CONTRACT OBLIGATIONS AND FORCE MAJEURE PROVISIONS IN THE WAKE OF CORONAVIRUS (COVID-19)

Posted: April 13, 2020 | News

The COVID-19 pandemic has severely affected the ability of businesses in California and around the world to meet contractual obligations. Within a short time after the World Health Organization (“WHO”) declared COVID-19 a “pandemic,”[1] government entities around the world began imposing unprecedented restrictions on travel, large gatherings, restaurant food service, and shuttering of many businesses across all economic sectors, schools, and sports events. The governors of forty-two states, the District of Columbia and Puerto Rico have issued so-called “stay-at-home’ orders advising residents to remain indoors except to perform essential work, duties, or chores. Business interruptions and cancelled events multiplied quickly due to restriction on large gatherings, stay-at-home orders, and pandemic fears, resulting in impeding the ability to manufacture, distribute, and sell their products and services. As a consequence of these restrictions on businesses and gatherings, which make it impossible or very difficult for parties to fulfill contractual duties, many contracting parties are increasingly looking to contract language for potential excuses for nonperformance, such as “force majeure” provisions or other legal doctrines.  

            Businesses should affirmatively consider the business and legal risks that the COVID-19 pandemic poses to ongoing business operations and proactively take steps to mitigate those risks, assess the ability of the business to avoid contractual obligations without liability, and assess the availability of insurance to cover losses or liability. Taking such proactive steps can help a party asserting a claim of “force majeure” to prove it took reasonable actions to avoid business interruption.

What legal mechanisms are available to excuse a party’s non-performance of contract obligations when extraordinary events prevent fulfilling its contract obligations, and how can we expect them to fare in the courts?  What business and legal strategies should businesses pursue?

1. LEGAL RIGHTS
2. Force Majeure

Courts look to several issues when considering the applicability of a force majeure event:

(a) whether the event qualifies as force majeure under the contract; (2) whether the risk of nonperformance was foreseeable and able to be mitigated; and (3) whether performance was truly, objectively impossible.

The first step is to look to explicit contact language relating to “force majeure” or related

legal doctrines. Where the contract explicitly covers an event, those terms will usually control. Unlike other states, however, California courts may consider an event that is not explicitly listed as a “force majeure event” if it is “unforeseeable at the time of contracting.”[2]

1. Does the Event Qualify as a Force Majeure Event under the Explicit Contract Provisions or Otherwise?

We first consider cases where the contract explicitly contains a force majeure clause that covers an event, such as a “pandemic.” Force majeure clauses are contract provisions that excuse a party’s nonperformance when “acts of God”  or other extraordinary events prevent a party from fulfilling its contract obligations.[3] In California law, the principle is codified in Civil Code § 3526: “No man [or woman] is responsible for that which no man [or woman] can control.”  Further, Civil Code § 1511(2) provides that the performance of an obligation is excused “when it is prevented or delayed by an irresistible, superhuman cause or by the act of public enemies of this state or of the United States, unless the parties have expressly agreed to the contrary.”

The initial and primary focus is on whether the force majeure clause at issue covers the type of event a contracting party claims is causing its nonperformance. Force majeure clauses are usually interpreted narrowly, so for an event to expressly qualify as a force majeure event under the contract the court will examine the contract language carefully. Fortunately for companies seeking to excuse nonperformance of a contract obligation, the classification of COVID-19 as a “pandemic” by the WHO should trigger a force majeure clause that expressly provides for “pandemics,” “epidemics” or other “viral outbreaks.” If the contract explicitly covers pandemics, government travel bans, or government declarations as a force majeure event, the courts will move on to the next step in the legal analysis.  By the same token, some clauses explicitly exclude a “pandemic” as a force majeure event. In that case, the matter is settled and the pandemic itself does not qualify (though one or more common law defenses discussed below may qualify). Subsequent to the outbreak of the pandemic, some contracts have been drafted to expressly declare that  a “pandemic” does not qualify as a force majeure event – perhaps because the contracting parties recognized a pandemic was, at the time of drafting, not unforeseeable.[4]

Apparently, no California published case has considered whether a pandemic or contagion qualifies as a force majeure event or other ground for excusing nonperformance. The unique facts of each case and each industry or business will determine the result.

Second, unlike many other states, California law recognizes a non-listed event can still qualify as a force majeure event within a force majeure provision, if it is “unforeseeable at the time of contracting” and qualifies as an “irresistible, superhuman cause” at the time of contacting. See Autry v. Republic Productions, 30 Cal.2d 144 (1947). When there is no applicable contract language specifying any force majeure effect, California contract law has nonetheless recognized an excuse for nonperformance when one party’s performance is made impossible or impracticable by intervening and unforeseeable events despite any language in the contract. This equitable protection is codified in provision quoted above, Civil Code 1511(2).

2. Was the Risk of Nonperformance Foreseeable and Able to Be Mitigated?

Even if a party can surmount the first requirement, it cannot invoke force majeure if it

could have foreseen and mitigated the potential nonperformance. California courts hold that force majeure is the equivalent of the common-law defense of impossibly (discussed in more detail below), such that the inability to perform a contract obligation is excused due to an “unforeseeable event” that is outside the parties’ control.[5]  A party to a contract seeking to invoke force majeure must show “that, in spite of skill, diligence and good faith on his [or her] part, performance became impossible or unreasonably expensive” due to the force majeure event.[6] 

In addition, the party seeking to invoke force majeure must also prove that the force majeure event was the proximate cause of the party’s inability to perform.[7] That is, the pandemic and attendant government closures and restrictions must have caused the inability to perform, not other circumstances.           

A party’s performance will not be excused where the event preventing performance was expected or a foreseeable risk at the time of contacting. That said, even if the event was unforeseeable, courts still will assess whether the “nonoccurrence” of the event was a “basic assumption… on which the contract was made.”[8]  For example, contracting parties enter into the contract assuming that the subject matter of the contract will not be destroyed. On the other hand, it is not a “basic assumption’ that existing market conditions or the financial situation of the parties will not be adversely affected by market conditions.[9]  As a result, mere market shifts or financial inability to perform generally do not constitute “unforeseen events,” the nonoccurrence of which was a “basic assumption” of the contract.

How do these principles apply to COVID-19?

Recent government regulations intended to contain the pandemic of COVID-19 may make it easier to invoice a force majeure clause not previously triggered by the virus itself. Government restrictions on travel, movement and large gatherings have resulted in widespread event and travel cancellations, with an impact on scheduled events, restaurants, airlines, venue rentals and sport and entertainment sectors.[10]  Businesses may be able to invoke force majeure clauses to excuse contract nonperformance caused by these restrictions, if the clauses under examination enumerate government orders or regulations that make performance impossible; or if the legal restrictions that cause the closures can qualify as an unforeseeable, irresistible, superhuman cause.

This does not end the court’s analysis, as a contracting party seeking to invoke force majeure must still prove the inability to mitigate, along with the impossibility of performance.  Consequently, businesses should closely monitor COVID-19-related restrictions, closures, and losses and their impact on contractual performance--and take and document all reasonable steps to mitigate their effect on business operations.

A party seeking to apply force majeure principles must show that it made sufficient “reasonable” efforts to mitigate or reduce the impact of the force majeure event, such as seeking other service providers, vendors, or alternative means of performance. As an example, a drilling company sought to be excused from its drilling contract when it was unable to obtain tools needed to do the work because its supplier was on strike. Even though strikes were listed as among the force majeure events that could excuse performance, if the other tests were met, the court found that the company could and should have procured the necessary tools from an alternate supplier. That the alternate supplier would have cost the company greater expense, did not excuse the failure to mitigate because the company had failed to show that the additional expense or other methods were “extreme or unreasonably difficult.”[11]

3. Was Performance Objectively, Truly Impossible?

In general, parties to contracts assume the risk of their own subjective inability to

perform their contractual duties unless the contact specifies otherwise.[12] Accordingly, courts apply an objective assessment of whether performance sought to be excused is objectively impossible or impracticable; whether the performance is subjectively beyond a party’s individual capacity is irrelevant.[13]  In a concise statement of the distinction between subjective and objective impossibility, California courts consistently hold that the inability to perform “must consist in the nature of he thing to be done and not in the inability of the obligor to do it.”[14]

To take an example of rejection of the impossibility defense, a tire store proprietor leased space for his tire store. However, the outbreak of WWII led to government restrictions on the sale of new tires such that performance was impossible. The California Supreme Court disagreed, holding that the restrictions were not wholly unforeseeable because the contract was entered into when the nation was still debating entry into the war; and because a part of the debate focused on the likelihood of rubber products and other civilian uses being diverted to military use. Further, the contract still had value despite the limitation because the seller could still sell some tires. 

Thus, businesses seeking to excuse nonperformance under a contract on grounds of force majeure, should highlight the impact the pandemic and attendant government restrictions have on an industry-wide basis, not merely on their own individual business.  The disruption of many supply chains and other vendor shutdowns may bolster the argument that the inability to perform is due to “the nature of the thing being done,” even if they do not directly disable the contracting party from performing.

2. Excuse for Nonperformance Based on Impracticability and Frustration of Purpose

Even if a contract has no force majeure clause, or if performance is not strictly

impossible, a business should consider common law legal doctrines of impracticability and frustration of purpose.

Unlike many other states such as New York, California courts may excuse performance where it is impracticable, or if the event in question has completely “frustrated” the purpose of the contract.[15]  It is fair to expect that the COVID-19 pandemic will require courts to rule on pleas to liberalize the doctrines of impossibility, impracticability, and frustration of purpose.

The long-standing doctrine of impracticability is closely related to impossibility. While California courts require objective impossibility for force majeure clauses, courts also hold that “impossibility as excuse for nonperformance of a contract is not only strict impossibility but includes impracticability because of extreme unreasonable difficulty, expense, injury or loss involved.”[16]  To be clear, however, the California Supreme Court has held that the mere fact that performance under a contract involves greater expense and hardship than anticipated does not excuse the obligation. Rather, the party obligated to perform must establish that there exists “extreme and unreasonable difficulty, expense, injury or loss involved.” Businesses seeking to excuse nonperformance should document the magnitude of the extreme and unreasonable cost or futility of performing due to the loss of business caused by the pandemic or government restrictions.

Another common law legal concept closely related to both impossibility and impracticability is the legal doctrine of frustration of purpose.  Under this doctrine, “performance remains possible, but is excused whenever a fortuitous event supervenes to cause a failure of the consideration or a practically total destruction of the expected value of the performance.”[17]       

Frustration of purpose requires many of the same elements as impossibility or impracticability (e.g., unforeseeable event that cannot be mitigated), but does not require a supervening event that impedes a party’s performance. The elements of frustration of purpose include: (a) an occurrence substantially frustrates a contract’s principal purpose; (b) the nonoccurrence of the event was a basic assumption of the contract; and (c) the event was not the fault of the party asserting the defense. The main issue governing frustration of purpose is whether the unforeseeable occurrence has so altered the circumstances of the contract that performances would no longer fulfill any aspect of its original purpose. Frustration must be nearly total; it is insufficient that a transaction was expected to be profitable, but now is unprofitable.

An example of possible application of this doctrine is where the cancellation of a season of baseball or other sports event due to the prohibitions on large gatherings at stadiums and arenas. The government restrictions on large gatherings, and the resulting cancellation of Major League Baseball or NBA basketball, render the services of vendors who support the games unnecessary. The vendors can still perform the services (e.g., provide food service to sell) but the “principal purpose” of the contract to provide the services (to support thousands of fans in attendance) is now frustrated, delayed, or cancelled. It would seem that the doctrine of frustration of purpose may afford the stadium managers a legal basis to excuse nonperformance of the vendor contracts.

2. CONTRACT OBLIGATION STRATEGIES IN THE WAKE OF COVID-19

Businesses should be proactive and not wait to get sued

1. A business that knows it will be unable to perform a contract obligation should not

wait for the other contracting party to sue. Rather, it should seek to negotiate a resolution if possible. If not possible, the business can bring a declaratory relief suit to establish the legal issue that it is excused from performance due to force majeure, impossibility, impracticability, or  frustration of purpose.  Declaratory relief is equitable in nature, and the issues addressed in this blog are also equitable in nature, and legal issues are for the court to decide (even though the outcome can depend on facts). Thus, courts are to consider issues of fairness, equity, and public policy. Initiating a declaratory relief action can give the plaintiff an advantage by framing the issue and lower litigation expense, by avoiding a later protracted lawsuit for damages caused by non-performance.

2. Further, businesses should take proactive steps to ensure continuity of operations to

meet existing contractual obligations, e.g., change suppliers, seek alternative means of performance.

3. If companies expect that COVID-19 may result in their own or their counterparties’

inability to satisfy contractual obligations, they should evaluate the viability of either force majeure or common law principles of excuse for nonperformance. This assessment may be more complicated given that a business may be on both sides of this issue—as a performing party in some cases, and as a receiving party in others. A coherent strategy must consider the full range of the company’s contract obligations. Also difficult is that legal standards may differ from state to state. A company must be mindful of the results of asserting these principles in different state, thus highlighting the need for a comprehensive strategy.

4. Business interruption insurance should be considered or invoked. Such insurance is

intended to cover losses resulting from direct interruptions to a business’ operations and generally covers lost revenue, fixed expanse such as rent and utilities, or expenses of operation from a temporary location. Such insurance can also cover lost profits and costs that indirectly result from disruptions in a company’s supply chain.

Our experienced attorneys at North & Nash, A Professional Law Corporation Attorneys can advise you on your contract obligations in light of the impact of COVID-19 crisis.  We are here to help you develop a comprehensive legal strategy to address the complex legal issues that will follow in the aftermath of this pandemic.