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Apr 20, 2020

Analysis of Non-Performance of Contractual Obligations in Light of the COVID-19 Pandemic

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ANALYSIS OF NON-PERFORMANCE OF CONTRACTUAL OBLIGATIONS IN LIGHT OF THE COVID-19 PANDEMIC

On March 11, 2020, the World Health Organization officially declared the coronavirus outbreak (“COVID-19”) a global pandemic.[1] In addition to the human cost, COVID-19 continues to cause widespread disruption to commercial activity around the world including stay-at-home orders issued in most states, including, in many cases, the closure of in-office personnel functions by all non-essential businesses statewide, and the U.S. federal government has issued restrictions on non-essential travel across the borders of Canada and Mexico. As a result, businesses throughout the U.S. may be faced with practical inabilities and/or economic difficulties in performing certain of their contractual obligations and may seek to determine whether they or their counterparties have any legal basis on which to excuse performance of those obligations. Of course, there is no one-size-fits-all answer to this question, and the legal ramifications of the virus on any particular business and its particular contractual obligations will be fact-specific and dependent on the specific provisions of each contract and the particulars of the state laws that governs each contract’s interpretation and enforcement.

To guide companies in determining when contractual performance may or may not be excused in light of the COVID-19 pandemic, this article sets out several general principles that contracting parties should consider when evaluating how to address the difficulties of performance posed by the wide-ranging effects of this situation. In the article, we consider the legal principles generally applied in giving effect to and interpreting express force majeure clauses, material adverse effect (MAE)/material adverse change (MAC) clauses, and the common law doctrines of impossibility, impracticability and frustration of purpose, as well as several other contractual interpretation concepts that may bear on whether or not performance is required or excused in light of the unusual exigencies posed by the COVID-19 pandemic. This article is general in nature and is not intended to replace the need for individualized legal advice, which must be tailored to the specific facts of each situation.

Force Majeure

Contractual force majeure clauses provide a narrow defense excusing a party’s obligation to perform in certain enumerated circumstances beyond the parties’ control.[2] The construction of any particular force majeure clause will depend on the facts and circumstances of the situation, including the language of the clause and its meaning within the context of the broader contract, the extent to which the event prevents performance, the custom and practice in the particular industry, and nuances of governing state law. Nonetheless, following are some general principles applied by courts throughout the U.S. in analyzing whether performance is excused by a claimed force majeure event.

  • Force majeure clauses are interpreted narrowly, meaning that the type of event that prevents performance must be expressly identified in the clause in order to excuse performance.[3]
  • When a force majeure clause includes a “catchall” phrase in addition to an enumerated list of specific events that constitute force majeure, the catchall phrase generally is construed within the context of the preceding listed events or causes so as to include only events that are of the same general kind or character as the specified events mentioned in the clause.[4]
  • The non-performing party has the burden to establish that a force majeure event occurred and excuses its performance.[5]
  • Unless otherwise agreed in the contract, the occurrence of a force majeure event excuses performance by both parties.[6]
  • In some jurisdictions, the non-performing party might be required to demonstrate its efforts to perform its contractual duties despite the occurrence of the claimed force majeure event.[7]
  • Similarly, some jurisdictions require the non-performing party to demonstrate that the claimed force majeure event was unforeseeable at the time the parties entered into the contract.[8]
  • Finally, in most cases, mere adverse economic conditions or non-extreme financial hardship will not constitute force majeure excusing performance of contractual obligations.[9]

In light of the government-issued shelter-in-place directives in many states and municipalities, force majeure clauses that include some form of governmental action among the events that excuse performance may be of greatest relevance in the current circumstances. Of course, any party seeking to rely on any such provision would have to prove that performance of the party’s contractual obligations was prevented by the unforeseen governmental shelter-in-place directives through no fault of the party. For example, in Castor Petroleum v. Petroterminal De Panama, 107 A.D.3d 497, 498, 968 N.Y.S.2d 435, 498 (1st Dep’t 2013), the Appellate Division in New York affirmed a trial court’s determination that the attachment by a Panamanian court of the plaintiff’s oil excused the defendant’s obligation to perform under an oil transportation and storage agreement. In that case, the force majeure clause expressly relieved the defendant of its obligations in the event that performance was prevented by “government embargo or interventions or other similar or dissimilar event or circumstances.”[10]

Whether a U.S. court will consider the COVID-19 pandemic and/or the associated business disruptions, including those caused by the various governmental “shelter-in-place” directives a force majeure excusing contractual performance in whole or in part will vary from case to case, depending on such factors as the language of the relevant contractual provisions, the scope and extent to which the pandemic and/or governmental directives have actually impeded the parties’ ability to perform, whether alternative means of performance are available and the parties’ efforts to seek out such alternatives, and whether the conduct of the parties themselves caused the nonperformance, among others.

Material Adverse Effect/Material Adverse Change Clauses

A contract may also include a material adverse effect (MAE) or material adverse change (MAC) clause that, depending on the particular facts and circumstances and the specific language included in the clause, may be invoked to excuse a contracting party’s performance in light of the COVID-19 pandemic. MAE/MAC clauses are often included to permit one or more parties to escape their performance obligations should fundamental conditions change for the worse after the parties commit to a transaction, such as an acquisition or financing. The party invoking the MAE/MAC clause to avoid performance of its obligation—for example, to close an M&A transaction or to advance a draw request pursuant to a draw agreement—bears the burden of proving that an MAE/MAC occurred.[11]

MAE/MAC clauses most frequently have been litigated in the context of M&A transactions, and courts have interpreted them narrowly, seeing them “as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”[12] The factors that are most frequently considered in determining whether an MAE or MAC occurred include:

  • the foreseeability of the alleged cause of the MAC or MAE;
  • who assumed the risk of such an event;
  • the durational significance of the event in the context of the transaction; and
  • whether the cause of the material adverse change is based on industry-wide or company-specific developments.

These factors are considered together, and no single factor is dispositive. In general, however, courts are reluctant to find that an MAE/MAC has occurred when the claimed MAE/MAC is based on the realization of a risk that was foreseeable or known to the parties, when a business downturn is a result of industry-wide rather than company-specific developments, and/or when the negative impact of a development is not expected to last a particularly long time relative to the duration of the underlying transaction.[13] Parties should bear in mind that the analysis of whether an MAE or MAC occurred is highly dependent on the facts and circumstances (and typically requires expert testimony). As such, the party seeking to invoke a MAC/MAE clause is unlikely to prevail without an evidentiary hearing, full summary judgment record or an expedited trial.[14]

Impossibility, Impracticability, and Frustration of Purpose

In the absence of an express contractual provision, a party might seek to excuse nonperformance of its contractual obligations pursuant to the related common-law doctrines of impossibility, impracticability of performance, or frustration of purpose. These doctrines are narrowly applied and have several common features:

  • As with force majeure and MAE/MAC, the party asserting the defense bears the burden of proof.
  • The event resulting in non-performance must have been unforeseen at the time of contracting.[15]
  • The party asserting the defense must show that it made every effort to perform and its actions or inactions did not cause the event resulting in non-performance.[16]

Impossibility and impracticability are similar doctrines that excuse performance when an unanticipated event that could not have been foreseen or guarded against in the contract makes performance impossible or impracticable. Some courts and jurisdictions require actual objective impossibility,[17] whereas others require impracticability, meaning that performance would require excessive and unreasonable cost—not simply that performance would be more costly than anticipated or would result in a loss.[18] The doctrines of impossibility and impracticability have been applied to excuse performance permanently or temporarily in contexts where governmental action has rendered performance permanently or temporarily impossible, but not where governmental action simply makes it more difficult or more costly to perform.[19] For example, in Bush v. Protravel International, Inc., the court held that the plaintiff raised a triable issue of fact as to whether her obligation to cancel a travel package was temporarily excused under the doctrine of impossibility on September 11, 2001, and the days that immediately followed, when New York City “was in [a] state of virtual lockdown with travel either forbidden altogether or severely restricted,” and the Governor of New York had issued an Executive Order extending the statutes of limitations for all civil actions in all New York State courts for a period of time that extended beyond the date when the plaintiff was able to notify the travel agency of her cancellation.[20]

Parties whose contractual performance has been temporarily or permanently prevented due to the various COVID-19 governmental shelter-in-place directives, shutdowns and travel bans may be able to rely on the doctrines of impossibility or impracticability if they can show they were not at fault, did not contribute to or in any way cause the impossibility, and that the governmental action was unforeseen at time of contracting.[21] Parties should keep in mind that these doctrines are applied narrowly and rarely succeed when the intervening governmental action merely results in greater difficulty or financial expense or loss.[22]

The doctrine of frustration of purpose, by contrast, may have less applicability in the current circumstances. Frustration of purpose discharges a party’s duties to perform under a contract where an unforeseen event has occurred, which, in the context of the entire transaction, destroys the underlying reasons for performing the contract, even though performance is possible. Frustration of purpose excuses performance when a “virtually cataclysmic, wholly unforeseeable event renders the contract valueless to one party;” it is not enough that the transaction has become less profitable for the affected party or even that the party will sustain a loss.[23] Because the frustration of purpose must be so substantial and the frustrating event must be one that could not have been foreseen or provided for by means of contractual safeguards, the doctrine is rarely found to apply in practice.

Additional Contractual Considerations

Parties evaluating their contractual obligations in light of the business disruptions caused by the COVID-19 pandemic should also consider whether their contracts include conditions precedent that have not been satisfied, whether non-satisfaction of those conditions precedent excuses performance temporarily or permanently, and/or whether satisfaction of certain conditions precedent can or should be waived. In the absence of agreement, litigation over such issues can be complicated and drawn out, as well as fraught with collateral considerations arising from the seriousness of the virus’s effects.

Similarly, parties should be careful not to communicate or conduct themselves in ways that might inadvertently convey an intent to abandon contractual obligations to another party. The wrong messaging may be interpreted as an anticipatory breach, and a contracting counterparty may suspend its own performance until it receives adequate assurances as to the other party’s ability to satisfy its own obligations.[24] Contrariwise, parties concerned that a counterparty may fail to perform at a crucial junction may seek assurances or performance from the counterparty and may initiate litigation if such assurances are found insufficient.

Contracting parties should be also be cognizant of potential breaches by their contractual counterparties and be prepared to address whether such breaches would excuse their own performance. In general, and absent contrary contractual provisions, only material breaches permit converse non-performance.[25] A breach is material if it goes “to the root of the agreement between the parties.”[26] The materiality of a breach is a fact intensive inquiry that weighs multiple factors, including “the extent to which the injured party will be deprived of the benefit which he reasonably expected.”[27]

In view of uncertain times of economic upheaval, parties should continually reassess the economic terms of their contractual obligations and whether a breach is more economically efficient than performance. Such assessments should consider the impact of the pandemic on the non-breaching party’s ability to mitigate its losses, which will likely be taken into account in assessing whether and the extent to which the non-breaching party is entitled to damages.

Footnotes

[1] WHO Director-General’s opening remarks at the media briefing on COVID-19, World Health Organization (March 11, 2020), WHO Director-General's opening remarks at the media briefing on COVID-19 - 11 March 2020.
[2] Stroud v. Forest Gate Dev. Corp., No. CIV.A. 20063-NC, 2004 WL 1087373, at *5 (Del. Ch. May 5, 2004).
[3] See, e.g., Kel Kim Corp. v. Cent. Markets, Inc., 70 N.Y.2d 900, 902-03, 519 N.E.2d 295 (1987) (“Ordinarily, only if the force majeure clause specifically includes the event that actually prevents a party’s performance will that party be excused.”); Richard A. Lord, 30 Williston on Contracts § 77:31 (4th ed.) (“What types of events constitute force majeure depend on the specific language included in the clause itself.”).
[4] See, e.g., Kel Kim Corp., 70 N.Y.2d at 903 (catchall clause providing that force majeure events include listed events “or other similar causes beyond the control of such party” is subject to the principle of interpretation “that the general words are not to be given expansive meaning; they are confined to things of the same kind or nature as the particular matters mentioned”); Stroud, 2004 WL 1087373, at *5 (noting that force majeure provision in real estate development contract containing listed events followed by phrase “or any other reason whatsoever beyond the control of [the developer]” ordinarily would be “construed within the context established by the preceding listed causes,” but inclusion of the word “whatsoever” suggested that “an especially narrow reading of the phrase was not intended”).
[5] See, e.g., Phillips Puerto Rico Core, Inc. v. Tradax Petroleum Ltd., 782 F.2d 314, 319 (2d Cir. 1985); Aukema v. Chesapeake Appalachia, LLC, 904 F. Supp. 2d 199 (N.D.N.Y. 2012) (applying New York law).
[6] See, e.g., PT Kaltim Prima Coal v. AES Barbers Point, Inc., 180 F. Supp. 2d 475, 482 (S.D.N.Y. 2001) (applying New York law).
[7] See, e.g., Phillips Puerto Rico Core, Inc., 782 F.2d at 319 (“the non-performing party must demonstrate its efforts to perform its contractual duties despite the occurrence of the event that it claims constituted force majeure.”); Watson Labs., Inc. v. Rhone-Poulenc Rorer, Inc., 178 F. Supp. 2d 1099, 1110 (C.D. Cal. 2001) (under California law, a party claiming performance was excused by an express force majeure provision must show “affirmatively that his failure to perform was proximately caused by a contingency within [the] terms [of the force majeure clause]; [and] that, in spite of skill, diligence and good faith on his part, performance became impossible or unreasonably expensive”).
[8] See, e.g., VICI Racing, LLC v. T-Mobile USA, Inc., 763 F.3d 273, 288 (3d Cir. 2014) (applying Delaware law); Watson Labs., 178 F. Supp. 2d at 1111-12 (applying California law).
[9] See, e.g., VICI Racing, 763 F.3d at 288 (under Delaware law, “financial hardship itself does not constitute a condition excusing performance under a force majeure provision”); Route 6 Outparcels, LLC v. Ruby Tuesday, Inc., 88 A.D.3d 1224, 1226, 931 N.Y.S.2d 436 (3d Dep’t 2011) (under Pennsylvania law, adverse economic conditions do not constitute force majeure excusing performance of a contract).
[10] See also, e.g., Reade v. Stoneybrook Realty, LLC, 63 A.D.3d 433, 434, 882 N.Y.S.2d 8, 9 (1st Dep’t 2009) (where “governmental prohibition” was a specified force majeure event in a commercial lease, landlord’s obligation to perform was suspended while a judicial temporary restraining order was in effect).
[11] See, e.g., Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 739-40 (Del. Ch. 2008).
[12] In re IBP, Inc. Shareholders Litig., 789 A.2d 14, 68 (Del. Ch. 2001) (emphasis added).
[13] When an MAE provision is more detailed and contains express inclusions and/or exclusions, however, courts have been more willing to conclude an MAE/MAC has occurred because of foreseeable risks, provided the language of the agreement supports such a holding.
[14] See, e.g., Capitol Justice LLC v. Wachovia Bank, N.A., 706 F. Supp. 2d 23, 30 (D.D.C. 2009) (denying summary judgment on the basis that the “MAC clause is ambiguous, and it is for the fact-finder to decide whether a MAC is any meaningful or significant adverse change, or whether a MAC is an unforeseeable adverse change”); All. Indus., Inc. v. Longyear Holdings, Inc., 854 F. Supp. 2d 321 (W.D.N.Y. 2012) (denying summary judgment because there was no evidence that the effect was material in the circumstances); Solutia Inc. v. FMC Corp., 456 F. Supp. 2d 429, 442 (S.D.N.Y. 2006) (noting that the MAE “question [is] inherently difficult to resolve on summary judgment because it requires an assessment of all the facts and circumstances surrounding the situation”).
[15] See, e.g., Kel Kim Corp., 70 N.Y.2d at 902.
[16] See, e.g., Kama Rippa Music, Inc. v. Schekeryk, 510 F.2d 837, 842-43 (2d Cir. 1975) (“The party pleading impossibility as a defense must demonstrate that it took virtually every action within its powers to perform its duties under the contract.”) (applying New York law)
[17] See, e.g., Kel Kim Corp., 70 N.Y.2d at 902.
[18] See, e.g., Habitat Tr. for Wildlife, Inc. v. City of Rancho Cucamonga, 175 Cal. App. 4th 1306, 1336, 96 Cal. Rptr. 3d 813 (2009) (“A thing is impossible in legal contemplation when it is not practicable; and a thing is impracticable when it can only be done at an excessive and unreasonable cost. This does not mean that a party can avoid performance simply because it is more costly than anticipated or results in a loss.”); Maudlin v. Pac. Decision Scis. Corp., 137 Cal. App. 4th 1001, 1017, 40 Cal. Rptr. 3d 724 (2006) (“The obligation to perform is not excused or discharged by a temporary impossibility—it is merely suspended—unless the delayed performance becomes materially more burdensome or the temporary impossibility becomes permanent.”).
[19] See, e.g., Bush v. Protravel Int’l, Inc., 192 Misc. 2d 743, 750-54, 746 N.Y.S.2d 790, 795-97 (Civ. Ct. 2002) (holding that measures taken by the State and City governments, including the declaration of a State of Emergency in the wake of September 11, 2001, strongly supported the claim that performance had been rendered temporarily impossible for a period of time); see also, e.g., In re Martin Paint Stores, 199 B.R. 258, 266 (Bankr. S.D.N.Y. 1996) (“[T]he entry of a judicial order that renders performance legally impossible excuses the party who must perform as long as he did not cause or fail to prevent the entry of the judicial order.”), aff’d sub nom. S. Blvd., Inc. v. Martin Paint Stores, 207 B.R. 57 (S.D.N.Y. 1997); Stasyszyn v. Sutton E. Assocs., 161 A.D.2d 269, 271, 555 N.Y.S.2d 297, 299 (1st Dep’t 1990) (“absent an express contingency clause in the agreement allowing a party to escape performance under certain specified circumstances, compliance is required even where the economic distress is attributable to the imposition of governmental rules and regulations or the inability to secure financing”).
[20] Bush, 192 Misc. 2d at 750-54, 746 N.Y.S.2d at 795-97.
[21] See, e.g., Inter-Am. Dev. Bank v. Nextg Telecom Ltd., 503 F. Supp. 2d 687, 696 (S.D.N.Y. 2007) (“A government order prohibiting performance under a contract may be grounds for claiming impossibility, but only where ‘the fault of the party owing performance did not contribute to the order. . . . Resolution of the defense of impossibility requires an examination into the conduct of the party pleading the defense in order to determine the presence or absence of such fault. In all but the clearest cases this will involve issues of fact’ that preclude summary judgment.”).
[22] See,e.g., 407 E. 61st Garage, Inc. v. Savoy Fifth Ave. Corp., 23 N.Y.2d 275, 281, 296 N.Y.S.2d 338, 344, 244 N.E.2d 37, 41 (1968); (“[W]here 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.”).
[23] See, e.g., Gander Mountain Co. v. Islip U-Slip LLC, 923 F. Supp. 2d 351, 359 (N.D.N.Y. 2013), aff’d, 561 F. App’x 48 (2d Cir. 2014) (applying New York law); Waegemann v. Montgomery Ward & Co., 713 F.2d 452 (9th Cir. 1983) (applying California law); Chase Manhattan Bank v. Iridium Africa Corp., 474 F. Supp. 2d 613, 620 (D. Del. 2007) (applying Delaware law).
[24] See, e.g., Norcon Power Partners, L.P. v. Niagara Mohawk Power Corp., 92 N.Y.2d 458, 463, 705 N.E.2d 656 (1998) (anticipatory repudiation of a contract may take the form of “either a statement by the obligor to the obligee indicating that the obligor will commit a breach that would of itself give the obligee a claim for damages for total breach or a voluntary affirmative act which renders the obligor unable or apparently unable to perform without such a breach.”).
[25] See, e.g., Comedy Club, Inc. v. Improv W. Assocs., 553 F.3d 1277, 1289 & n.12 (9th Cir. 2009) (applying California law); Medinol Ltd. v. Bos. Sci. Corp., 346 F. Supp. 2d 575, 618 (S.D.N.Y. 2004) (“As a general principle of contract law, a material breach excuses the other party’s nonperformance.”) (applying New York law).
[26] See, e.g., Frank Felix Assocs., Ltd. v. Austin Drugs, Inc., 111 F.3d 284, 289 (2d Cir. 1997) (“A party’s obligation to perform under a contract is only excused where the other party’s breach of the contract is so substantial that it defeats the object of the parties in making the contract.”) (applying New York law).
[27] See, e.g., Barbagallo v. Marcum LLP, 925 F. Supp. 2d 275, 287 (E.D.N.Y. 2013), aff’d, 552 F. App’x 102 (2d Cir. 2014), (citing Restatement (Second) of Contracts § 241 (1981) (listing circumstances that are significant for determining materiality of a breach)).

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