COVID-19: Impact on contractual obligations
Navigating business interruptions, from breaches of contracts to force majeure
Our clients are seeing significant supply chain disruption; the cancellation of conferences, sporting events and international travel; closure of public places; and restrictions on movement. As businesses suffer broadening interruptions to their operations, complex (and often interrelated) questions regarding force majeure, breaches of contract and insurance coverage are emerging. Below are the most pressing questions clients are asking us and our thoughts on those issues.
There may be an entitlement to relief where your contract contains a force majeure (or equivalent) clause. It is important to consider notice provisions carefully.
You must determine whether the clause codifies the events giving rise to relief. Historically, many contracts included a pandemic head of relief, and that is now very likely to apply to COVID-19. Where the clause does not provide specific relief (and operates as a code) there is unlikely to be an entitlement. We have seen a number of recent claims by parties seeking to shoehorn a COVID-19 argument into a force majeure clause that purports to cover the field and lists, for example, natural disaster, lockout and/or civil unrest. Such claims are unlikely to succeed (see below).
Relief under a clause linked to the impacts of the exercise of governmental powers is likely to become increasingly relevant, as we see various jurisdictions (including at a state and federal level in Australia) take measures to control the spread of the virus.
There is no implied force majeure concept in Australia. However, this concept may be implied into contracts governed by civil law jurisdictions, including China, and you should consider the governing law of your contract and the place(s) of performance.
- Trigger events: You will need to demonstrate a causal nexus between the relevant event and the impact on your business. For a customer, while your demand for certain goods or services may have declined as a result of COVID-19, you will not necessarily be excused from an obligation to purchase minimum quantities of those goods or services under your contract if you are not prevented from complying with the purchasing obligation as a result of the virus. Hardship is unlikely to be relevant (on the buy and sell sides).
- Notice requirements: You may be required to give notice of the relevant event (in some cases, 'immediately') in order to seek relief.
- Known events: It is arguable that a party entering into a contract in late February, when the COVID-19 epidemic was known, will not subsequently be entitled to relief on the declaration of a pandemic.
- Requirement to mitigate: The terms of the contract may require you to show evidence that you have taken all reasonable steps to avoid the event or the impact of its consequences.
Some contracts include a right (often mutual) to terminate if the relevant event occurs for a specified period. There will likely be notice requirements, both when the event occurs and before termination.
There may also be consequences of termination for your business that you will want to consider, including liability for the counterparty's stranded costs, the effect on your commercial relationship with the counterparty, and reputational damage. There is also a risk of wrongful termination (or repudiation), for which the counterparty can claim damages, so you will want to ensure your termination rights are clear.
You may have the following alternative options available to you:
- Reduce the volume of services and/or goods you procure under the contract if your demand has dropped. This may involve revising your forecasts immediately.
- Exercise step in rights while your supplier is unable to deliver the goods and/or services.
- Consider alternative suspension rights under the contract that may be more suitable.
- Negotiate a commercial arrangement with your counterparty that is mutually acceptable in the circumstances.
In limited circumstances, you may seek to rely on the common law doctrine of frustration. This will bring a contract to an end in circumstances where an intervening event has occurred, through no fault of the parties, which makes a contractual obligation impossible to perform or transforms a contractual obligation into a fundamentally different obligation.
The doctrine of frustration has a very narrow scope. Frustration will not arise where there has been mere hardship – even if severe – where the event in question has been foreseen or where the change is only temporary or transient.
Courts have found that frustration has arisen in the following potentially relevant circumstances:
- a fundamental change in the basis of the contract;
- when the contract can no longer go ahead as envisaged;
- when an event occurs that has no immediate impact on the contract, but will foreseeably affect it in the future;
- supervening impossibility through government interference (possibly applicable, particularly if the Australian Government bans large gatherings of people); and
- a change in law rendering performance illegal (not relevant to COVID-19, at present).
Again, repudiation risk is a critical consideration. Damages may well be significant in the context of long-term relational contracts; it will be worthwhile to consider the potential consequences of repudiation, by reference to any limitation clauses (regarding consequential loss and or liability caps).
Reliance on a force majeure clause to obtain relief from performance will often lead to disputes. A particularly fruitful area for disputes relates to a failure to provide timely notification (in many circumstances, timely notification will be a condition precedent to an entitlement). We also commonly see disputes about the claiming parties' knowledge of the relevant events, and relating to the alleged nexus between the event and the impact on performance. For example, a supplier's claim might be contestable where impediments to performance can be reasonably overcome, including by finding alternative subcontractors; or if it fails to mitigate the effects of the event. Clearly, you should also assess whether resisting the supplier's claim will negatively impact upon your ongoing business relationship (and whether that is acceptable).
The doctrine will not apply where the relevant events are addressed in an appropriately drafted force majeure clause (or elsewhere in your contract). There are a number of examples of the courts holding that a claim for frustration must fail. Given the risk of repudiation, it is a high-stakes strategy and one that is likely to create disputes in the current environment. It is our expectation that suppliers in some industries will seek to rely on this doctrine, to obtain leverage to negotiate more onerous terms. In those circumstances, you need to make clear to suppliers that they must satisfy a very high threshold, by demonstrating that the contract is no longer capable of performance (through no default by the purchasers of goods and materials). The onus is on the supplier to establish that it satisfies that threshold, and purchasers ought to seek fulsome evidence and explanations as to how the contract has been said to be frustrated.
This is an option, provided the existing supplier has not been appointed on an exclusive basis. However, bear in mind that if you intend to continue the existing supply arrangement, you may be liable to pay your existing supplier once it becomes able to perform its obligations again. Flexibility should also be built in to any new supply arrangements, to take account of the current circumstances.
Where businesses need to find a new or replacement supplier (whether temporarily or on a longer-term basis), in the current environment they should draft the supply contract in a way that contemplates the commercial risks of COVID-19. The following provisions will be key:
- Priority clauses can be used to protect against the possibility of further shortages. These clauses may require the supplier to distribute its products on a pro rata basis among its customers, or even to prioritise one customer. Without these protections, most suppliers will be motivated to provide available stock to the highest bidder.
- Pandemic or contagion clauses can set out the parties' obligations in the specific event that supply is affected by COVID-19. Using a dedicated clause, rather than resorting to a general force majeure or exceptional event mechanism, will afford businesses greater control and certainty.
- Term and termination clauses should contemplate the broader commercial considerations of the business. If the replacement supplier is providing a temporary supply of goods or services while arrangements with the old supplier remain on foot, the new supply contract should be flexible, potentially containing a short term and termination provisions that allow for a quick exit by the customer.
You should review and understand the terms and conditions of your insurance arrangements, as each policy can differ significantly, depending on its wording.
The types of insurance that are particularly likely to be relevant are business interruption insurance (BII) and contingent business interruption insurance (CBII).
Generally, BII covers loss of income in circumstances where your operations are interrupted as a result of damage to the premises from which your business is conducted; whereas CBII insures against losses incurred because your ability to supply a product or service is interrupted due to an impact on your suppliers. Losses caused by interruptions due to epidemics or pandemics are often excluded in these types of policies but, in some cases, cover may be available. For example, some BII policies extend the concept of damage to include notifiable disease.
Take note of any excesses, the indemnity period and the limits of cover for these kinds of insurance policies. Prompt notice to insurers is also likely to be important.