Contracts and COVID-19
It is important to consider how the coronavirus (COVID-19) may affect your business relationships. Every situation and contract will be different, requiring its own assessment and consideration of risks and how to respond.
It Could Happen to You . . .
The duration and extent to which COVID-19 will affect business relationships is unclear, but it will have an impact.
- Companies with whom you do business may experience disruptions—anywhere from supply chain interruptions to government-mandated quarantines and travel bans—that prevent them from performing their contractual obligations.
- Lenders may seek further security or assurances before proceeding with loans or become slower to approve new loan agreements or draws on existing lines of credit, thus restricting access to such funds.
- Government processes may slow as governmental agencies redirect attention and resources elsewhere or experience operational disruptions.
- Development and construction processes will be impacted—please see Impact of COVID-19 on Real Estate, Construction and Supply Contracts Alert for more details.
While these are just a few examples of how COVID-19 may impact your business, it is important to review your contracts in order to be prepared for what may arise. Before taking action under an existing contract or entering into a new one, you should consider your own legal rights and responsibilities, and those with whom you are contracting.
What is “Force Majeure”? – and Does it Apply to COVID-19?
A contract’s force majeure clause may provide one or both parties with some relief when certain extraordinary events delay or prevent performance of a party. Commonly referred to as “Acts of God,” the extraordinary events that constitute a force majeure event are rare and are not reasonably foreseeable. They typically involve matters such as war, natural disasters, governmental directives preventing performance and, potentially, global pandemics.
Force majeure clauses are found in all types of contracts, including leases, supply contracts, and commercial loan agreements. While these clauses are frequently captioned “Force Majeure,” or the term itself is used in the contract clause, that is not always the case. Instead of seeing a force majeure clause, your contract may have a clause that simply lists a number of extraordinary events triggering risk shifting or addressing performance obligations. This is where to look to determine whether your contract addresses events like a pandemic.
The first step in thinking about force majeure is to determine whether your contract(s) have such a clause. If so, you should determine whether it covers an event such as COVID-19. But even if your contract does not have a force majeure clause, that is not the end of the story.
If a Contract Does Not Have a Force Majeure Clause, Then What?
Impossibility or Impracticality
If your contract does not have a force majeure clause, certain legal principles under North Carolina law and the general common law of contracts will apply in the event unforeseeable circumstances intervene and make it impossible or impractical to perform (often referred to as the “doctrine of impracticability”). General financial hardship will not excuse performance or justify terminating the contract. Instead, there must be an intervening event that could not reasonably have been foreseen. For example, assume that a party is obligated to deliver light fixtures made in China, but imports from China are halted due to a pandemic, and it is not possible to purchase substitute fixtures from a third party (or it would be wastefully expensive to do so). If the contract does not put the risk of a pandemic or a government embargo of goods on the party responsible to deliver the light fixtures, then the party may be excused from the contract due to the doctrine of impracticability.
Be mindful that even without a force majeure clause the terms of the contract can control the outcome of a dispute over a rare event that makes performance impractical. If the parties explicitly contemplated a particular event might occur and agreed to put the risk of it on one of the parties, then that is the deal that was made and the “Act of God” occurrence will not relieve a party of its obligation to perform. While it is difficult to imagine that parties to a contract would contemplate the worldwide pandemic we are now experiencing, they may have more generally contemplated supply chain disruptions, and so a careful review and reasonable construction of the language of the contract is important.
Frustration of Purpose
Besides impossibility and impracticability, there is also a doctrine known as “frustration of purpose.” The two overlap to some degree: both involve events that were not reasonably foreseeable, and both come into play for contracts that do not have a force majeure clause or terms that put the risk of the rare event on one of the parties. The key difference is that impracticability means that it is impossible or nearly impossible to perform, while frustration of purpose assumes a party can still perform but it would be unreasonably burdensome to do so where the rare event has made the reason for entering into the contract irrelevant. For example, assume that a promoter rents a 20,000-person arena to hold a basketball tournament. If a tornado destroys the arena, the doctrine of impracticability applies and the promoter is excused from performing and can terminate the contract. But make a different assumption: if the arena is leased but the tournament is cancelled due to COVID-19 concerns, it is still possible to use the arena for basketball games, but the purpose of renting the building has been frustrated. Therefore, the promoter may be excused under the doctrine of frustration of purpose.
Steps You Can Take . . .
Every situation and every contract will be different. If you are currently operating under an existing contract, the doctrines of force majeure, impracticability, or frustration of purpose should be considered only in extreme circumstances and should not be taken lightly. Cessation of performance or termination of a contract on the basis of these doctrines is challenging, even when a party believes that a rare, unforeseeable event has occurred. If wrong, that party could be putting itself in breach.
Before finalizing negotiations and executing a new contract, taking action regarding an existing contract, or responding to another party who is seeking to take action, consider the following first:
- Review your existing contracts. In searching voluminous contract documents, it may be helpful to search for such terms as: “force majeure,” “events,” “frustration of purpose,” “impossibility,” or “impracticability.”
- Re-read contracts you are about to enter into, including the form or “boilerplate” contract language. Consider whether to add or revise a force majeure clause.
- In addition to reviewing your contracts, talk with the other parties to the contract, and learn about any potential barriers to performance they now have or may have in the future which could affect the value of their contract with you, or impact your ability to perform a contract that you have with someone else.
- Similarly, if you are a supplier or purchaser under a supply contract, consider your supply chain and make contingency plans to address potential disruptions.
- Review your insurance policies and talk with your insurance broker to determine if you have adequate business interruption insurance or other forms of applicable coverage, or if you need it.
- Talk with your lender to understand what actions it may take concerning loan closings, access to credit, or its business operations in a way that could affect you.
As the COVID-19 outbreak unfolds, we urge you to be safe and wish for the very best of health and outcomes for all. We also understand that protecting your business will be critical to you during this uncertain time. Accordingly, it’s important to understand your legal rights and responsibilities before taking any action or responding to actions taken by others.
If you have any questions related to this alert, please do not hesitate to contact a member of our litigation group or your regular Smith Anderson lawyer.
Special thanks to David Ortiz, contributing writer.