Business contracts and COVID-19: seven topics, five surprises

By Andrew White

04-2020

Global pandemic COVID-19 has caused shockwaves in the global economy.  Businesses everywhere are reviewing their commercial contracts, to assess their rights and manage risk. 

Below I take a look at some of the commercial contract issues triggered by COVID-19.  It's impossible to cover all of these in detail, or to touch upon the countless other legal issues triggered.  However, I will share five surprises - points which may not be familiar even to those immersed in the area.

I will look at the topics generally, rather than from the perspective of a single industry sector or set of players.    

1. Business strategy

It's important to know your contractual rights, remedies and risks. And as lawyers we're committed to helping you optimise your position.  

But it's ultimately a business decision how to exercise those rights, and manage risks. And it's never been more important to focus on the bigger picture.  

In many sectors, long-standing competitors have put aside their rivalry to collaborate. Contracting parties have chosen not to enforce claims, in order to focus on practical solutions.  And statute laws are being amended to facilitate these outcomes. 

Always consider your rights in the context of what your relationships, your business sector and society as a whole, may look like once the crisis is over.   

2. Practical safeguards

With so many businesses in turmoil, and workers at all levels experiencing huge personal upheaval, uncertainty and threats to their wellbeing, it would be tempting to push some practical matters down the 'to do' list, because they feel mundane and non-essential.  

In fact, these can be crucial in safeguarding your rights.  Here are examples:  

When a contract variation is agreed - for example a postponement of rental payments under a lease, or a rescheduling of delivery milestones - record the variation in writing. 

Here's Surprise 1: Don't rely on an oral variation, even if the change has been agreed cooperatively, and is being implemented.  As a result of an English Supreme Court ruling from 2018, your oral variation could  turn out to be non-binding.

Be sure to serve notices on counterparties where the contract requires it, being meticulous about the detail, and time limits  

Be rigorous in notifying relevant third parties, where required, of the steps you're taking - this could be insurers, industry regulators, suppliers down the supply chain, lenders, shareholders, and many others

Retain written records of decisions you've taken, your efforts to find solutions, your response to the actions of counterparties, financial losses you may be incurring, and the surrounding facts - relying, where possible, on trusted public domain sources of information   

And if the business does not have the corporate 'headspace' or person power to deal with all of these, - which would be totally understandable - then ask your external advisers to help you.   

3. Force majeure - international concept, diverse rules

The basic concept of 'force majeure' - where events outside control impede performance under a contract - is widely recognised internationally.  But the mechanics, and important surrounding details - vary according to different legal systems.  

Under US law, a 'force majeure' clause is not implied into most contracts, and it is for parties to negotiate the provision.  However, a concept similar to 'frustration' is recognised in the legislation of most States.  In some European countries (such as France) force majeure is implied into contracts under its Civil Code.  But in others (like Germany) it is not, though its Civil Code enacts a concept similar to frustration.  Meanwhile, in China 'force majeure' is basically codified under contract legislation.    

At the start of any contract review, check the so-called 'governing law' clause, because that will determine the body of rules which applies in this potentially highly  confusing area.

Under English law, and this is very well known, there is no statute of force majeure, or implied term. You can only claim 'force majeure' if there's a contract clause.  Such a clause can shield you from liability for non-performance or delay, as the case may be.   But to invoke it, you'll need to show four matters:

1. that a 'force majeure' trigger event occurred, as defined in the clause

2. that its impact on your performance falls within the language of the clause (for example, that it 'prevented', 'delayed', or 'hindered' performance) - you must also show that if it had not been for the impact of COVID-19 you would have been 'ready' and 'willing' to perform

3. that the event was genuinely beyond your control - that may be obvious regarding the outbreak of COVID-19, but it may be harder to show regarding its knock-on effect on you

4. that there were no reasonable steps you could have taken to avoid or mitigate the event, or its consequences   

The business may strongly feel that it 'goes without saying' that force majeure applies.  But it's vital to read the relevant clauses closely, take account of the complex and fast-moving surrounding circumstances, and work through the four-part test above.  

Force majeure clauses, and the scenarios in which they are being reviewed, are almost infinitely varied.    

4. Mitigation of the impact

If you want the protection of a force majeure clause, you must show that you took reasonable steps to mitigate the consequences of COVID-19.   

Here's Surprise Number 2: as a matter of English law, the mitigation duty does not derive from an express clause in the contract.  Instead, it appears to be inherent in how the courts approach force majeure clauses.  

While many would assume that COVID-19 is a clear-cut force majeure trigger event, it's the failure to mitigate which could prevent businesses from relying on the force majeure mechanism.     

In one precedent-setting case, passenger ferry operator Sealink claimed force majeure when it was unable to operate services to the Channel Islands because of strike action (a defined force majeure event).  But the Court of Appeal rejected Sealink's claim, because Sealink had not shown that it had taken reasonable steps to mitigate the impact of the strike.  The Court reached this conclusion despite the absence of a mitigation clause in the contract. 

In another headline case, a seller of cotton seed expellers to a buyer in Hong Kong claimed force majeure when the Chinese supplier to the seller was unable to procure the goods because of a severe drought in the relevant Chinese province.  The buyer, Cargill, claimed that the seller was in breach of contract, and the dispute came before a very senior English court, the Privy Council. It held that, in order to defeat the Cargill's claim, the seller would need to show, not only that a force majeure event had occurred, but that it could not have obtained the same goods from another source.

Once again, steps to mitigate were considered inherent in force majeure.  There was no express clause in the contract requiring steps to find an alternative supplier.   

These and other cases illustrate that 'force majeure' is not just a matter of the trigger event but about the action a business takes in its aftermath. 

What constitutes 'reasonable steps' will vary, and will be measured at the time the obligation arises. But it may require spending money, and it will certainly require you to follow your business's corporate contingency plans, whether this entails a business continuity programme, alternative supply chain arrangements, or simply continuing to work remotely.  

If you don’t fulfil your own business's contingency plans, it will be almost impossible to show you took the reasonable steps necessary following the impact of Covid to be able to rely on force majeure.   

5. Frustration and its limits

Frustration is a free-standing legal principle under English law, and it applies without needing to be mentioned anywhere in the contract.  It will be most relevant to contracts which do not include a force majeure clause, or to oral contracts, meaning those which have not been written down.  

But it is very demanding to show frustration, and successful illustrations are quite rare.  

Frustration requires that the external event should be outside the parties' control, and not foreseeable, and also that it should make the obligation physically or legally impossible to perform, or else that it makes the contract radically different so that its so-called 'common purpose' can no longer be achieved.   

A recent example of the difficulties of showing 'frustration' arose in a dispute involving a European Union institution, the European Medicines Agency (EMA). The EMA vacated its London HQ two years after the Brexit referendum, claiming that its lease of office space was "frustrated", that the contract was at an end, and that it was therefore no longer obliged to pay rent, for the remaining 21 years of its 25 year agreement.   But an English High Court strongly rejected this.  

Had Brexit made rental payments physically impossible ? No.  Had payments become legally impossible? No.  Did the EMA lack legal capacity to pay? No.  And had the so-called 'common purpose' of the lease been frustrated? Again, no.  

On that last point, the court concluded that the EMA's purpose was to regulate European pharmaceuticals, and that the landlord's purpose was basically to generate an income stream.  

The idea that the parties shared a unifying 'common purpose', which had been neutralised by Brexit, was dismissed.  

While this was just a High Court case, the EMA abandoned a legal 'appeal' against the verdict, and the judgment is built on a comprehensive analysis of earlier Court decisions.  

Here's surprise number 3: some contracting parties like product suppliers are claiming frustration because they assert that they share a 'common purpose' with the counterparty, whose end-market for the products has been decimated. 

But, as the EMA case shows, the idea of a contract having a 'common purpose', so that performance is made pointless, is a tough argument to prove, and be prepared to push back against it.     

There could be a resurgence of frustration claims, due to the global scale and severe impact of COVID-19.  But at the end of the day, the claim of 'frustration' will remain a challenge.     

What's more, frustration is absolute in its effects. It doesn't suspend a contract temporarily, or enable the parties to adapt it. Frustration quashes the contract altogether, from that moment on.  Do you really want that? Many contracting parties don’t. They favour preserving their long-term relationships for when the crisis is over, rather than having to 'start from scratch', which is what the frustration mechanism would force them to do.

6. Economic downturn and contracts  

'Force majeure' and frustration traditionally operate where performance is physically or legally impeded.  But neither doctrine is applicable where a contract has become more expensive to perform, or for that matter uneconomic. 

In the aftermath of the financial shocks of 2008-9, a purchaser of an executive jet pulled out of its purchase contract, and demanded a refund of its advance deposit, arguing that the uncontrollable downward spiral of the world economy meant it could rely on a force majeure clause.   

A High Court judge categorically rejected the purchaser's argument

In another case from around the same time, a developer declined to start work on a property development, because it claimed that in the prevailing economic climate it would not be able to reach even the minimum sales targets for residential units which had been agreed in the contract.  The developer argued that it was not in breach because the contract had been 'frustrated' by the economic downturn.  

The High Court rejected this argument as a matter of principle.  in addition, evidence in court showed that the prospect of a downturn was foreseen by the parties when the agreement was entered into   

The common theme of such cases provides Surprise Number 4: economic change - however drastic, damaging or disruptive - is ordinarily not considered 'force majeure' or frustration.

In the context of COVID-19, a well-recognised example is where a customer's end-market for goods or services has vanished, but it is still obliged to purchase minimum volumes of supplies under a long-term supply contract.  The customer cannot ordinarily claim force majeure under that supply contract.  

Unquestionably It's onerous for it to be locked into a contract commitment to purchase goods which it cannot sell.  But the solution lies in a commercial renegotiation, not in the law of either force majeure or frustration.

7. A holistic approach to contract reviews

While force majeure and frustration issues have understandably attracted a lot of attention, it is important to apply a 'holistic' approach to contracts, and to review contracts as a whole when assessing your rights and remedies.  In many sectors there are specific industry-shaped clauses which can apply (for example, the obligation under many logistics and shipping contracts only to transport to a "safe" destination).  More general clauses which will be relevant include the following: 

  • hardship clauses, entitling suspension of performance, or variation of terms, linked in expressly to adverse economic changes
  • Material Adverse Change clauses (known as 'MAC' clauses), which are found in many lease, finance and business sale agreements, and which permit walkaway in certain circumstances
  • compliance with laws clauses, under which a party is released from obligation because it would otherwise be in breach of relevant law (for example on health and safety) 
  • dual-sourcing or multi-sourcing clauses, which entitle a customer to appoint other suppliers if its exclusive supplier cannot maintain performance

There are so many other potentially relevant clauses. So here's Surprise number 5:  these types of clauses could provide your business with rights, like suspension or termination rights, which are at least as far-reaching as the remedies provided by a force majeure clause.       

A related tip is this:  if you are using software tools to help interrogate large volumes of contracts, the holistic approach is especially important.  If the software is instructed to search for words like 'force majeure', 'disease' or 'pandemic', but is not directed in accordance with a wider, holistic perspective, legal rights which are available could be missed. 

Conclusion and further support

In summary, there's no 'right answer' to the massive contractual challenges of COVID-19.  Businesses need to keep the fast-moving environment under constant review.  And they should strive for coherent, consistent strategies, which are implemented flexibly and in an internally joined-up way.

Many of my Bird & Bird colleagues have published guidance on the COVID-19 section of the firm's website to assist you.  

For example, you can take a look at  the Cross-border Overview of Contract Issues, and other content under the Contract tab, as well as a range of content from many international sector and practice groups.  

I hope that this content, and the content produced by my Bird & Bird friends and colleagues, provide you with added information, tools and insights at this critical time.  

Please don't hesitate to approach us if you need further support.  Take care and stay safe. 

2 April, 2020