Contractual Considerations Following COVID-19
20 March 2020
The COVID-19 epidemic presents a host of challenges for businesses, the degree and duration of which remains to be seen. Businesses are faced with declining confidence in the market, significant supply chain disruptions, sharp currency fluctuations, mandatory or voluntary quarantines and restricted travel, all of which create problems for subsisting contracts and ongoing contract negotiations. It is likely that a contracting party’s ability to discharge their obligations will be impeded by these challenges and as such there are a number of contractual considerations to be undertaken to identify the business risks arising from COVID-19. Below are some practical steps businesses can take to mitigate the impact on their business together with consideration of the contractual provisions that may be of assistance.
1. Identify at Risk Resources, Services & Customers
Businesses should conduct a review of their key resources, services and customers to identify those which may be at risk and those that will be more heavily relied upon as a consequence of COVID-19.
Whether or not those resource and services will be impacted, will depend upon a range of matters such as whether the subject resources are stored or delivered via a location which is subject to travel restrictions and the location of relevant employees and any quarantine restrictions imposed upon them. Demand within the market may result in a drop off of key customers.
Once identified, businesses should consider what internal procedures are in place or could be arranged to navigate this disruption. The first steps should include appointing personnel to monitor the risk. Opening a dialogue with key suppliers to ascertain what measures they can take to limit disruption will help assess the high level impact on the business. Can the customer profile be diversified? This gathering of information shall inform the subsequent planning with actions prioritised appropriately. Additionally, business continuity plans should be dusted off, revised and revisited throughout the epidemic.
2. Contract Review
Once the key resources, suppliers and customers have been identified, the relevant contracts should be reviewed to determine what contractual rights may be available. The law in some countries will excuse a party where they are prevented from discharging their obligations under a contract, if prevented due to circumstances beyond their control, such as a natural disaster. However, there is no such concept within the laws of Northern Ireland (nor in England and Wales).
A party unable to discharge its contractual obligations would be in breach and unless there are adequate provisions within the contract, liable to pay damages for such breach. Contracts may even provide for the payment of liquidated damages owing to a breach. Examination of liability limitation clauses will be required to ascertain the extent of exposure. As such, it is important that businesses quickly address what solutions contracts contain and in absence of same, whether common law can assist. Potential solutions will now be addressed in turn.
3. Force Majeure
Owing to the limited remedies available to contracting parties under common law when a contract becomes impossible to perform within this jurisdiction, most contracts contain what is known as a force majeure clause. The purpose of a force majeure clause is to excuse a party’s non-performance or permit suspension of performance of their contractual obligations in certain circumstances. This will help avoid the risk of the other party terminating the contract due to non-performance.
Careful examination of the relevant force majeure clause will be required to assess whether COVID-19 will fall within the contract definition of a force majeure event. COVID-19 will not be expressly referenced within any such clause, however it may fall under the force majeure event description if it has been widely drafted. Whilst each contract will require review on a case by case basis, it is common to see wording within the definition of force majeure event that makes reference to an epidemic or pandemic or action taken by a government or public authority, which would align with the circumstances presented by COVID-19.
Relief in respect of force majeure clauses are quite often limited to those events that were not reasonably foreseeable. Therefore, those contracts entered during the course of the COVID-19 pandemic will not be able to avail of any relief afforded by the force majeure clause, as it was a known risk at the time the contract was entered.
In order to successfully rely upon any available force majeure clause, the contracting party will have to establish causation that the force majeure event has prevent or substantially hindered performance of the contract. The standard of “hindrance” applied will be subject to the drafting of the force majeure clause, however it is unlikely that the drafting will permit for circumstances were performance has simply become difficult. The more likely standard is that performance has been prevented directly as a result of COVID-19. For example, non-performance of on-site services owing to government imposed lock-down will clearly prevent the performance of a contract and the causational link will be satisfied.
Should it be determined that the relevant force majeure clause will apply to COVID-19 and the circumstances of the contracting party, the conditions attaching thereto should be reviewed. Notice requirements and a duty to mitigate the effects are commonplace. Quite often non-performance under a force majeure clause is subject to a time period, such as three months, and thereafter the parties are provided a right to terminate. As such, it is important the contract terms are reviewed in full. It may become necessary to have without prejudice discussions with the counterparty to determine whether a further extension can be agreed in light of the ongoing pandemic.
4. Material Adverse Change
In circumstances where the business cannot rely upon a force majeure clause, there may be alternative provisions within the contract that may offer some assistance. Again, subject to a review of the contract, a “material adverse change” clause may act as a shield against breach of contract. Typically, such clauses provide an option to terminate or suspend obligations of performance owing to a material change in the business. As with force majeure, whether or not COVID-19 will constitute a material adverse change event will depend upon the definition provided. The contracting party wishing to rely upon a material adverse change clause should become familiar with the conditions and notice requirements of the clause, to ensure the relief sought is not thwarted owing to non-compliance with the conditions.
5. Price Adjustment Clauses
Price adjustment clauses are more likely to be found in medium to long term contracts. Businesses may find that COVID-19 will trigger a price review mechanism within the contract, to help redress increased costs they face. Before engaging any available price review mechanism, the businesses will have to weigh the commercial risk of destabilising the contract relationship in an uncertain market against the risk of proceeding with the contract upon the current price terms.
If the contract does not contain a force majeure clause, or COVID-19 does not fall within the contract definition of force majeure, the common law doctrine of frustration may discharge the contract obligations. The doctrine of frustration provides that a contract is frustrated when something occurs following formation which would render it impossible to fulfil the contract. There are limited statutory remedies should frustration cause any loss.
Frustration is rarely recognised due to the high threshold applied following a vast body of case law on the subject. Whilst a consistent test has not been applied throughout the case law, it is clear that frustration can only be invoked in the most narrow of circumstances. Any assessment of whether frustration will apply will include consideration of:
- whether the event occurred after the contract was formed;
- whether the event is so fundamental that it would be regarded as striking at the root of the contract and the result is entirely beyond what was contemplated by the parties when they entered the contract;
- it is not owing to a fault by either party; and
- it renders further performance impossible, illegal or makes it radically different from that contemplated by the parties at the time of the contract.
This high threshold may be satisfied in some contractual arrangements owing to the complications of COVID-19, for example performance of a contract requiring travel to Italy, which is subject to a state-imposed lockdown. Businesses which find that their contract has not been “frustrated” to this same extent, will not be able to avail of the doctrine of frustration.
If a contract is no longer commercially viable, businesses may wish to consider their termination rights to stem the flow of any further loss. Some contracts provide for termination for convenience, subject to determined notice periods. However, businesses should be wary of any claw-back clauses which may be triggered on foot of early termination. In addition, there may be approaching break clauses to be mindful of, which should be diarised accordingly.
8. Ongoing Negotiations
In the event that businesses are currently negotiating contracts, the following should be considered before proceeding:
- review of the risk to the business for breach of contract owing to COVID-19;
- the term should be measured in length;
- force majeure clauses will not be of any benefit in respect of default arising out of COVID-19 as they are foreseeable at the time of contract;
- inclusion of an appropriately drafted material adverse change clause;
- inclusion of price review mechanisms; and
- express provision for suspension of obligations or termination owing to events arising from COVID-19.
It is clear that the impact of COVID-19 will apply differently to each business. Likewise, the response and redress available within contracts will require review on a case by case basis. Nonetheless, early assessment of the risks will be key in identifying material contracts and informing the response thereto. Proactive businesses conducting contract reviews at the earliest opportunity will be able to identify potential solutions to the challenges faced and seek the requisite advice to help set-off any loss.
If you have any queries please contact the Commercial Law team at Carson McDowell for further information.
*This information is for guidance purposes only and does not constitute, nor should be regarded, as a substitute for taking legal advice that is tailored to your circumstances.