Shearman And Sterling

coronavirus, COVID-19

Mar 24, 2020

The COVID-19 Crisis and Force Majeure in Credit Agreements

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THE COVID-19 CRISIS AND FORCE MAJEURE IN CREDIT AGREEMENTS

 

With respect to lender performance obligations (including to fund advances) under a New York law governed credit agreement, the COVID-19 crisis raises a question as to whether lenders may invoke force majeure (or similar legal theories) at common law to excuse such performance.  In the absence of an explicit clause in a contract to limit performance during a force majeure event (which would be unusual in a typical credit agreement), New York law provides two limited bases of relief, on the basis of the common law defenses of: (1) impossibility and (2) frustration of purpose. Both bars are difficult to assert successfully and, even if successfully invoked, offer only limited relief to lenders or any agent seeking to stall performance under a credit agreement.

Conclusion

Ultimately, both the defenses of impossibility and frustration of purpose have been applied narrowly by the courts. It is only extreme circumstances that might excuse performance under a credit agreement, and if relevant, temporary impossibility only excuses performance for the limited amount of time where performance is objectively impossible.

Impossibility Defense

The defense of impossibility of performance excuses a party’s obligations only in a narrow set of circumstances.  First, the impossibility must have been caused by an event that could not have been foreseen or guarded against in the contract. Second, this defense requires the objective impossibility of the contractual performance because of the destruction of either: (1) the subject matter of the contract or (2) the means of performance. Kel Kim Corp. v. Central Markets, Inc., 524 N.Y.S. 2d 384 (1987).

In the case where parties are expected to perform under a credit agreement, the party seeking to excuse performance must prove it lacks the absolute means to perform as a result of a force majeure event. An increase in cost of performance, even an extremely cumbersome increase that leads to insolvency or bankruptcy, does not excuse performance as impossible. As such, the defense of impossibility sets a high bar for parties.

In addition to permanent impossibility, temporary impossibility may, in extreme cases, serve as a defense to a breach of contract claim for a brief duration of time. One case serves as a stark illustration of this limited defense: Bush v. Protravel Int’l, Inc., 746 N.Y.S. 2d 790 (NYC Civ. Ct. 2002). 

Immediately following the September 11 attacks, “New York City was in the state of virtual lockdown with travel either forbidden altogether or severely restricted.” The court found that the contractual parties could not have foreseen or guarded against the lockdown in their contract. That said, the defense of temporary impossibility does not excuse performance altogether; the court excused performance made impossible by the government mandated lockdown, but only until it became possible to perform again.

In the situation that some states (including New York) are in, where the outbreak of COVID-19 requires limiting personnel access, for example, and such access is absolutely necessary to perform certain steps under a credit agreement, the defense of temporary impossibility, then, may suspend the contractual duty until the impossibility ceases and possibly for an additional reasonable time thereafter.  However, even in situations of lockdown, if certain obligations may continue to be performed if they are not “location dependent” to the extent that capabilities exist or are available for such purposes, the defense is not available.

Frustration of Purpose Defense

The defense of frustration of purpose allows the discharge of duties under a contract where unforeseeable events render the contract valueless to one party. Metro. Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989).

To meet the threshold for this defense, a force majeure event must change the circumstances such that the performance of one party would be virtually worthless to the other, frustrating the second party’s purpose for which it agreed to contract in the first place. In other words, without that purpose, the transaction would have made little sense at its inception.

As with the impossibility defense, a showing that the contract would be financially disadvantageous to one party does not rise to the level required to excuse performance. As a result, this defense sets a high bar for litigants seeking to excuse performance under a credit agreement in response to the COVID-19 outbreak.

Authors and Contributors

Robert Freedman

Partner

Project Development & Finance

+1 212 848 4340

+1 212 848 4340

New York

Alexandro M. Padrés

Partner

Project Development & Finance

+1 212 848 7499

+1 212 848 7499

New York

Jesse Van Genugten

Associate

Project Development & Finance

+1 212 848 5393

+1 212 848 5393

New York