The COVID-19 pandemic may deem unenforceable or result in non-performance of executed contractual obligations. In light of global trends, deals are being drastically limited, postponed, or canceled until the virus is contained, and even permanently, resulting in tremendous economic consequences.
Given of such events, compelling legal questions arise concerning the contractual rights and obligations related to these transactions.
First, What Does Your Contract Say?
Where possible, the mutual intent of the parties will be determined solely from the written terms of the contracts, and the general rule is that the terms in that document will bound a person who signs a contractual document.
If there is a contract, parties must look at indemnification and defense provisions in the documents. Key provisions, including the material adverse change, force majeure, and termination rights, are often used to limit liability or allocate risk.
A force majeure provision allows the contract parties to allocate the risk of certain force majeure events such as acts of God, hurricanes, earthquakes and other natural disasters, epidemics, terrorism, government acts, embargoes, labor strikes and lock-outs, and other events beyond the control of the parties. Force majeure clauses work to mitigate the negative effects of force majeure events, including business interruption and supply chain disruption.
The material adverse effect clause includes specified events, occurrences, facts, conditions or changes that are materially adverse to business, results of operations, condition (financial or otherwise) or assets of a business; or the ability of to consummate the transactions contemplated by the parties, in a purchase or merger agreement or as a condition to closing.
Parties to a contract use a contractual indemnity provision to customize risk allocation.
Indemnification clauses vary widely, but in a typical indemnification provision, the indemnifying party promises to reimburse the indemnified party from and against losses, liabilities, claims, and causes of action, incurred by the indemnified party that are caused by, arising from, or are related to the specified events giving rise to the indemnity.
Contract termination rights often are found in contract provisions that allow a party to end the agreement for cause or no cause. Cause is often defined by the parties, for example, the bankruptcy of one party could be a valid cause to seek termination of the agreement.
The World Health Organization has declared COVID-19 as a pandemic, which makes it likely to excuse performance or terminate the agreement as a qualifying event, under the provisions mentioned above including epidemic or pandemic or as a result of travel bans, business closings, curfew, quarantine or shelter-in-place, imposed by the government.
Second, Do You Have an Insurance Policy to Cover Suspension or Cancellation, for Business Interruption Damages, or such Defaults?
“Most commercial policies provide for some business income loss coverage, usually defined as the actual loss of business income sustained during the period of restoration due to the “necessary suspension or delay of operations caused by direct physical loss of or damage to property at a location directly caused by a covered peril.” For example, if a tornado (which is a covered cause of loss) damages a business and causes the business the cease operating, the business interruption coverage would likely pay for lost income until the damage can be repaired and business can be restored.
What constitutes “direct physical loss of or damage” to property in an insured’s policy may vary from state to state. In Georgia, both the state and federal courts agree on the interpretation of that policy language.
To obtain coverage resulting from the Coronavirus outbreak, the existence of the virus would need to constitute a Covered Cause of Loss, which results in physical loss of or damage to the covered property. This is unlike a fire or other causes of loss that result in visible damage to property. As business across the country close due to the Coronavirus, they may be closing even though there is no apparent/visible damage at all. However, what if Coronavirus is found within a business – does this constitute damage to property? As we have seen from the first COVID-19 related business income loss case filed in Louisiana, insureds will argue that the “direct physical loss” to property requirement is met because the virus can remain on surfaces for days. In that case, Ocean Grill filed suit against its insurer Lloyd’s of London, the governor of Louisiana and the State of Louisiana seeking a declaratory judgment that there was coverage under its policy when the governor of Louisiana barred public gatherings of 250 or more, with no exception for restaurants.
Insureds may also cite to Civil Authority coverage provisions to recover their business losses caused by shelter-in-place orders issued by the state, city or county authorities. Civil Authority coverage triggers payments for lost business income, but the “direct physical loss of or damage” requirement we discussed aboved must be loss of or damage, not to the insured location, but to other premises. To invoke coverage, the civil authority must prohibit access to an insured’s location due to physical damage to property of another. Insurance policies may condition coverage on other requirements thus necessitating a thorough review of an insured’s policy and an analysis of the law in the applicable jurisdiction.
The issue is whether the current shelter-in-place orders across the Country qualify as a civil authority order sufficient to invoke coverage. Of course, the language of the orders will control. Insurers should ask the following questions:
1. Does the order prohibit the employers and their customers from accessing the businesses?
2. What is the reason cited for the civil authority issuing the order?
3. Was the order issued to protect the health and safety of the public or was it the result of the direct result of property damage?1
For more information about insurance coverage, visit https://www.deflaw.com/blog/blog/covid-19-updates/preparing-for-covid-19-related-first-party-property-claims-georgia
Third, Can You Employ the Doctrines of Impossibility, Impracticality, Frustration of Purpose, or Failure of Conditions as Excuses for Non-Performance?
Under Georgia law, any party attempting to avoid performance is required to show evidence of both the existence of a force majeure event and that it reasonably attempted to fulfill its contractual obligation but was prevented by the occurrence of the event.
The risks associated with a supervening event like COVID-19 are allocated by (i) express provision (such as force majeure clause), and (ii) statutory or case law, applied by a court in the absence of an express agreement to the contrary. For example, the Uniform Commercial Code (UCC) allocates price fluctuation risks between buyers and sellers. Price fluctuations excuse a party’s performance only in limited scenarios where underlying changes to the relevant market were brought about by an event that the parties: (a) assumed would not happen as a basic condition of their agreement; and (b) could not guard against.
Consequently, in the event that the contract does not contain a force majeure clause, or if the provision is too ambiguous, or even worst, there is no written agreement at all, parties seeking to cancel or suspend obligations in the context of COVID-19, may have to invoke other contractual defenses or excuses to perform contractual obligations that arise after a contract has been executed, including supervening events, such as impossibility, impracticability, frustration of purpose, failure of conditions, anticipatory repudiation, or later agreements between the parties such as modification, rescission, and accord and satisfaction, and waiver.
Supervening events such as COVID-19 must occur after a contract has been executed, but before the time complete performance is due. A supervening event can excuse performance if (i) the requirements of impossibility, impracticability, or frustration of purpose are met (see definitions below); (ii) the event occurred without the fault of either party. Negligence, misconduct, or sometimes control may be sufficient to deny recovery; (iii) the event’s non-occurrence was a basic assumption of the parties’ agreement; (iv) the risk of an event was not allocated to either party.
Impossibility excuses performance when a party’s contractual obligations become objectively impossible because of a supervening event. For a party to successfully use COVID-19 as an excuse, performance must be impossible, not just financially unappealing or slightly more difficult, regardless of any amount of time, money, or energy spent.
Impracticability excuses performance or delays in performance if a supervening event like COVID-19 materially changes the inherent nature of a party’s obligations to become substantially more difficult, complex, or challenging, resulting in the excessive and unreasonable increase in performance costs. To be eligible for this excuse, the COVID-19 must render performance unduly burdensome and result in an increased cost of performing that materially changes the parties’ contractual relationship.
Frustration of Purpose is a limited excuse that applies when, due to a supervening event such as COVID-19, a party’s principal purpose for entering the transaction is destroyed or obviated. With this excuse, performance is not impossible, but one party’s reason for doing the deal no longer exists.
Moreover, Failure of Conditions is the occurrence or non-occurrence of a condition that may excuse a party’s performance or a delay in performance, depending on whether the condition at issue is a precedent, concurrent or a subsequent condition. Conditions are facts or events on which a party’s contractual obligations are contingent and can be categorized as express or implied.
If the event affecting performance occurs before contract execution, parties must look to non-performance excuses like mistake (including mistakes made in contract bids), misunderstanding, fraud (including fraud in the inducement), illegality, duress, undue influence, and lack of capacity to determine whether a party’s performance is excused.
Government Actions Often Claimed to Excuse Performance
Performance generally may be excused if supervening government action has made it impossible or impracticable or has frustrated one party’s purpose. However, parties seeking to have their performance excused cannot (i) know or have reason to know of the possibility of the particular government action; and (ii) be responsible for or complicit in the government action.
Parties often invoke impossibility as an excuse because of the following supervening government actions: (i) A change in the law: A contract, legal at the time of execution and later made illegal because of an intervening statutory or regulatory enactment, is wholly terminated when the new law takes effect; (ii) Executive orders and administrative decisions: Similar to changes in the law, a contract, legal at the time of execution and later made illegal because of an intervening executive order or administrative decision, is wholly terminated when the order or decision takes effect. Absent an agreement to the contrary, supervening executive and administrative action can only excuse a party’s performance if, when possible, the party contests the action (for example, by diligently seeking a government permit); and (iii) Court orders or decisions: Judicial orders making performance impossible, such as injunctions, can excuse performance if the party whose performance is affected did not substantively cause its entry; or fail to prevent its entry by procedural or other similar means.
Temporary and Partial Performance Interruptions
When a supervening event temporarily, such as COVID-19 causes impossibility, impracticability, or frustration of purpose, the parties generally may suspend their performance during the change in circumstances. Once the circumstances revert to those under which the parties agreed, the party whose performance was affected by the supervening event must resume performance in full and must be granted a reasonable extension of time to perform. If a temporary suspension itself materially alters a party’s obligations or expected benefits, impossibility, impracticability, or frustration of performance could excuse the affected party’s performance altogether.
Moreover, a supervening event such as COVID-19 excuses only those obligations affected by the event. Therefore, in contracts with divisible performance obligations, a supervening event could cause only partial impossibility or impracticability. A party’s unaffected performance obligations are not excused if either (i) substantial performance is still practicable, taking into account any reasonable potential performance substitutions; or (ii) within a reasonable time, the affected party agrees to fully perform any remaining obligations; and permit his counterparty to retain any performance benefits already rendered.
What Other Alternatives Do You Have?
A party to a contract expects that if it performs as agreed, the other party will likewise perform when its performance is due. Parties in a contract for the sale of goods has the right for anticipatory repudiation and the right to demand adequate assurances of performance.
An Anticipatory Repudiation occurs when one party (repudiating party) repudiates before its performance is due. If there is an anticipatory repudiation by one party that substantially impairs the value of the contract to the other party (aggrieved party), the aggrieved party may, subject to certain conditions (i) await performance by the repudiating party; (ii) cancel the contract; (iii) resort to any remedy available for a breach; and (iv) in all cases, suspend its own performance.
In an anticipatory repudiation, the repudiating party’s performance need not be impossible. Rather, the test is whether a reasonable person would conclude that the repudiating party cannot or will not perform the contract.
In the alternative, parties in a negotiation generally may modify, rescind, or substitute a contract, subject to the original contract’s terms. Therefore, performance under the original agreement is excused in favor of a valid later agreement’s terms. Later agreements include modifications, rescissions, and accords and satisfactions.
A modification is a change to one or more terms of the original agreement that leaves the main purpose of the contract intact. In rescission by agreement, the parties discharge the remaining performance obligations under an existing contract, promising to forego their counterparty’s performance. Accord is the discharge of contractual duties by the substitution of a new contract, providing for performance different from that due under the original contract. Satisfaction is the full performance of the new contract, satisfying the new agreement and extinguishing any obligations from the original contract.
The parties can also negotiate a Waiver. Generally, under a waiver, one party surrenders or relinquishes (waives) claims against another party. Used as an excuse, waiver prevents contract parties from lulling their counterparties into the belief that performance is unnecessary and later demanding performance or alleging breach of contract. The party owing performance asserts that his counterparty relinquished his right to performance through either an express or implied waiver.