COVID-19 Update – What to Consider When Performance of Your Contract is Affected

COVID-19 is having an enormous effect on business, globally.  It is impacting the ability of organisations around the world to maintain operations and fulfil contractual obligations.  Organisations are unable to meet their commitments and are facing counterparties and supply chain partners telling them the same.  Legally, what are your rights under contracts whose performance is affected by COVID-19?

The short answer is (as it so often is!): it depends.  Mostly, it depends on what the contract says and, for cross-border contracts, which country’s law applies.

Read our client alert in which we explore, from an English law perspective, the relief from performance that may be found in the contract and where to find it.  Morrison & Foerster has already written about the comparable position in the United States.

Under English law, it’s clear that the key issue will be to understand and apply the specific terms of each contract, with the English courts looking to interpret contractual clauses by initially considering the natural and ordinary meaning of the wording used. However, there are potentially relevant clauses found in many contracts that, if worded sufficiently, may provide respite for a party seeking to avoid performance. Force majeure clauses are a common element in commercial agreements and may have been drafted widely enough to capture the COVID-19 situation or its consequences. Specific events of default (or termination events) may cover changes in financial or operational condition that have been triggered by the effects of the pandemic and parties should also consider the wording of the attempted catch-all provision, the ‘materially adverse change’ clause. 

The interpretation of these clauses will, in almost all cases, be a complicated (and often disputed) question and involve detailed analysis of the contractual terms and the factual situation before a party can determine that a clause can be relied on to justify non-performance.

Force Majeure or Frustration?

The UK is a common law jurisdiction. So any contract governed by English law requires strict performance, and there’s no automatic or implied right to claim force majeure as some sort of legal equivalent of a “Get out of Jail Free card”. As is so often the case under English law, the legal position comes down to what the contract says. A contract party whose performance or operation is adversely affected by the COVID-19 outbreak is required to perform its obligations as written in the contract, and will be potentially liable to the other contract parties for a failure to do so.

Frustration

The main relevant common law principle – the doctrine of frustration – typically has limited application to protect parties to an English law contract from an inability to perform. Frustration only applies in certain limited circumstances where performance has become impossible; it’s not sufficient if performance has merely become more difficult or expensive than originally anticipated. Moreover, the doctrine of frustration only offers limited remedies. That is, frustration results only in termination (plus recovery of monies paid under the contract before it was ended, subject to an allowance, at the court’s discretion, for expenses incurred by the other party) and the parties being excused from further performance. To qualify, an event must be unforeseen, not existing at the time of contract, have occurred without fault of either party, must either make contract performance impossible, or destroy the fundamental purpose of the contract. 

English courts have set a high bar to the use of the doctrine of frustration. It’s conceivable that COVID-19 could result in some valid claims for frustration (for example, where the contract requires performance in a country or region that is subject to a government-imposed lockdown). However, frustration ought to be seen as a fall-back or secondary option – and most parties to an English law-governed commercial contract will need to work out the extent to which they are protected by an express force majeure clause.

Force Majeure

The limitations of contract frustration as a remedy are the reason why force majeure clauses are included in contracts to provide a clearer contractual remedy. The aim of a force majeure clause is to excuse one or both parties (temporarily or permanently) from performance of the contract following the occurrence of certain events. The central principle is that a party to an agreement ought to be excused from (or entitled to suspend) performance of its obligations in whole or part upon the occurrence of unexpected events or circumstances outside that party’s control.  Contracts may also specify a right of termination if the force majeure circumstances endure (in order to avoid parties having to keep resources available over an extended period of time).

A force majeure clause (or, indeed, any other provision in an English law-governed agreement) will be assessed by the English courts in accordance with the usual (and well established) rules on contractual interpretation. In the leading case in this area (Arnold v Britton [2015] UKSC 36), the Supreme Court confirmed that, when interpreting a written contract, the court will try to identify the intention of the parties by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”. This means that the court will assess the meaning of the words of the contract in light of the following factors:

(a) the natural and ordinary meaning of the clause;

(b) any other relevant provisions of the agreement;

(c) the overall purpose of the clause and the agreement;

(d) the facts and circumstances known or assumed by the parties at the time that the agreement was executed; and

(e) commercial common sense. 

An English court would disregard not only any subjective evidence of any party’s intentions but also the parties’ post-coronavirus state of knowledge (focussing on what they intended at the time of contracting and before any expectation might have set in that the clause may need to cover a global pandemic). 

Process Issues

The party claiming force majeure usually has to comply with certain requirements to invoke the protection that the clause provides. These would usually be, at a minimum:

(a) to give notice in writing of the event and its predicted effects as soon as reasonably possible, stating the commencement date and extent of such delay or prevention, the cause and its estimated duration;

(b) to use reasonable efforts to mitigate the effects on contract performance;

(c) to resume performance as soon as reasonably possible after the removal of the cause of the delay or prevention.

The burden of proof is on the party seeking to rely on the force majeure clause, who must prove that the event falls within the clause and that non-performance was due to the event. In the current COVID-19 situation, a party may feel that it’s self-evident that force majeure applies – but, contractually, it still usually needs to be invoked by notice. Time limits would normally apply to give notice. And there is a clear line of English law cases that require that parties comply strictly with the contract notice requirements (at the risk of not being protected if they fail to do so) – so parties ought to check the Notices provision as well as the force majeure section.

Some contracts may impose a direct link between strict adherence to the claim/notification process and the right to protection, i.e., failure to give prompt notice deprives the affected party of the right to claim the benefit of force majeure.  That’s negotiable but, whatever the notice procedures in the contract are, they should be followed.  Remember that it doesn’t matter if the whole world knows about the happening of the force majeure event, it’s the service of the notice that triggers the protection.

English courts will imply a duty to mitigate an event within a defined set of force majeure circumstances – including, we must assume, events stemming from COVID-19.  In Channel Island Ferries v Sealink [1988], the English Court of Appeal said that any clause that included language referring to events “beyond the control of the relevant party” could only be relied on if that party had taken all reasonable steps to avoid its operation or mitigate its results.  If an affected party ceases its efforts to mitigate, a court may conclude that the performance obligations should re-commence.

Consequences

A force majeure clause ought to specify the consequences of the force majeure event. Usually, that would be the postponement of all affected performance requirements until the alleviation of the force majeure event – i.e., a right of suspension of performance.  But the contract may well also specify that all other services should be performed as usual.

The clause will typically provide that the force majeure event does one or more of the following – but the exact consequences of claiming force majeure ought to be checked against the contract language:

(a) excuses the affected party from performance of certain obligations under the contract;

(b) allows an extended period to perform the affected obligations;

(c) allows the affected party or the other party the right to terminate the contract; and/or

(d) exempts the affected party from liability for any delays (e.g., no LDs or service credits) or additional expense incurred.

Some contracts will contain prioritisation requirements, e.g., to require the provider to commit to devote at least equal resources to restoration of the customer’s service as to its other clients; or to commit not to re-assign key personnel to other roles pending the restoration of service. Again, these requirements should be complied with so far as possible – although it may require the Judgement of Solomon to prioritise between key customers where resources are massively constrained by COVID-19 restrictions.

Effect on Payment

Customers would normally expect to reduce payments pro rata for services not delivered due to force majeure. However, if one force majeure option is to source services elsewhere, the contract may specify that the provider is liable for payment for such alternate source services for so long as the delay in performance continues.

Link to Termination

If service is disrupted or suspended for a certain period of time (which would depend on the nature and materiality of the service), either one or both parties would have the right to terminate the contract (in whole or in part). 

The contract may have specified intermediate steps short of termination, e.g., a right to procure, or direct the provider to procure, services from an alternate source; or to remove the affected services from the scope of the agreement and equitably reduce the charges to reflect the terminated services.

Link to BC/DR

Depending on the type of arrangement, the provider may be required to implement a disaster recovery or business continuity plan. This needs to be checked. Does the contract require that a business continuity plan or resilience plan exists? If so, does it actually exist? How current is it?  Has it ever been tested? What does it require you to do – and what does it require your contract counterparty to do?

It’s generally viewed that a force majeure clause should not affect the provider’s specific obligation to provide business continuity and disaster recovery services. A reasonably common provision is: “The Supplier cannot claim relief if the force majeure event is attributable to a failure by the Supplier to comply with the provisions of the DR/BC Plan (unless such failure is also due to a force majeure event affecting the operation of the DR/BC Plan).” 

Other potentially relevant clauses

Aside from any force majeure clause, a contract may also contain other relevant provisions with an ultimate effect similar to force majeure. Such provisions could provide a party with termination or suspension rights in the event of unexpected or disruptive occurrences, such as is the case with COVID-19. For example, the occurrence of certain events (or more likely, consequences of the occurrence) could trigger termination events that had been expressly written into the contract, such as termination rights following the cessation or suspension of operations by a party. This is particularly relevant in financing agreements where events of default are often drafted broadly and designed to take effect if there is a significant impact to the borrowers’ ability to repay any financing.

Further, certain contracts may obtain a clause providing for termination or suspension in the event of a “material adverse change”. These “MAC” clauses are designed as a “sweep up” to cover termination events (or events of default) that are not expressly included in the agreement. In some circumstances, depending on the scope and looseness of the drafting of the MAC clause, this introduces a degree of uncertainty as to whether the clause has been properly triggered, and this can leave any enforcing party in the unfavourable situation of having breached the contract itself if it is later found that the conditions for a MAC have not been met. 

The interpretation of these clauses are specific to the facts of each situation and the wording of each clause. However, helpful guidance was given by the English courts in the case of Grupo Hotelero Urvasco SA v Carey Value Added SL & anor [2013] EWHC 1039 (Comm). In that case, the court found inter alia that: (i) a change will only be material if it affects a company’s ability to perform its obligations under the relevant agreement; (ii) a party cannot trigger a MAC clause in respect of circumstances of which it was aware at the outset; and (iii) in order to be material, a change must not be merely temporary.