The current Covid-19 pandemic and the ensuing economic disruptions have created havoc for many businesses. As the fallout continues, companies might be faced with uncertainty about whether they can meet their obligations under certain contracts, about the ability of their contractual counterparties to perform, or both. This situation should compel companies to think about the rarely considered concept of force majeure and related contract defenses.
This alert addresses issues relating to force majeure clauses in commercial contracts as well as the related contract doctrines of impossibility of performance, impracticability of performance, and frustration of purpose. It also discusses some additional contract law theories that might be helpful, as well as practical considerations for how to deal with these issues in different circumstances.
This discussion is necessarily generic because these issues depend on the specific terms and circumstances of the applicable contracts. Further, these issues most likely will be governed by state law, which could vary in how certain legal concepts are interpreted and applied.
FORCE MAJEURE CLAUSES
A force majeure (FM) clause is a contract provision that allows a party, in certain specified circumstances, to discontinue or delay further performance and avoid further liability to the other party. It is a contractual allocation of risk regarding events specified in the provision that would impact a party’s ability to perform. If the specified event occurs, the risk is allocated to the obligee and the obligor’s duty of performance is excused or modified. The scope and effect of an FM clause obviously depends on the language of the particular provision in issue. An FM clause is subject to normal principles of contract interpretation.
FM clauses typically specify certain events with particularity, but they also may include non-specific “catch-all” language such as “acts of God,” “natural disasters,” or “similar events that are beyond the control of the impacted party.” Specified events may include:
- Natural phenomena such as flood, fire, or earthquake;
- Medical epidemics (potentially applicable currently);
- War, invasion, civil unrest, or other hostilities;
- Terrorist acts or threats;
- Government orders, laws, or declared emergencies;
- Power outages;
- Labor strikes or work stoppages.
Because an FM clause is part of the express terms of the parties’ contract, an FM clause should provide a stronger legal basis for relief versus the more general contract doctrines discussed below. As a practical matter, however, courts are likely to narrowly construe the language of FM clauses because such clauses have the effect of abrogating other provisions of the parties’ contract. Courts may apply some or all of the following concepts in interpreting the reach of FM clauses:
- The event or condition generally must:
- Arise after the contract was made;
- Be extreme in effect, and cause unreasonable and unbargained-for difficulty in performance; and
- Not have been reasonably foreseeable.
- The risk of loss due to the event or condition was not otherwise addressed in the contract.
- The cause of the event or condition must have been beyond the reasonable control or fault of the party seeking to invoke the clause.
- The exercise of prudence, diligence, or due care could not have prevented the event.
- Generally, increased expense or economic hardship of one party alone is not sufficient to invoke an FM clause – e.g., decline in market demand for a product or service, change in competitive circumstances, increase in the cost of performance, pricing changes, etc.
FM clauses also may have express exclusions – events that might impede a party’s ability to perform but that in a particular contract are foreseen and excluded. This is consistent with the concept that the parties may allocate risk of future events as they see fit to negotiate and state in the contract.
Significantly, not all FM clauses authorize or allow the same type of relief. The particular relief usually is specified in the clause, and it may not totally excuse the obligor’s performance. Potential relief may, depending on the specific language, include:
- The right to terminate a contract;
- Discharge of certain types of performance obligations;
- Extended time for a party to render performance;
- Ability to renegotiate price or pass along increased costs to the other party.
Finally, be aware that language having force majeure-like effect – to excuse or allow delay of a party’s performance under certain circumstances – might appear in contract provisions other than a designated “force majeure” clause. Thus, it is important to review carefully all contract provisions and not just look for a provision with the title of “Force Majeure.”
OTHER POTENTIALLY APPLICABLE CONTRACTUAL DOCTRINES
Impossibility of Performance
Some states recognize that a contracting party’s obligations may be discharged if that party’s performance is rendered impossible by an intervening event outside that party’s control and not due to the fault of that party. In Georgia, for example, the doctrine is codified by statute: “If performance of the terms of a contract becomes impossible as a result of an act of God, such impossibility shall excuse nonperformance, except where, by proper prudence, such impossibility might have been avoided by the promisor.” O.C.G.A. § 13–4–21. Other states apply a similar common-law rule.
Common concepts courts use in evaluating this defense include:
- Whether the intervening event was foreseeable;
- The extent to which the event rendered performance truly impossible or merely more difficult or more expensive;
- Whether the non-performing party could have protected against the risk of harm by prudent planning or foresight;
- Equitable considerations as to which party was better situated to bear the risk.
The test for impossibility is an objective one, and it is a fact-intensive inquiry. Impossibility is a defense to a claim for breach, so the party asserting impossibility bears the burden of proof. Most commentators observe that this defense will rarely be successful, and a contractual FM clause usually provides a stronger argument. For example, this defense did not prevail in many cases where a party alleged that the 2008 financial crisis constituted a supervening event that rendered that party’s contract performance impossible.
Impracticability of Performance
This defense is like impossibility, but it is a subjective inquiry that focuses on the particular circumstances of the contractual relationship in question. The Restatement (2d) of Contracts describes the central inquiry as “whether the non-occurrence of the circumstance was a ‘basic assumption on which the contract was made.’” Again, courts will focus on whether one party or the other may be said to have assumed the risk of the occurrence of the subsequent event or condition. The foreseeability of the event or condition is also significant because if it was unforeseeable, that suggests the parties considered that its non-occurrence was a “basic assumption” of the contract. Further, the occurrence of the event or condition must not be due to the fault of the party asserting this defense. The UCC contains a similar defense of commercial impracticability in section 2-615(a).
The defense applies, at least in concept, broadly to all types of impracticability. The most commonly recognized scenarios where impracticability might arise include death or incapacity of a person necessary for performance, supervening destruction of a specific thing necessary for performance, and supervening prohibition or prevention by law. The first two scenarios would not apply to the current virus crisis, but the legal prohibition factor might apply in circumstances where a government orders that certain businesses close or that people be quarantined in their homes. Moreover, there is no reason why the existence of a public health emergency of the type we are now experiencing, even without official government prohibitions, could not be a legitimate basis for this defense, and indeed there are some older cases recognizing the defense based on outbreaks of contagious diseases.
Finally, it should be noted that the defense of impracticability is not necessarily absolute, and it may apply only so long as the event or condition makes performance impracticable. Relief from performance may apply only during the period of the disabling event or condition. Thus, the impracticability defense might not allow a party to terminate a contract and may only allow it to delay or defer performance. Of course, if the contract must be performed within a certain time and the disabling event continues for the entire contract period, the contract would be subject to termination under this theory.
Frustration of Purpose
This doctrine applies in situations when a change in circumstances makes one party's performance virtually worthless to the other, frustrating his purpose in making the contract. The key concepts are similar to those discussed above regarding impracticability:
- As described in the Restatement, “when 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 the circumstances indicate the contrary.”
- Foreseeability is important because if the change in circumstance is foreseeable, the non-occurrence of that event is less likely to have been a “basic assumption” of the contract.
- The change in circumstance must not be the fault of the party seeking discharge.
The frustration doctrine is distinct from the doctrines of impossibility and impracticability because there is no impediment to performance by either party.
The frustration of purpose defense, however, requires a high standard of proof. The purpose frustrated must be the primary purpose of the contract, such that without it the transaction would have made little sense. The frustration also must be substantial, not just a change that makes the contract more difficult or less profitable for the party advancing the argument.
OTHER CONTRACT PROVISIONS AND DOCTRINES THAT MIGHT PROVIDE BENEFIT
Although an FM clause is what most people think of to address this type of unforeseen crisis, there are other contract provisions and doctrines that should be considered as potential ways to avoid liability or interpret an agreement more favorably under the circumstances. They are discussed briefly below.
Best Efforts Clause – Some contractual duties might be subject to a best efforts clause rather than a stricter or more absolute performance standard. A best efforts standard would be more forgiving in the case of a crisis like this one because if the party is doing all it reasonably can under the circumstances, it likely will be deemed to have met its contractual obligation even if those efforts are not as effective as they would have been under normal circumstances.
Doctrine of Substantial Performance – Even if you cannot avoid a contractual duty, the doctrine of substantial performance may provide some protection. If a party has substantially performed and provided the other party with the fundamental benefit of its bargain, minor deficiencies in performance may be excused or at least not provide a basis for the other party to declare breach.
Right to Terminate Certain Contracts – If there are contracts as to which you might want to cease performance, you should analyze whether those contracts give you a right to terminate. Some contracts may allow at-will termination, but there typically are notice provisions with which a party must strictly comply. For those that do not allow at-will termination, consider whether there are grounds to declare the other party in material breach which, if not properly cured, would allow for termination.
Implied Covenant of Good Faith and Fair Dealing – This doctrine can apply in at least two relevant ways. First, it can serve to limit the exercise of a party’s discretion in the manner of its performance to avoid opportunistic behavior and avoid taking advantage of the other party in a way not contemplated at the time of contracting. Second, it can be a “gap-filler” to guide the interpretation of other contract terms to address situations not expressly addressed in the contract. For example, this doctrine might be argued to limit discretionary price increases or provide a basis to demand renegotiation of terms that were intended to vary during the course of the contract. It cannot be used to add to or vary existing contract terms.
Finally, here are some practical considerations to keep in mind regarding these issues:
- Review your key commercial, supply, and operations contracts now. Determine if they have FM clauses and what those clauses say. Also identify other relevant provisions like limitations of liability and dispute resolution requirements.
- Look for other contract provisions that might provide relief from performance. Many commercial leases, for example, have a “damage and destruction” clause that provides rights for the tenant in the event of certain casualty losses, and an FM event might qualify.
- If you want to invoke an FM clause or otherwise take a position that your performance has been rendered impossible or impracticable, you should give notice promptly. FM clauses may have their own notice requirements and deadlines. Explain in detail the circumstances supporting the applicability of your position.
- If you receive notice of default under a contract that has a potentially applicable FM clause, or if one of the contract doctrines discussed above might apply as a defense to the default, make sure to promptly and specifically assert those defenses in response to the default notice. In addition to avoiding a claim of waiver, raising these issues immediately could lead to additional time to cure or open the door to other negotiated resolutions.
- If you can partially perform, and there is no clear basis under the FM clause or otherwise to terminate the contract, you should make all reasonable efforts to perform to the extent possible. This will put you in a better light if litigation ensues, and it also could mitigate any damages in the event a court determines that performance was not excused and there was a breach.
- If there is a significant contract you are concerned you might be violating, consider seeking a declaratory judgment that an FM clause authorizes relief or that the impossibility, impracticability, or frustration of purpose doctrines apply. If you can continue performing, seeking declaratory relief likely would avoid potential liability for breach. Also, threatening or instituting a declaratory judgment action might provide leverage to renegotiate the contract in question to obtain more favorable terms.
- If there is a crucial contract that you are concerned might be terminated by a counterparty, consider seeking a TRO or preliminary injunction to require the counterparty to continue performance. Again, even the threat of this type of action might allow you to negotiate more favorable terms.
- If you consider litigation make sure you are aware of the potential consequences of the public positions you take. For example, if you take a litigation position that the virus crisis triggers an FM clause in one contract, a counterparty to a different contract might try to use that position against you to trigger an FM clause in that other contract.
- Finally, consider any insurance coverage options that could conceivably apply. Give notice promptly if there is any chance coverage might exist. It should be noted, however, that many CGL policies themselves have FM riders or exclusions that are very specific, so policies must be analyzed with great care.