By Anthony P. Alden, Special to California Business Journal.
In light of the unprecedented spread of COVID-19, and the measures taken to halt it, contractual obligations are becoming more difficult, costly, or even impossible to perform. Global supply chains have been disrupted as China, the global leader in manufacturing output, put at least 50 million people under a mandatory quarantine for more than a month. Businesses may find that commercial agreements that seemed lucrative at the time are now money losers. As market conditions worsen, institutions may face challenges accessing credit and investors may re-evaluate existing and prospective commitments. Business leaders should be aware of a few fundamental legal principles that may help them navigate a precarious commercial environment.
Force Majeure: The purpose of a force majeure clause in a contract is to limit damages in a case where the reasonable expectation of the parties and the performance of the contract have been frustrated by circumstances beyond the control of the parties. A sample force majeure clause might read: “The parties’ performance under this Agreement is subject to acts of God, war, government regulation, terrorism, disaster, strikes (except those involving a party’s employees or agents), civil disorder, curtailment of transportation facilities, or any other emergency beyond the parties’ control, making it impossible to perform their obligations under this Agreement. Either party may cancel this Agreement for any one or more of such reasons upon written notice to the other.” U.S. courts look at various elements when considering a claim of force majeure.
Does the contract contain an applicable force majeure clause? There must be a contractual force majeure clause that encompasses the claimed force majeure event. Force majeure clauses are typically construed narrowly and applied only to the events listed in them.
Was the force majeure foreseeable? If there is an applicable force majeure clause but the epidemic is not listed, rather it is only captured through catch-all language, some courts may independently inquire whether the applicable event was truly unforeseeable.
Was performance rendered impossible? Performance will generally be excused only if the force majeure rendered performance impossible. Courts may look into whether performance was attempted and failed before excusing performance for a force majeure, though this varies by jurisdiction and can usually be overcome by the language of the contract. Courts will usually find that a government order prohibiting performance renders contractual performance impossible and therefore excused.
Was it the force majeure that rendered performance impossible? The occurrence of a force majeure and coincidental impossibility of performance are not enough to excuse performance; it must be the force majeure that renders performance impossible.
Have all contractual pre-requisites been met? Parties should pay careful attention to the particular requirements of the contract. Some contracts require due diligence, notice, and/or seeking assurance before force majeure can be raised as an excuse.
In some cases, a force majeure may be a sufficient excuse even where performance was not truly impossible but rendered prohibitively difficult. A business that may be unable to perform its obligations due to the virus should act in good faith and document the circumstances as best as possible. Helpful, contemporaneous documentation may make the difference in close cases. As government actions, orders, and supply chain disruptions in response to the virus become increasingly severe, businesses considering the applicability of a force majeure clause will want to carefully document the effects of these events on their ability to fulfill contractual obligations. Businesses should pay particular attention to the effect of government interventions, such as travel and import restrictions, because these are often the most compelling bases for invocation of a force majeure clause.
Frustration of Purpose: Without an applicable contractual force majeure clause, a business may still be able to escape contractual obligations due to an epidemic when a change in circumstances makes performance of the contract virtually worthless. Litigating frustration of purpose involves two required inquiries: (1) Was there a mutually understood basis of the contract without which the transaction would have made little sense?; and (2) Was the basis of the contract fully and completely frustrated? The contract need not have been rendered impossible, just pointless to one party due to frustration of its purpose. Businesses should consider whether there is a record to show that all counterparties understood the factual basis that foregrounds the contract. If a mutually understood purpose can be shown, businesses should consider how they can show the effects of the novel coronavirus on that purpose.
Impossibility: Where there is no applicable force majeure clause, and no mutually understood contractual purpose, but contractual performance is rendered impossible, the excuse of impossibility may apply. At least two elements must be present: (1) Performance of the contract must have been made impossible; and (2) The event causing impossibility must have been unforeseeable. If it was a foreseeable event that could have been negotiated around in the contract (e.g., in a force majeure clause), courts will be reluctant to excuse performance based on impossibility. In some cases, an impossibility defense may succeed where extreme external factors have rendered performance impossible within the realm of reason, even if not truly impossible. The outcome of any future litigation may depend heavily on the specific facts developed. Businesses should actively document the specific effects of the outbreak on their contracts, business, and industry.
Material Adverse Change / Effect: Merger and acquisition agreements present a particular species of challenging performance, given the stakes involved. Some such agreements contain a so-called material adverse change or material adverse effect clause (“MAC” or “MAE”) that allow a buyer to terminate the agreement in the event of a material adverse event. Courts presented with an applicable MAC clause (that does not exclude epidemics) will also typically inquire whether the supposedly material event was unknown at the time of contracting and substantially threatens the overall earnings potential of the target in a durationally-significant manner. Businesses assessing whether a MAC has occurred should consider the following:
Were the conditions underlying the MAC known at the time of contracting? For contracts entered into after the start of the outbreak, the answer might be yes. That would hurt, but not necessarily destroy, a MAC claim, depending on the actual facts and circumstances of the case. Going forward, the novel coronavirus should be specifically dealt with in negotiated MAC clauses – as some companies are already doing.
What are the long term implications of the MAC? Buyers that seek to invoke the coronavirus as a MAC will have to prove that its effects are more than a short-term hiccup. While exceptions exist, as a rule-of-thumb, courts may uphold the application of MAC clauses after being presented with evidence of sustained drops in performance exceeding 40% year over year. Courts are unlikely to be persuaded by cyclical fluctuations, but may be moved by such massive year-over-year downturns.
Does the novel coronavirus affect the target greater than its peers? Courts often frown upon the application of a MAC for industry-wide downward trends. Look for analyst predictions of a company-specific downturn markedly more significant than its peers. An industry-wide downturn is not preclusive to the application of a MAC, but it cuts against the argument that the target experienced a true MAC.
Is there a direct link from the MAC to the target’s downturn? Businesses that believe they may need to litigate the applicability of a MAC should look carefully at the reasons for the downturn in performance at the target. Courts will seriously consider evidence that the downturn is for reasons unrelated to the MAC, or even lack of evidence that the downturn and the MAC are related.
Is a privately negotiated resolution possible? Although this is not likely to play into the outcome of future litigation, courts are historically reticent to apply MAC clauses. Given the uncertain and difficult landscape for enforcing a MAC in litigation, parties might want to consider whether they can achieve an agreeable adjustment to the deal price in private negotiations based on the unexpected effects of the novel coronavirus.
Ultimately, it may be premature to tell how long-lasting the effects of the COVID-19 epidemic will be. But if corporate earnings are depressed and analysts predict potential longer-term effects for certain companies and industries (e.g., cruise lines), MAC clauses may become relevant.
The novel coronavirus has and will continue to give rise to extreme business disruption and new and unforeseen liabilities across the business spectrum. Businesses should be aware of their legal rights, and potential exposures, and consult with legal counsel about proactive measures to both avoid liability and prepare for potential legal challenges ahead.
Anthony P. Alden is an attorney at Quinn Emanuel Urquhart & Sullivan, LLP, the largest firm in the world solely devoted to litigation and arbitration.