COVID-19 and Force Majeure
I can safely guess with near certainty that your business is currently having to weather hit after hit with customers and employees unable to leave their home, essential supply chains drying up, deliveries being delayed, new regulatory schemes to address health and safety increasing costs, reducing revenue and delaying service provider response time.
FORCE MAJEURE
Before these last few months, most contracting parties thought of Force Majeure (if they thought of it at all) as a backup plan for when unforeseeable events and Acts of God occur making performance impossible—e.g., hurricanes, tornadoes, earthquakes, civil wars and riots, piracy and sabotage, etc. Force Majeure clauses are commonly included in contracts, but (fortunately) rarely invoked.
Today, COVID-19 is throwing out hurdle after hurdle. It’s having an adverse impact on virtually every sector of every industry. But is a disease, new or not, an “Act of God” that should alleviate parties of their contractual obligations and duties? If so, should it be automatically applied to all contracts? Only to contracts with Force Majeure clauses? Only to contracts with Force Majeure clauses that specifically address this type of situation? Or only for parties who can objectively prove that the COVID-19 has had a materially adverse effect on their ability to perform?
Avialex Law Group, LLP has been client calls asking these exact questions.
UCC & COMMON LAW PROTECTIONS
A Force Majeure clause does not always appear as a stand alone provision. There are additional common law protections that may be available in your jurisdiction that could potentially provide relief when (i) performance becomes impossible; (ii) performance becomes impractical; or (iii) there has been a frustration of purpose such that the performance of the contract would no longer accomplish the intended goal of the contract. A good example would be for a guaranteed cleaning services contract covering basketball arenas; the contract’s purpose has been frustrated with the season being delayed or cancelled; why clean an unused stadium?
MATERIAL ADVERSE EFFECT
In conjunction with any review of a Force Majeure clause or common law protections, the parties need to also consider: What is a “Material Adverse Effect?” The term “Material Adverse Effect” can mean different things to different people. Did the contracting parties define in the contract what would be considered material within the contract? Did the parties instead elect to simply look to industry norms for what is or isn’t material. That said, in today’s world we are going through a paradigm shift as it relates to how companies are doing business, which means past industry norms may no longer apply.
When defining what is material to a contract, the parties have much to consider: Will “Materiality” be a stand alone condition? Will it involve representations and warranties by the parties? What is the scope of how a Material Adverse Effect can be applied to a contract? Should the definition of “materiality” be based on systematic standards, industry indicators or contract definition? Will there be exclusions? Are contracts going to be interpreted based upon what “would” or “could” materially and adversely affect the contract’s purpose as intended by the parties?
WARRANTIES AND REPRESENTATIONS
Along these same lines, parties need to review their warranties and representations to ensure pre-COVID promises are still true. New liabilities that need to be disclosed? Are inventories and accounts receivables/payables in the same condition they were previously?
SHARING RISKS AND REWARDS
Instead of building in triggers that allow one or more parties to be excused from their contractual obligations, contracting parties can instead agree to mitigate risks and increase contractual benefits by agreeing, in advance, to split or share both the risks and rewards of an uninterrupted marketplace.
For example, earnout and milestone obligations, also known as “contingent considerations”, allow parties to increase or decrease their transaction considerations based upon success after closing or upon delivery. Obviously this takes a lot of negotiation but there tend to be some standard benchmarks used depending on the industry, product and service—e.g., revenue, net income, new product launch, hitting predetermined milestones, etc.
COMMON CONSIDERATIONS
The above contracting clauses, common law applications and considerations, while different in purpose, share some commonalities that contracting parties need to consider in advance:
How foreseeable is the interruption? Was it something that the parties could have contemplated in advance, and if so, was it addressed, and if not, why? If foreseeable, did they provide an exemption or carve out so that the event is included anyway?
What causation factors are involved in the Force Majeure event? Is the event the result of an action or inaction by a party or solely caused by outside forces?
Was the event avoidable? Could the party attempting to enact Force Majeure have taken steps at any point that could have stopped or minimized the business interruption?
If the parties need to work together or one party needs to mitigate interruptions, to what extent must each party go? Is there a defined “Due Diligence” standard? If so, is it objective or subjective? What are “commercially reasonable efforts”?
How are risks being allocated? Does one party face the majority, if not all, the risk associated with a specific event occurring? For example, is one party simply waiting to receive a product or service or are both parties working together in a joint venture and any business interruptions could damage both parties equally?
While the contract clauses, common law exemptions, and business mechanisms discussed above can help contracting parties address potential (and hopefully rare) devastating events, these mechanisms cannot just be added in boilerplate. There needs to be a holistic approach wherein the parties consider each other’s intended contractual obligations and ask which party is more likely to need to seek relief in response to an event like COVID-19. The goal should be to help each other perform under the contract instead of one party having a “gotcha” moment.
Generally speaking, most situations can and should be defined in advance even if in loose terms because different jurisdictions interpret Force Majeure, Material Adverse Effects, and common law differently. Depending on your state, you may be in a jurisdiction that will limit the applicability of a Force Majeure clause to cover only those events explicitly identified in the contract. If the parties want to include exclusions, exemptions or some form of carve out, identify the situations where you do or do not want the exclusions to apply.
NOTICE REQUIREMENTS
If your contract does have terms allowing for relief, what must the party seeking to invoke the provision do? First, look to the contract to see what, if any, notice requirements were put in place. If the parties had the foresight to address Force Majeure events and even included notice provisions for seeking relief, did they also specify whether and/or when notice is required--at the occurrence of the event? When the effect of the occurrence is felt? Or can notice be provided at any point during the duration of occurrence or effect?
The conversation does not start and end with the Force Majeure clause. The parties must also consider what their obligations are to the other party regardless of enacting a Force Majeure clause. Specifically, are there mitigation obligations? If so, what level of effort is appropriate? Does a party’s obligations terminate or is the obligation simply continued or reserved for performance at a later date?
If you are reading this article and wondering whether your company is being faced with a Force Majeure event right now, you are not alone. These concepts can be simple to state in the abstract while extremely difficult to define subjectively. Here are some examples:
Victims of an IT attack cannot claim that criminal activity is unforeseeable. Have the parties already negotiated what an acceptable recovery time would be?
Producers and suppliers of products with limited shelf lives know that delays and supply chain shortages can frustrate the purpose of an order, but when is the cause of a delay unforeseeable such that it cannot be planned for?
If your company requires a good or service that is only provided by limited sources, have you addressed whether alternative goods or services exist that would be considered of equal value such that there is an alternative way for a party to perform under a contract that will still fulfill the contract’s intent?
THOUGHTS FOR GOING FORWARD
Know your capabilities: Remote workers? Employee wellness?
Know your supply chain: Global/local sourcing? Strengths and weaknesses? Regional impact and expected timing for recovery?
Know your contracts: Termination rights, Force Majeure, Most-Favored-Company clauses, Exclusivity provisions, Triggering events, Impossibility and Frustration of Purpose, etc.?
Know your partners: Strength of relationships? Review continued credit worthiness?
Know your environment: Federal, State and local governments are all implementing laws, regulations and ordinances impacting how goods and services are delivered, stay up-to-date.
Know your insurance coverage: what policies are in place, what coverage is currently provided and what policies should be added going forward.
CLOSING
I want to close with a question, in the first quarter of 2020 COVID-19 came into our lives faster, harder and more disruptive than anyone could have expected (unless you are an infectious disease specialist). Now that we are all aware of COVID’s potential for disruption, will it ever be reasonable for someone to argue in the future that a second, third or even fiftieth outbreak is ‘unforeseeable’?
We have lived or are living through unprecedented lockdowns. What contingent considerations and exclusions should you start including in your contracts?
Now is the time where business models are being reconsidered, contractual obligations are being weighed and industry leaders are considering new plans for dealing with future Force Majeure events. How are you preparing your business?
By: John T. Van Geffen, Partner
Copyright 2020