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The Covid-19 pandemic has sent a lot of people scurrying: looking for masks, scavenging for toilet paper and re-thinking the conditions of everyday life. For businesses, one of the fundamental concerns raised by recent events is the effect of the pandemic on contractual obligations. Supply disruption, demand destruction and financial uncertainty have rendered businesses unable—or unwilling—to perform pre-existing contracts.
A worldwide pandemic seems like the quintessential force majeure event – an act of God that relieves a party from performing its contractual obligations. The reality is much more complex. The global pandemic and its attendant economic fall-out is not a “get out of contract free card” and invoking it does not automatically or assuredly erase contractual obligations.
Multiple common law doctrines, statutes and the explicit provisions of a contract determine whether a party is excused from their contractual obligations. Even if a party can establish that Covid-19 conditions excuse their performance, it must consider whether performance is totally excused or merely deferred. In many instances, these issues will be resolved in litigation that begins and continues long after the virus has receded.
Business owners and managers need to think carefully before they repudiate contract performance. This article will provide the basics of the law of excused performance, the idea that a party can avoid keeping their contractual promises without being liable to its counterparty for damages. Our goal is to provide context to those faced with decisions about contract performance.
At the risk of stating the obvious, courts take contractual promises seriously. It is a foundation of Anglo-American law – and an important facilitator of business relationships – that a party must keep its contractual promises. Indeed, a party contracting with another is generally entitled to receive exactly what was promised, whether that be a service, the payment of rent or new coat of paint on their house. If a party that is obligated to provide something fails to do so in the way the contract requires, it will be liable to the other party for the damage suffered as a result.
The rare instance when a party has an obligation to perform, fails to do so and is not liable for that failure is known as “excused performance.” The law provides few excuses to performance and overcoming the presumption that promises should be enforced is not easy. Moreover, the law seldom relieves a party of the financial obligation of paying for goods and services that have already been received. The protections the law does offer apply primarily to situations where a party seeks relief from delivering goods or services, wishes to be excused from purchasing such goods or services, or is requesting return of a prepayment and cancellation of the contract.
The occurrence of a force majeure event, or an “act of God,” is perhaps the most familiar excuse for non-performance, but the law also provides protection through the defenses of frustration of purpose, and impossibility or impracticality of performance. Statutes such as the Uniform Commercial Code (“UCC”) and the Convention on the of International Sale of Goods (“CISG”) also provide relief when conditions prevailing at the time of performance have changed radically from those existing at the time the contract was executed. While all these defenses are distinct and distinguishable, they are predicated on the existence of an unforeseen event that impacts performance.
“Two consenting adults (or companies) can agree to anything that is not illegal.” Double entendre aside, this sentence is fair generalization of the law’s view of contracts – when two parties reach an agreement, a court will generally enforce that agreement unless it is illegal. Thus, the first place to look to determine when and whether a party is required to perform some obligation is the agreement itself.
Many contracts contain provisions – known as “conditions precedent” – that make a party’s performance contingent on one or more events. If those conditions are not met, there is no obligation to perform. No excuse needed. For example, many merger and acquisition contracts and revolving lines of credit contain “material adverse change” clauses. These provisions, commonly referred to as “MAC” clauses, condition a party’s performance on the non-occurrence of a significant change, typically in the financial condition of one of the parties. The occurrence of a MAC will typically allow a party to not perform its obligations – whether that be to consummate an acquisition or continue funding a line of credit – without liability. Indeed, when a condition precedent is not met, there is no obligation to perform. These provisions can be complex and careful analysis of the condition precedent and whether it occurred is required.
Many contracts contain “force majeure” provisions – specific language that excuses performance upon the occurrence of events outside of the parties’ control. Although analysis of a force majeure excuse is dependent on the language of the agreement, it is important to understand that many courts interpret such language narrowly. Many contracts include provisions such as “performance is excused if it is rendered impractical due to conditions or events outside of the reasonable control of the parties, including but not limited to acts of war, embargo, strikes or labor unrest, political instability, or acts of God….” Although the “including but not limited to” language would suggest that all risks are covered, some courts have held that specific terms (such as the types of risks) limit general terms. In such jurisdictions, force majeure might apply only in the enumerated circumstances and not in the event of an unidentified emergency.
Even without specific force majeure language the common law excuses performance when it is rendered impractical because of “the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made….” Restatement (Second) of Contracts §261 (1981). While it is tempting to believe that contracting parties can “layer” protection by having the benefit of both explicit contractual language and common law protections, some jurisdictions view the remedies as mutually exclusive. Some state courts have held that where specific contract provisions exist that address force majeure, parties lose the benefits of the common law protections. The impact of such an approach underscores the importance of the language of force majeure clauses. Frequently dismissed as innocuous boilerplate, the language takes on increased importance as other protections become unavailable.
The seminal case that laid out the doctrine of frustration of purpose was the 1903 case of Krell v. Henry. In Krell, a party rented a room in order to have a good view of the coronation of Edward VII. When the coronation was delayed, plaintiff sought to recover the balance of the rent, while defendant counterclaimed to recover his deposit. In finding for the defendant, the court held that since an unforeseen event defeated the fundamental purpose of the contract – the viewing of the coronation – the defendant was discharged of his obligation to perform and was entitled to return of his deposit.
While the doctrine of frustration of purpose is still viable, courts impose strict limits on its use. A party claiming the excuse of frustration of purpose must establish that both parties understood and acknowledged the primary purpose of the contract. The subjective motivation of a party for entering into a contract is not sufficient to establish the defense, especially if the contract would appear to have value even without consideration of the party’s particular purpose. While the requirements necessary to establish frustration of purpose are a matter of state law, an example illustrates the concept. Consider the situation of a tenant who leases a house in Orlando in close proximity to the Disney parks with the purpose of visiting Disney World. Closure of the parks will clearly frustrate the primary goal of the tenant, but unless it can be shown that the landlord knew or had clear reason to know of the specific purpose of the lease, it is not likely performance will be excused.
Establishing the acknowledged “purpose” of a contract can be difficult. The contract recitals are among the best evidence since they are signed by both parties. However, even in “boilerplate” contracts with minimal recitation, a party may be able to establish a purpose through pre-contract communications between the parties. The terms of the contract may also be evidence of a particular purpose. In Krell, correspondence confirmed that the tenant had the use of the room for two days “but not the nights,” reinforcing that the only purpose of the room was to provide a good viewing point for the coronation.
Although lawyers—and courts—frequently use the phrases “impossibility of performance” and “impracticality of performance” interchangeably, they refer to distinct excuses to performance of a contract.
Historically, courts have excused performance of a contract when an unforeseen event destroys a unique object (e.g. destruction of a specific painting) or makes it impossible to render a unique service. (e.g. performance by a specific rock star). A party claiming the defense of impossibility must be able to establish that the subject of the contract is unique, and that substitute performance or product is not acceptable. As with other defenses to performance, the excuse of impossibility depends on the existence of a condition that was not anticipated by the parties and was outside of their reasonable control. Most significantly, the excuse of impossibility has not been construed to cover “financial impossibility” – the inability of a party to pay as required under the contract, even when such inability is caused by unanticipated circumstances beyond the control of either party.
In contrast, “impracticality” of performance is broader in scope. Contract performance is “commercially impractical” when unforeseen events “alter the essential nature of the performance.” Commercial impracticality has been used in an effort to buffer the impact of economic downturns.
It is left to the courts to determine whether an economic change “alters the essential nature of the performance” and they have not been generous in applying the defense. While the law varies by state, courts have generally required the party seeking to apply the defense to establish: (i) the existence of an event that made performance impractical;(ii) the contract was based on an assumption of the “non-occurrence” of the event; (iii) the event was not caused by a party seeking the benefit of the defense; and (iv) the risk of the event was not allocated to the party seeking to excuse performance. The vagueness of the criteria utilized by the courts suggest the difficulty of successfully applying the defense.
In making such a decision, courts will consider the timing of performance in relation to the existence of a triggering event. For example, an economic tsunami that may occur in the second or third quarter – as is possible with the current pandemic – will not necessarily be sufficient to render payment in the first quarter commercially impractical.
Statutory law has both codified and modified the commercial impracticality and the force majeure doctrines that are part of common law.
Section 2-615 of the UCC provides that performance of a contract by a seller is excused where it 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 in good faith with any applicable foreign or domestic government regulation or order whether or not it later proves to be invalid.” Article 79 of the CSIG provides similar – but not identical – protections. It excuses performance when there exists “an impediment beyond his control and that he could not reasonably be expected to have taken the impediment into account at the time of the conclusion of the contract or to have avoided or overcome it or its consequences.”
Unlike common law protections, the UCC specifies procedures to be utilized in order to invoke the provisions of Section 2-615. Section 2-615(b) provides that in circumstances where partial performance is possible, a manufacturer must allocate production in a “fair and reasonable manner.” Section 2-615(c) specifies the notice that must be given prior to suspending performance. Court decisions interpreting Section 2-615 are similar to those construing commercial impracticality and provide no bright line test as to when the excuse will be permitted. A few courts, relying on the language of Section 2-615 that relieves a seller of his obligation to perform, have held that the provision does not offer the same protections to buyers, despite language in the comments to the statutes suggesting that the language applies to both. Consequently, the UCC is no panacea to parties seeking to eliminate or defer their contractual obligations.
While the existence of an “unforeseen event” does not necessarily constitute a defense to contractual obligations, the existence of a government order limiting or prohibiting identified business activities can provide clarity in a way that acts of God do not. Common law doctrines, the UCC and many explicit contractual provisions excuse performance that is rendered illegal due to a government order or regulation. As with many other things, timing is everything.
Management of the Covid-19 virus in the United States has been a matter of state law, rather than federal law. Unlike China, where the government has issued certificates attesting that the operation of a business was suspended pursuant to government order, the situation in the United States is more complex. As of April 6, forty-three states had issued “stay-at-home” orders, curtailing the operations of non-essential businesses; seven states had not issued any orders—effectively allowing “business as usual.” Even with states issuing order, determining whether particular business operations are “essential” is a state by state determination. Compounding the issues are orders deferring legal remedies. Court directives suspending foreclosures, for example, defer a remedy for default without addressing the underlying contract provision. Relying on such pronouncements, unsuspecting tenants may defer payments, failing to recognize that penalties and interest continue to accrue.
It can also be anticipated that the process of terminating “stay at home” orders issued by states will not be uniform, with different return dates and different processes affecting resumption of normal operations.
In the absence of clear, consistent government orders, parties will be looking to the impact of the disease itself – rather than government efforts to control the disease – to justify force majeure. Such an impact may be difficult to establish. While the dangers of Covid-19 are evident, business disruption has been created because of the threat of infection, rather than the infection itself. Absent clear and consistent government orders, the courts will be left to navigate in unchartered seas to determine whether the threat of widespread infection is equivalent to the existence of widespread infection.
While it is tempting to view the Covid-19 virus as the legal equivalent of a “get out of contract free” card, such an interpretation would be rash. Parties who improvidently claim that force majeure or other doctrines relieve them of contractual obligations do so at their peril. A wrong “guess” will expose such claimants to liability for breach of contract. Even if parties can legitimately claim a defense, the fact intensive nature of the defense seems certain to lead to protracted litigation. In short, there are no slam dunks.
Businesses seeking to excuse or delay performance due to the impact of Covid-19 should view force majeure, commercial impracticality and the statutory protections as a shield, not a sword. Such defenses are useful if a party has no other choice. If circumstances are such that a party simply cannot perform his contractual obligations, the defenses may offer some mitigation. If, however, performance or negotiation is possible, that route may offer the better long-term option.
Understanding both the advantages and limits of legal protections can help parties make informed decisions and preserve relationships that might otherwise be damaged by precipitous action. In the context of contract law, there are few free rides.