party was to bear the
  associated loss and expense), or even the parties’ course of business and
  dealings. Industry customs may also provide clues to proper risk allocation. For
  example, industry custom in property rentals is for a premises owner to obtain
  casualty insurance rather than the party hosting its event on site. As such,
  risk for the loss of the property would flow more naturally to the owner.

Other
Contract Clauses

Various
additional contractual provisions may relate to an unexpected event like
COVID-19.

1. Material Adverse Change (MAC) Clause

Many commercial contracts include a
material adverse change clause (otherwise known as “material adverse effect”).
Where present, this clause could excuse performance or allow a party to suspend
performance should a materially adverse change occur. Events constituting a
materially adverse change are, as with force
majeure provisions, commonly enumerated specifically within the contract
and typically also involve wide-scale disruptions.

Historically, MAC clauses have been difficult to enforce, as courts are wary of excusing contractual performance for short-term changes in circumstances, but as is possible with force majeure and related defenses, courts may shift their stance in the coming months. For example, following the September 11, 2001 attacks, New York courts were more amenable to viewing declining rental prices in Manhattan as grounds to declare a material adverse change (See In re Lyondell Chem. Co., 567 B.R. 55, 123 (Bankr. S.D.N.Y. 2017), aff’d, 585 B.R. 41 (S.D.N.Y. 2018) (citing River Terrace Assocs., LLC v. Bank of N.Y., 10 Misc. 3d 1052(A), 2005 WL 3234228 (N.Y. Sup. Ct.), aff’d, 23 A.D.3d 308 (N.Y. App. Div. 2005))). Further, New York courts have allowed commercial parties to cease contractual performance based on demonstrated extensive financial losses during the pendency of a merger (see Katz v. NVF Co., 100 A.D.2d 470, 471 (N.Y. App. Div. 1984)).

• Covenants

Commercial contracts commonly contain covenants obligating parties to undertake or refrain from certain behavior. While it is unlikely that parties would have allocated obligations or risk regarding COVID-19 in a covenant, it is worth revisiting covenants within a contract to gauge whether they will affect or be affected by current circumstances. For example, many agreements include covenants obligating parties to provide notice that they are invoking force majeure or that material events have occurred that could give rise to litigation or loss beyond the ordinary course of business.

• Termination Provisions

Even if parties may not utilize force majeure or other contractual provisions to justify non-performance under a contract, there may be termination provisions that kick in based on the occurrence of certain contingencies, whether at-will or otherwise, such as for late delivery or a breach of a “time is of the essence” clause. It is worth viewing any such provisions within the context of the larger defenses of impossibility, impracticability, and force majeure excusal of nonperformance, in case the other party nonetheless attempts to invoke these doctrines to negate invocation of a termination provision.

This
is not the law’s first brush with the unexpected, and although this is a time
of wide-reaching uncertainty, woven into contract law, particularly, is a
system to guide parties through the serious impacts that unexpected events may have.
Our team at Cowan, DeBaets, Abrahams & Sheppard LLP will continue to provide
updates on legal developments related to the present circumstances and we are
available should you request further or specific guidance.