Alert March 27, 2020

Supply Chain Contracts During a Distressed Economy: Enforcement, Rights, and Remedies

As the coronavirus continues to spread globally and as governments react by imposing quarantines on not just individuals but entire cities and regions, businesses are looking to protect themselves from the worst impacts of the pandemic. Although some supply chains remain intact—indeed, many countries have essentially forced maritime shipping lanes to remain open by forbidding crews from disembarking—other supply chains are facing serious disruption, particularly given guidance from governments to suspend nonessential on-site business operations.

Whether because of the direct impact of the epidemic on a business’s operations or because of disruptions to counterparties, the coronavirus will test whether businesses can fulfill their supply chain obligations as both buyers and suppliers. Given the pervasiveness of the epidemic and the interconnectedness of the modern global economy, this crisis is likely to impact companies with even simple supply chains in unpredictable ways. Businesses assessing their supply chains’ exposures to the coronavirus should be sure to understand their legal rights and obligations, particularly as provided by UCC § 2‑615(a) and contractual force majeure clauses.

Uniform Commercial Code and Force Majeure Basics

For American businesses, Article 2 of the Uniform Commercial Code is likely to govern a number of their supply chain contracts. Under Article 2, which has been adopted by 49 states and the District of Columbia, a seller of goods may have its performance excused where the “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 or by compliance . . . with any applicable . . . governmental regulation . . . .” U.C.C. § 2‑615(a).

However, despite the widespread adoption of the UCC, a business’s rights and obligations with respect to its supply chain contracts may not be entirely clear from the text of the UCC alone. What constitutes “impracticable” or a “basic assumption” is subject to interpretation and, thus, disagreement. Additionally, the UCC explicitly allows parties to a contract to override its default provisions through contractual force majeure clauses. Courts will look carefully at wording of a force majeure clause to see if the clause covers any particular event, such as a pandemic, though they generally read such clauses narrowly. In some cases, a force majeure clause will only protect one—but not the other—party to the contract. Moreover, many American businesses have contracts with international suppliers and customers, and such contracts often specify that they are governed by the law of a foreign territory.

Other Factors Governing Applicability and Enforcement

Another significant factor to assess in determining whether performance might be excused is the distance—in both time and place—between the performance and the extraordinary event disrupting the performance. Generally speaking, a party seeking to claim that its performance is excused would do well to consider the objective reasonableness of the cancellation given the known facts at the time of suspension or interruption in performance.

As a historical example, after the September 11 attacks, courts heard a number of cases where parties attempted to invoke force majeure clauses in response to a perceived threat of terrorism. See, e.g., OWBR LLC v. Clear Channel Commc’ns, Inc., 266 F. Supp. 2d 1214 (D. Haw. 2003). In those cases, the courts found that the actual threat posed by terrorism did not justify canceling events that were scheduled several months after September 11. The cases held that even if fears of terrorism might have diminished the economic profit from performance, heightened fears and diminished profits were insufficient to excuse performance. On the other hand, courts have held that ship captains are entitled to turn back where there is a reasonable apprehension of danger, such as from enemy warships. See, e.g., N. German Lloyd v. Guar. Tr. Co. of New York, 244 U.S. 12 (1917).

In the present context, purely economic motivations and fears unsupported by recommendations from public health or governmental authorities or will not likely be rewarded, whereas actions demonstrably necessary to protect the public health will be more attractive candidates for excusal of performance, especially where a contract excuses performance merely where performance has been rendered “inadvisable” by the extraordinary event as opposed to prevented altogether.

Options and Remedies

Should a business determine that performance is excused—or, on the flip side, that a counterparty has wrongfully claimed excuse—contract law, and in particular, the UCC, give a number of remedies to affected suppliers and customers.

Where a seller is suffering from production shortages due to unforeseeable emergencies, § 2‑615 of the UCC allows a seller to allocate its production among its customers “in any manner which is fair and reasonable,” so long as that seller also “seasonably” notifies those customers. Should a seller satisfy the allocation and notice requirements, the seller’s failure to timely deliver an order will not be treated as a breach of contract under the UCC’s default rules. Of course, the terms “fair and reasonable” and “seasonably” in § 2-615 are indefinite standards that are potentially subject to dispute.

In contrast to its treatment of sellers, the UCC generally does not permit a customer to decline a delivery of conforming goods or otherwise cancel a contract, at least not by default. Where a customer wrongfully cancels an order or refuses delivery, the seller is entitled to sue for damages. Although the seller must generally attempt to mitigate damages by reselling the goods in a “commercially reasonable manner” (another term subject to interpretation and dispute), the seller is otherwise entitled to the sale price specified in the contract. That said, a negotiated resolution is always an option in any commercial dealing, and the UCC facilitates such renegotiations by requiring no consideration for the modification of agreements that fall within its purview.

Short-Term Risks, Long-Term Outlook

Even after determining what the laws and contracts say, businesses still must decide what to do. Simply because UCC § 2-615, a contractual force majeure provision, or some other legal option is available to a business does not mean that the business should rush to exercise all of its legal rights. If there is any good news, it is that this epidemic will pass, and the world will return to normal.

As companies work to mitigate the financial downside from the coronavirus, they will also need to preserve their ongoing business partnerships that will help them grow and prosper once this crisis is over. In other words, the coronavirus epidemic will require businesses to not just manage risk but also relationships. For example, it may be the better choice for a supplier to cancel a delivery without penalty rather than seek all possible legal remedies against a struggling regular customer. Whatever the circumstance, Goodwin attorneys are ready to assist businesses affected by the current coronavirus outbreak.

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Please visit Goodwin’s Coronavirus Knowledge Center, where firm lawyers from across the globe 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.