Goodwin has written extensively on the challenges presented by the COVID-19 coronavirus (see our COVID-19 Knowledge Center) and, among these important issues, we also want to encourage our clients to be proactive in responding to the potential impact of COVID-19 on both existing and potential business agreements and relationships. Now that the World Health Organization has formally classified the outbreak of COVID-19 as a pandemic, and the full spread of the virus remains uncertain, it is important that businesses consider the potential implications of the virus on negotiation and performance of their contracts. Whether you are planning to negotiate or currently negotiating contractual agreements, or whether your commercial operations and relationships have already felt the impact of this novel coronavirus, there are several considerations to keep in mind to ensure the smooth operation of your business and to mitigate the potential for litigation amid a pandemic.
Implications of COVID-19 on Contractual Provisions and Performance
COVID-19 could have a significant impact on how parties view and negotiate contractual provisions, particularly those provisions that could potentially excuse or toll performance, or terminate an agreement, including: force majeure provisions, material adverse change/material adverse effect clauses, and representations and warranties. There are also various principles at common law and under the Uniform Commercial Code (“UCC”) that may apply when an event was not reasonably anticipated or actually “negotiated” by the parties, such as the doctrines of impossibility, impracticability, and frustration of purpose.
Given the uncertainty of COVID-19’s impact on businesses and industries, it is important to consider how such provisions could affect existing or future agreements. Indeed, knowing when a party’s performance may be excused or modified can help to avoid a material breach of contract or, alternatively, to know when litigation against a non-performing party is appropriate.
A force majeure clause is a contractual provision that excuses a party from performance and limits damages when circumstances beyond that party’s control prevent it from fulfilling its contractual obligations. Most contracts include a force majeure provision, but not all emergencies or unexpected scenarios will constitute an excuse for nonperformance under a force majeure clause—whether an event would relieve a party from performance will depend heavily on the language of the provision.
When a pandemic like COVID-19 occurs, a party may attempt to invoke a force majeure clause. When a contract expressly defines force majeure to include “pandemic,” “epidemic,” “outbreak,” “quarantines,” “disease,” or similar terms, a party has a better chance of successfully invoking that clause to excuse performance in the event of a pandemic such as COVID-19. Enumerating qualifying events (or expressly excluding such references) reduces confusion surrounding covered events.
That being said, terms like “pandemic” or “epidemic” need not necessarily be listed to be covered by a force majeure clause. Parties can seek to excuse performance under more general force majeure terms or broad catchall provisions, which are often included (e.g., “act of God,” “disaster,” “emergency,” or other similar terms or phrases). However, if challenged, the interpretation of those terms and how broadly the clause can be read will ultimately be left up to the court and the applicable governing law, with the burden on the party seeking to invoke the provision. Moreover, some commonly used terms may already have established definitions or limitations in the case law and may be interpreted more or less broadly depending on the jurisdiction. For example, at common law, an “act of God” was defined narrowly as “such inevitable accident as cannot be prevented by human care, skill or foresight; but results from natural causes; such as lightning and tempest, floods and inundation.” McHenry v. Philadelphia, W. & B.R. Co., 4 Del. 448, 449 (Del. Super. Ct. 1846). Given this definition, a party relying exclusively on an “act of God” provision to excuse its performance will face an uphill battle, as it struggles to establish that no amount of human care, skill, or foresight could have prevented the outcome of a pandemic, such as the current one.
To the extent a pandemic like COVID-19 (or a similar event) would not itself fall within a broad force majeure phrase like “act of God,” it may be that secondary events flowing from the pandemic could nevertheless be covered by a force majeure provision. Specifically, clauses that are defined to include an “act of government” could provide a strong basis for excused performance given the likelihood and expectation of a government response to these types of unanticipated events. We are currently seeing this play out in response to COVID-19 across the globe (e.g., emergency declarations, mandatory lockdowns, citizen quarantines). As such, we suspect that parties who are unable to perform as a result of government counteractions, such as trade barriers or restrictions, would be more likely to successfully invoke a force majeure clause that includes government acts, unless subject to other restrictions or limitations. For this reason, parties currently negotiating may also want to consider building in provisions addressing events beyond government orders, such as government guidance. For example, many governments are recommending that people self-isolate in response to COVID-19, even if it is not a formal policy or order. Parties should also consider the significance and impact of a company’s disaster plan. Many companies have implemented remote and work-from-home plans, which could impact non-critical areas of operation. [For further information on steps to reduce workplace risks and associated potential employer liability, see Goodwin’s Responding to the COVID-19 Outbreak: Ten Questions and Answers for Employers.]
Ultimately, the successful invocation of the clause will likely depend on the particular facts and circumstances, specific language of the contractual provision, jurisdiction, and/or governing law. See, e.g., Pac. Vegetable Oil Corp. v. C. S. T., Ltd., 29 Cal. 2d 228, 238 (1946) (“The test is whether under the particular circumstances there was such an insuperable interference occurring without the party’s intervention as could not have been prevented by the exercise of prudence, diligence and care.”); In re Cablevision Consumer Litig., 864 F. Supp. 2d 258, 264 (E.D.N.Y. 2012) (noting that, under New York law, “force majeure clauses are aimed narrowly at events that neither party could foresee or guard against in the agreement”). Because these provisions are ordinarily interpreted narrowly, specific, enumerated references to certain events will provide a stronger argument that such events are covered by the force majeure clause.
But even when a pandemic or similar event is expressly defined as a force majeure event, a contracting party may not immediately be excused from performing. As a result, if a party prematurely stops performance, that party may be in material breach. Prior to halting performance, the contract should be carefully reviewed for any limiting language or triggering language in the clause—such as any durational requirements or language specifying that performance will only be suspended or delayed as opposed to prevented. A party may also be required by the contract or law to first pursue alternative actions for performance or establish none exist regardless of cost prior to being excused from performing. Or a party may be required to provide a particular form of notice before ceasing performance. On the other hand, where one party refuses to perform, the other party may be under an obligation to mitigate the effects of the event, e.g., sourcing services, materials and/or workers from elsewhere, if possible. Careful consideration should be given to the foregoing when negotiating and drafting the force majeure clause, which will allow the parties to preemptively allocate risk of loss and other obligations in the event of such an occurrence.
Material Adverse Change/Material Adverse Effect
A material adverse change (“MAC”) or material adverse effect (“MAE”) provision allows for the potential termination of a merger or financing agreement by an acquiror based on unforeseen circumstances having a significant financial or other business impact. A broadly written “provision is best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner.” In re IBP, Inc. Shareholders Litigation., 789 A.2d 14, 28 (Del. Ch. 2001) (emphasis added).
While interpretation and application of MAC clauses vary by jurisdiction and governing law, they typically require a durationally significant impact on a party’s financial condition. Short-term issues (even highly disruptive ones) are not likely to be sufficient. Given this heightened standard, it is perhaps unsurprising that there are few reported decisions in which a party successfully invoked a MAC clause, excusing its performance. In Akorn, Inc. v. Fresenius Kabi AG Inc., C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018), the Delaware Court of Chancery permitted the termination of a merger based on a MAC provision. The court held that the target company had suffered a significant financial downturn post-closing which lasted for a full year with “no sign of abating.” The court also held the target company had several regulatory compliance issues in breach of its contractual representations. The court reasoned that these company-specific issues supported finding a MAC and excusing the acquirer from performing.
Only time will tell whether COVID-19’s impact on any given individual company or industry will be of sufficient scope and duration to trigger a MAC provision. Given the implicit need for a waiting period to determine materiality, attempting to use a MAC provision to terminate an existing agreement in the immediate aftermath of such an event is unlikely to be successful. As such, in the near term, parties confronting these issues should consider the invocation of other contractual provisions or principles, as discussed herein. That being said, for similar future events, parties should discuss the desired scope of a MAC clause or exceptions thereto. Detailing what events and resulting consequences do or do not constitute a MAC including how long a party must experience a MAC under the provision can be tremendously valuable. [For further information on COVID-19’s impact on M&A activity, see Goodwin’s COVID-19 and the Impact on M&A.]
Impossibility, Impracticability, and Frustration of Purpose
In the absence of specific contractual provisions addressing unforeseen events such as COVID-19, the contract principles of impossibility, impracticability, or frustration of purpose may operate as gap-fillers to govern the allocation of risk.
The doctrine of impossibility may be used to excuse non-performance in the absence of a contractual provision providing for the same when an unanticipated, unforeseen event makes performance objectively impossible. At common law and under the UCC, which applies in the context of goods, the doctrine of impossibility has been interpreted narrowly and is often limited to the destruction of the means of performance by an act of God (e.g., natural disaster) or by law. Accordingly, successful use of this doctrine will depend on the particular facts of each case.
Economic hardship caused by a pandemic or similar event is unlikely to be sufficient on its own for application of the impossibility doctrine. But where performance is precluded or prohibited by law in response to such an event, a party may successfully invoke the impossibility doctrine. For instance, in Bush v. Protravel International, Inc., a New York court assessed whether a customer who had attempted to cancel a safari following the September 11 attacks could be excused from failing to cancel the contract according to its terms. 746 N.Y.S.2d 790 (N.Y. Civ. Ct. 2002). The court ultimately held that measures taken by the State and City governments, including their declaration of a State of Emergency in the wake of September 11, strongly supported her claim that performance of the contract had been rendered impossible for a period of time, and, thus, raised a triable issue of fact that could entitle her to relief from the cancellation penalty provision by virtue of impossibility. Id. at 793. Note, though, that impossibility may not fully excuse performance if only temporary, but could nonetheless operate to suspend performance.
Impracticability and Frustration of Purpose
Related doctrines of common-law/commercial impracticability and frustration of purpose may also apply. While these may set a slightly lower standard, they are still applied narrowly. Under common law and UCC principles, performance of a contract may be rendered impracticable when an extraordinary, unforeseen occurrence, the nonoccurrence of which was a basic assumption of contract, makes it extremely difficult or highly unreasonable to perform. Severe shortages of materials that render performance objectively impracticable may be encompassed by the impracticability doctrine. But, like with the impossibility doctrine, financial impact alone or costly supply interruptions, when alternative means for performance are available, are likely insufficient for application of the doctrine.
Distinct from the impracticability doctrine, the common law doctrine of frustration of purpose focuses less on the actual ability to perform on the contract and more on the impact on the overall objective of, or the motivations for, the contract. Similar to impracticability, there must have been an unforeseeable, supervening event, the non-occurrence of which was an assumption of the contract, but which substantially frustrates or obviates the purpose of the underlying contract as understood by the parties. The frustration of purpose must go to the core of the contract and make one party’s performance of no value to the other party.
In any case, those with existing contracts, the performance of which may be impacted by the coronavirus pandemic, should keep these doctrines in mind in the absence of a strong force majeure clause. The applicability of these doctrines will depend on what was reasonably foreseeable at the time of contract and assumes that a party could not have guarded against it. Foreseeability is also subject to change and will be fact-determinative. Indeed, attempts to rely on the impracticability doctrine based on the impact of COVID-19 with respect to contracts signed today as opposed to before the introduction of the virus are almost surely to fail.
In sum, consider the following:
- Given the narrow application of the MAC provisions and the doctrines of impossibility, impracticability, or frustration of purpose, force majeure provisions that specifically identify qualifying events are preferable for reducing uncertainty.
- The doctrines of impossibility, impracticability, and frustration of purpose should be considered as gap-fillers available when no express provision governs the allocation of risk associated with unforeseen events.
- The soundness of including “pandemic” or “epidemic” within the definition of a force majeure clause.
- Whether a force majeure clause covers related events that may result from an epidemic or pandemic, providing a potential basis to excuse nonperformance even without including “pandemic” or “epidemic.”
- Whether a party truly cannot perform because of force majeure event (to the extent a force majeure requires that) or is simply facing increased costs.
Representation and Warranty Provisions
In addition to the clauses discussed above, parties should also consider the use of contractual representations and warranties to help address the impact of unexpected circumstances. For one, use of a MAC qualifier throughout the representations and warranties section of a contract, in addition to a general MAC clause, can provide further protection to the parties assuming that phrase is sufficiently defined to cover these types of circumstances. In addition, more robust and specific representations, including those surrounding a party’s legal compliance, operational capabilities, and emergency response plans or programs associated with potential unforeseen events, can be strategically used to capture the understanding and expectations of the parties in the event of an occurrence like the COVID-19 outbreak. This is particularly true where an agreement has or will incorporate a non-reliance clause through which the parties agree they are not relying on any statements or representations not expressly set forth in the agreement.
Ultimately, in light of the coronavirus pandemic, it is important to take a close look at existing agreements with a particular focus on the provisions addressed above and keeping in mind important contract principles. This will help you determine the contours of your business relationships and the parties’ respective rights and obligations or possible limitations thereof.
When drafting or amending agreements in the future, negotiations should include a discussion of the parties’ expectations in these types of situations, including any conditional terms that the parties agree may apply before performance can be excused. Parties should also consider adding contractual protections that expressly allocate risk and responsibilities and also build in additional time for performance of certain provisions (or closing of a deal) in the event of potential disruptions. Full disclosure in negotiations and express contract provisions will clarify the legal rights and obligations of the parties and help avoid the commercial issues that many businesses are likely to face in the event of extraordinary events or circumstances. As part of this strategy, all parties should also think carefully about and discuss at the outset the types and availability of alternative means for performance. In other words, ensure that the parties have identified and prepared for a “Plan B” to help avoid a material breach of contract. Most importantly, parties should generally discuss the parties’ allocation of risk and who will bear the associated financial obligations or losses with respect to a contract resulting from pandemics or similar events. Doing so in advance can avoid contentious and costly litigation.
Lastly, even for already existing contracts, parties can discuss any potential roadblocks to performance and work through any disputes before resorting to contract termination or litigation. In the case of an on-going contractual relationship, consider formally or informally renegotiating, modifying, or amending the contract, as may be appropriate and if feasible based on your business demands. If not feasible, determine and discuss ways of either mitigating the scope of potential damages or the impact of the disruption to the other side. For those currently faced with the possibility of a non-performing party, communication is key. [See also Goodwin’s Insurance Considerations in Light of COVID-19 discussion of potential insurance coverage considerations and implications, including with respect to business interruptions.]
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Please visit Goodwin’s Coronavirus Knowledge Center, where lawyers from across Goodwin are issuing new guidance and insights to help clients fully understand and assess the ramifications of COVID-19 and navigate the potential effects of the outbreak on their businesses.