The coronavirus disease 2019 (“COVID-19”) global pandemic and the government responses being implemented to seek to slow its spread have caused many individuals and organizations to consider the impact COVID-19 will have on their business and their ability to meet obligations under their commercial agreements.
As a general rule, parties are required at law to comply with their contractual obligations, unless certain exceptions apply. Exceptions may be specifically contemplated in written agreements or in some cases may be implied by a court as a result of exceptional circumstances.
This article considers the following questions:
- Can a party rely on a “force majeure” clause in a commercial agreement to delay or excuse performance of its obligations as a result of COVID-19?
- Is COVID-19 a “material adverse effect” under a purchase agreement in a mergers and acquisitions (“M&A”) transaction?
- Can a party terminate a commercial agreement on the grounds that COVID-19 frustrates or makes the performance of the agreement impossible?
- What are some other considerations parties should be alive to when considering the impact of COVID-19 on their commercial agreements?
Can COVID-19 Constitute Force Majeure Under a Commercial Agreement?
Many commercial agreements include language which provides that in the case of an extreme and unforeseeable event beyond the control of either party (called a “force majeure”) one or both parties may suspend, delay or even terminate the agreement.
Force majeure clauses are about allocating risk for future events that could affect the ability to carry out contractual obligations, and are meant to protect against events outside normal business risk and beyond the parties’ reasonable foresight and control.
Whether or not a party can successfully claim a force majeure in connection with COVID-19 will depend on a number of factors, including:
- Whether COVID-19 meets the criteria of a force majeure event under the agreement— COVID-19 is more likely to qualify as a force majeure in the case of an agreement that refers to “pandemic”, “outbreak” or “disease” (or “quarantine” or “government restriction”, in the case of agreements impacted by government steps to mitigate the outbreak) as opposed to a broader phrase like “circumstances beyond the party’s reasonable control”. Force majeure clauses may also expressly exclude certain events, for example inability of a party to perform its obligations due to lack of funds or exclude certain obligations, such as the obligation to pay rent under a lease.
- The impact COVID-19 actually had on the party’s ability to perform the contract—Agreements generally require that a force majeure actually affect a party’s ability to perform the contract to a required extent before the clause can be invoked.
- Steps the party has taken to avoid or mitigate the effect of COVID-19 on the contract — Many force majeure clauses will include an express obligation on the party invoking the clause to avoid or mitigate the event of force majeure to the extent possible.
- The requirements for giving notice of the force majeure event under the agreement— Agreements typically set out procedures for when a party invoking a force majeure clause must give notice to the other party in order to rely on the clause.
Before invoking a force majeure clause in a commercial agreement, a party should closely review the language of the agreement, consider the factors discussed above and seek legal advice as to the likelihood of success of relying on the clause. Terminating or delaying performance of an agreement can involve a high risk of a legal claim by the other party that an event was not a force majeure, and potentially significant damages if such claim were successful.
Where a commercial agreement does not include a force majeure clause, a party will not be able to claim force majeure in connection with COVID-19, although it may be able to rely on the legal doctrine of frustration or impossibility (discussed below) in attempting to terminate or delay the contract.
Can COVID-19 be a Material Adverse Effect in an M&A Transaction?
Many purchase agreements in M&A transactions include the concept of a “material adverse effect” (or “material adverse change”) to measure the negative effect certain events may have on the transaction, to qualify the representations and warranties a party is making in the agreement, and/or to provide that a party may terminate the agreement before completing the transaction if such a material adverse effect occurs.
Some agreements specifically define what constitutes a “material adverse effect” while others do not. Definitions often refer to a material adverse effect as being generally any effect or change that has a materially adverse effect on the business or asset being purchased, or on the ability to complete the transaction, but may also specifically exclude certain changes, such as those relating to changes in general economic conditions, applicable law or as a result of disasters or acts of God.
Whether a party can invoke a material adverse effect provision in response to COVID-19 is highly dependent on the facts of the specific M&A transaction, and the language of the purchase agreement.
That said, invoking a material adverse effect clause at this point in time carries the risk that doing so could very well result in a lawsuit with the other contracting party. In some circumstances it will be difficult to show clearly that the negative effect is “material” given that the long-term effects of the COVID-19 pandemic on the operations of a particular business, and the economy in general, are likely uncertain at this time. In others, the negative effect may more clearly constitute a material adverse effect, such as where operations of the business to be acquired have been shut down.
Can COVID-19 Frustrate or Make Performance of a Contract Impossible?
Where commercial agreements do not include express contractual provisions for force majeure or material adverse effect, there is some relief available at common law, as in certain circumstances a court may find that an event has frustrated or made the performance of the contract impossible. These legal doctrines apply in the case of exceptional circumstances, and courts typically take a narrow approach to their interpretation and application.
The doctrine of frustration excuses the performance of a contract where extreme events have made the purpose of the contract substantively different than what the parties had originally intended at the time that they entered into the contract. Impossibility will apply where such events have made performance of the contract objectively impossible (not just more difficult or less feasible in terms of time or resources required).
The extreme event that is at the centre of the frustration or impossibility claim cannot be the fault of either party and cannot be something that was contemplated or reasonably foreseeable at the time the parties entered into the agreement.
Where the circumstances of the COVID-19 pandemic have made performance of the agreement objectively impossible, or radically different than what was originally intended, these legal doctrines may apply, although in both cases the legal bar is high and will be driven based on the specific facts of the situation and agreement in question.
What Are Some Other Considerations Relating to COVID-19 and Commercial Agreements?
In evaluating the impact of COVID-19 on a commercial agreement, a number of other factors may be relevant:
- Specific Requirements in the Agreement– Parties must review the language of their commercial agreements in detail, especially for provisions that relate to termination, and ensure they are complied with strictly. This includes reviewing any requirement for giving notice to the other party under the agreement, and how such notice must be given (for example, there may be complications in giving notice by mail where a party has closed its physical office and employees are working remotely).
- Negotiated Solutions – The COVID-19 pandemic is negatively impacting businesses across entire sectors of the economy, and in many contexts contracting parties are negotiating ways to weather the storm, preserve their mutually-beneficial relationships and resume normal operations following the pandemic. In many cases the best course of action will be to consider and negotiate alternate interim arrangements during the crisis, as opposed to looking to terminate agreements and potentially dispute the matter through litigation.
- Insurance Claims – Parties are encouraged to review their business interruption insurance and other polices and consider if any losses resulting from breach or repudiation of agreements can be claimed. Whether losses caused by COVID-19 are an insured risk will depend on the terms of the insurance policy, so these should be reviewed in detail and discussed with insurance providers, particularly as many are adopting specific procedures related to COVID-19.
EKB’s Business Law team is experienced and knowledgeable in all areas of drafting, negotiating and disputing commercial agreements and is here to assist business owners navigating contract and other issues in the context of the ever-changing COVID-19 pandemic.