Shearman And Sterling

coronavirus, COVID-19

Apr 22, 2020

Airlines: Options under Airline Contractual Arrangements

Subscribe

Jump to...

 

AIRLINES: OPTIONS UNDER AIRLINE CONTRACTUAL ARRANGEMENTS

Force Majeure, Impossibility and Frustration under New York and English Law

Force Majeure. As with many other industries around the world, supply arrangements in the aviation industry have suffered major disruption as a result of the COVID-19 pandemic. A key issue to look out for is whether an airline’s supply contracts (and any other contracts that have been severely affected) have a “force majeure” clause that has been or might be triggered.

A force majeure clause excuses performance when unforeseen circumstances outside a party’s control prevent (or, under English law contracts, hinder or delay) the party’s performance of a contract. It will always be most important to interpret the wording of the particular clause in the context of the force majeure event and the contract generally.

Under New York law, this doctrine is available only where a contract contains an express force majeure provision. Such clauses are narrowly construed and must include the event or type of event that prevents a party’s performance in order to excuse that performance. Thus, for circumstances relating to COVID-19 to qualify under a force majeure provision, there must be contractual language that covers an event that can be reasonably construed as preventing performance, such as an “epidemic” or “government directive.” Some courts have determined that the non-performing party must demonstrate efforts to perform despite the force majeure event, while others have concluded that the non-performing party must show that the non-performance was the “unavoidable result” of the event. However, alternative attempts to perform may not necessarily be required where, for example, they would be “unusually foolhardy.”

Force majeure clauses in English law contracts operate broadly in the same way. However, there are some key differences: typically, the triggering event need only hinder or delay performance, and the affected party must show that he has taken all reasonable steps to try to mitigate the event’s consequences. If the clause is triggered, the party affected may be entitled to an extension of time to perform, suspend performance for the duration of the event, or, if it continues over an extended period, possibly even to terminate the contract. It may (and need) not be the COVID-19 pandemic itself that triggers a clause, but rather its knockon effects. In relation to airlines, that may be a supplier’s inability to supply essential goods or services (e.g., fuel, food and refreshments, etc.) in which case it will be the supplier seeking to invoke the clause. If there is a Government ban on a particular flight route for certain categories of passenger (e.g., the USA’s ban on nonU.S. citizens coming from Europe), that may give those passengers a right to invoke force majeure under an airline’s contract of carriage.

What about airlines who wish to invoke force majeure? Payment obligations to aircraft lessors and suppliers will be an area of particular concern for airlines. With large numbers of flights cancelled, passengers not booking new flights, and a range of fixed costs (such as aircraft and premises leasing and staff costs) still to pay, many airlines are suffering from acute cash flow pressures. Many flights have been cancelled because of a precipitous drop in demand. Generally, New York and English courts have held that financial hardship alone does not constitute a force majeure event. For example, a New York Court found that the First Gulf War—which reduced air travel demand and increased oil prices—was likely insufficient to constitute a force majeure event because it was short in duration and because such conflicts were a “risk of doing business in an international forum.”

Will a force majeure clause help in the current circumstances? Possibly, but there are a range of options depending on the wording used, and it is more likely payment obligations will not be covered. At one end of the spectrum are clauses that expressly exclude payment obligations from their scope. Other clauses that do not exclude payment obligations may be difficult to invoke if they only refer to the “prevention” of performance. Not making a payment because it is uneconomic will likely not suffice. Typically, under New York law, the claimed force majeure event must be severe enough that it actually prevents the performance of a contractual duty, and the burden of establishing both the prevention and the causal link is on the party seeking to excuse nonperformance. Under an English law contract, a “hindrance” clause may cover a payment obligation, but that would likely depend on how much of an impact making the payment would have on the rest of the airline’s business, e.g., a payment that risks pushing the airline into cross-default under financing arrangements or even insolvency would more likely be sufficient. The safest clauses to rely on in this context are those that provide for events that render a contract “uneconomic” (although these will be much less common).

As a general rule, care should be taken to analyse precisely what impact any supply interruption, travel ban, difficulty making payments or other consequence of COVID-19 has actually had on the airline’s business (or the counterparty) and how that might fall within the wording of the force majeure clause.

Often the right to relief for force majeure will be conditional upon notice (including evidence of the triggering event) being given to the other party within a specified period. Given such time limits and the dynamic nature of the COVID-19 outbreak, we have seen examples in some quarters of parties issuing “protective” or “rolling” force majeure notices to ensure the right to invoke force majeure is not lost and/or to account for the pandemic’s developing impact.

Impossibility and Frustration. New York law may also excuse non-performance under the doctrine of impossibility. Impossibility may apply where there is no express contractual language invoking it and performance is excused only when an unforeseen event makes performance objectively impossible and the risk “could not have been foreseen or guarded against in the contract.” Moreover, without an express force majeure provision in an agreement, a party attempting to invoke impossibility could face an additional burden to show that the event preventing performance was truly unforeseeable—i.e., that the omission of a force majeure provision did not reflect the parties’ intent to assign the risk of such events to the non-performing party.

Frustration of purpose under New York law may excuse performance even where performance is technically possible but where unforeseeable events render performance essentially valueless. Courts have held that the frustrated purpose must be “so completely the basis of the contract” that, without it, the contract “would have made little sense” at the time the parties entered into the agreement. As with force majeure (and impossibility), however, the frustration of purpose doctrine does not apply “merely upon a showing that it would be financially disadvantageous to perform.” Thus, this analysis too will turn heavily on individual factual circumstances and whether a court determines that events relating to COVID-19 have destroyed the fundamental purpose of a particular contract or have only made performance difficult or unprofitable.

A party may seek to terminate or rescind an agreement due to impossibility or frustration, or may cite these doctrines as a defence against a claim for breach of contract; however, some courts have recognised that if performance is made impossible for a limited duration it will be excused only on a temporary basis.

The English law doctrine of frustration is similar in scope to impossibility/frustration of purpose under New York law, although it generally only applies if there is no force majeure provision that covers the relevant event in the contract. If a frustrating event occurs, the contract automatically comes to an end (and in some circumstances amounts paid under the contract up to the time of the event can be recovered).

As the New York and English law impossibility/frustration doctrines require impossibility of performance or a fundamental change to the nature of the contract, they will usually be more difficult to rely on than a force majeure clause. A total government ban on any travel or even a particular flight route may provide the necessary “impossibility.” But less severe constraints will be less likely to do so.

Force Majeure in other European Jurisdictions. In certain other European jurisdictions, force majeure exists as a legal doctrine that can be applied in the absence of specific contractual provisions and other doctrines similar to impossibility and frustration are also available under local law. The relevant doctrines are jurisdiction specific.

MAE or MAC Contractual Provisions

Material Adverse Effect (MAE) or Material Adverse Change (MAC) clauses[1] are found in a range of commercial contracts, including financing and acquisition agreements. They provide for certain contractual consequences where a “material” change or event occurs that adversely impacts an attribute (such as the financial condition or operations) of one of the parties. Such consequences include providing a right to terminate for the unaffected party, or triggering an event of default or breach of warranty. They are another potential option for airlines to be aware of either as a means of terminating contracts to deal with the consequences of COVID-19 or because such clauses could be invoked by counterparties against them.

Under New York[2] and English law, whether a MAC has occurred is heavily dependent on the specific facts and circumstances, including the language of the relevant contractual provisions. Thus, airlines should review their existing contractual agreements including aircraft purchase/lease agreements carefully to assess whether such provisions might be triggered by COVID-19.

New York courts have typically considered MAC clauses in an M&A context. The key issues that arise are whether the relevant “change” was foreseeable or within the contemplation of the parties at the time of the agreement, whether it was within the control of the parties and the magnitude of the impact, including whether it is based on industry-wide or companyspecific developments and the durational significance of the impact. Thus, the applicability of such provisions will depend on, among other factors, the duration of the impact of COVID-19 on the affected party—even a severe decline over a six-month period may not be of sufficient duration to constitute a MAC.

While MAC clauses are worded similarly in English law contracts, there is very limited guidance in English case law as to how they are to be interpreted. What is reasonably clear is that to be “materially adverse,” the relevant change/event:

  • must significantly or substantially impact the affected party’s ability to perform its obligations;
  • must be more than temporary; and
  • must not have been known to the parties when entering the contract, i.e., there needs to be a “change.”

Under both New York and English law, MAC clauses are generally regarded as difficult (and a risk) to invoke because their scope is uncertain. They are usually expressed in non-specific terms—i.e., what is “materially adverse” could have a wide range of meaning in any particular case. If the invoking party has no right to rely on the clause, the other party may be entitled to substantial damages or to terminate the contract for repudiatory breach.

A MAC issue is most likely to arise for airlines as potential events of default in their aircraft and other financing arrangements. For the reasons above, lenders will naturally be cautious in seeking to rely on any MAC, but the impact of COVID-19 is unprecedented and may force parties with limited options (and who hitherto have steered clear of such clauses) to use them.

Airlines should therefore consider the following in the context of COVID-19 and any MAC clauses in their financing contracts:

  • How big an impact has COVID-19 had on the airline’s financial condition (or any other relevant attribute set out in the clause)? There can be a large grey area between good financial health and insolvency but the closer towards insolvency COVID-19 is pushing the airline, the more likely a clause could validly be relied on. If the operations of the airline are the relevant focus, consider what proportion of its business overall the affected operations represent and how severely they have been affected.
  • How specific to the airline concerned is the adverse event? An issue specific to an airline or even the aviation industry is more likely to suffice. Arguably, the airline industry has been hit harder than other industries by the impact of COVID-19. But an economic downturn or weakening of demand generally will not be enough, so a lender would need to be confident that the airline (or the aviation industry) has been uniquely affected by COVID-19.
  • When was the contract entered? If it was, e.g., in the weeks following the initial outbreak of COVID-19 in China (or later) then it may be the parties would be taken to be aware of the relevant COVID-19 impact (or its likelihood) so as to prevent reliance on the MAC clause.
  • How long is the impact on the airline’s business, operations, finances, etc., likely to last? It is difficult to predict at this stage how long COVID-19 will affect the aviation industry, but clearly there is a risk of disruption for many more months to come. This should be compared against the term of the contract to try to gauge whether the impact is ‘temporary’ (and therefore unlikely to fall within the MAC clause), but a few months is unlikely to be sufficient and any assessment will inevitably be uncertain (even if it were at least clear how long the disruption will last).

The same analysis could be applied in reverse to the extent airlines have MAC clauses in their favour in other contracts. However, given the uncertainty and risk involved in relying on an MAC clause, airlines may wish to look first to force majeure or other clauses that excuse performance or liability or provide for termination, before seeking to rely on an MAC clause.

Footnotes

[1] The two types of clauses are substantively the same
[2] This note does not address other US state laws, including that of Delaware, which is particularly relevant to the interpretation of MAC clauses. For further analysis of MAC clauses (including Delaware law considerations) in the context of the COVID-19 Pandemic, see our recent Perspective “ANALYSIS OF NON-PERFORMANCE OF CONTRACTUAL OBLIGATIONS IN LIGHT OF THE COVID-19 PANDEMIC” .

Authors and Contributors

Susanna Charlwood

Partner

Litigation

+44 20 7655 5907

+44 20 7655 5907

London

Daniel H.R. Laguardia

Partner

Litigation

+1 415 616 1114

+1 415 616 1114

+1 212 848 4731

+1 212 848 4731

San Francisco

Jonathan Swil

Counsel

Litigation

+44 20 7655 5725

+44 20 7655 5725

London

Kaleigh Aucoin Ramsey

Associate

Litigation

+1 415 616 1115

+1 415 616 1115

San Francisco