The cover of this week’s issue of The Economist shows a picture of the globe with a “Closed” sign hanging over it. So what happens when global commerce grinds nearly to a halt, as appears to be happening? And what happens to contractual relationships when an increasing number of businesses are being directed to shut down operations under “shelter in place” orders—as has happened in California, New York and elsewhere in the past 48 hours?
We’re finding out. The COVID-19 pandemic has already disrupted global supply chains and impacted the ability of businesses around the world to maintain operations and fulfill contractual obligations. Last week (what seems like a year ago now), the World Health Organization declared COVID-19 a global pandemic, and in the last few days, governments worldwide have imposed travel and public-gathering restrictions, state and local governments have closed schools and libraries, and a wide range of private businesses have voluntarily shuttered.
With this scale of disruption, companies are finding themselves unable to meet their contractual obligations—or they are faced with counterparties telling them that they are unable to do so. Soon enough, companies will likely find themselves on both sides of this line, depending on the contract. So what can you do to protect your companies given the onslaught of cancellations and busted contracts?
First and foremost, review the text of your key agreements to see if they contain a force majeure or other relevant provision. Broadly speaking, the purpose of a force majeure provision is to “relieve a party from its contractual duties when its performance has been prevented by a force beyond its control or when the purpose of the contract has been frustrated.” Phillips Puerto Rico Core, Inc. v. Tradax Petroleum, Ltd., 782 F.2d 314, 319 (2d Cir. 1985). As with any contractual dispute, the specific contract language, the governing law, and the specific facts will drive the resolution of any dispute about performance—and courts are likely to apply a force majeure clause narrowly. So bear in mind a few key questions when reviewing your contract’s force majeure provision:
If your contract does not contain a force majeure provision, non-performance may still be excused to some extent under applicable common law or statutes. For example, under the doctrine of impossibility, a party’s non-performance is excused only when (1) the destruction of the subject matter of the contract or the means of performance makes performance objectively impossible; and (2) the impossibility was produced by an unanticipated event that could not have been foreseen or guarded against in the contract. Kel Kim Corp. v. Central Mkts., Inc., 70 N.Y.2d 900, 902 (N.Y. 1987). The circumstances in which the impossibility doctrine applies mirror those of a standard force majeure provision, and thus do not include mere economic or financial difficulties. See 407 East 61st Garage, Inc. v. Savoy Fifth Ave. Corp., 244 N.E. 2d 37, 41 (N.Y. 1968)(“where impossibility or difficulty of performance is occasioned only by financial difficulty or economic hardship, even to the extent of insolvency or bankruptcy, performance of a contract is not excused”).
Relatedly, the impracticability doctrine (which the Restatement now considers together with impossibility) discharges a party’s contractual performance if (1) after the contract is made and without the party’s fault (2) an event occurs that impedes performance and the non-occurrence of which was a basic assumption on which the contract was made, and (3) the language or the circumstances do not indicate the contrary. Restatement (Second) of Contracts § 261 (1981). Qualifying events generally include acts of God or third parties that make performance impracticable, even if not actually impossible, because of “extreme and unreasonable difficulty or expense.” Id. at cmt. d. See Asphalt Int’l, Inc. v. Enterprise Shipping Corp., 667 F.2d 261, 266 (2d Cir. 1981) (“The doctrine of commercial impracticability focuses on the reasonableness of the expenditure at issue, not upon the ability of a party to pay the commercially unreasonable expense”). This includes a severe shortage of raw materials or supplies due to war or embargo, or “unforeseen shutdown of major sources of supply.” Restatement § 261 cmt. d. Bear in mind, however, that performance is impracticable only if the “extreme and unreasonable difficulty or expense” precipitated by the event cannot be overcome by the breaching party’s reasonable efforts. Id. Most states follow the Restatement’s definition of impracticability, and therefore courts in most jurisdictions will consider an impracticability defense. (In addition to impracticability, frustration of purpose, see Restatement (Second) of Contracts § 265 (1981), might be another defense to consider, though frustration of purpose cases are rare.) In either case, however, the language of the contract will be reviewed for indications that the parties have otherwise allocated the risk of such events.
State statutes may also establish background force majeure principles. For sale of goods contracts, the Uniform Commercial Code, which all fifty states have adopted in some form, excuses non-performance if it “has been made impracticable by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the contract was made.” U.C.C. § 2-615. And in California, Civil Code § 1511 excuses non-performance when “it is prevented or delayed by an irresistible, superhuman cause, or by the act of public enemies or this state or of the United States.” Cal. Civ. Code § 1511(2). This statute may be available for California companies or companies contracting with one, and parties should consider whether their own states have comparable provisions.
One final note. We have summarized the basic framework for analyzing whether performance under a contract is excused in this extraordinary time. As noted, companies should be mindful that they may well be as likely to seek to be excused from an obligation as they are to seek to enforce one. For that reason alone (if not out of a sense of unity as we all struggle to come to terms with the effects of this pandemic), companies should consider engaging key suppliers and counterparties to come to reasonable compromises that achieve the best possible outcomes under the circumstances. Of course, many companies will find themselves facing existential threats if they cannot be excused from certain obligations, and those companies will understandably use every tool in their arsenals to protect their interests. For others, though, discretion may be the better part of valor. At the end of the day, we’re all in this together.
For the latest information on how to navigate potential business and legal challenges stemming from the COVID-19 outbreak, please visit Morrison & Foerster’s Coronavirus (COVID-19) Resource Center. The center provides up-to-date insights and recommendations, as well as key contacts across regions and practice areas. Please stay healthy and informed.
Morrison & Foerster associate Robin Smith contributed to the writing of this alert.