COVID-19 – When a party cannot meet its contract obligations
Dudley Kneller | Partner, Gadens | Dudley.firstname.lastname@example.org
The current state of play
The outbreak of COVID-19 has ushered in extraordinary challenges to the Australian and global business landscape. The Government response and action to COVID-19 continues to evolve on a day-by-day basis, with further restrictions being imposed in a rapid attempt to control the spread of the virus.
The restrictions are being introduced at both a State and Federal level as both try to grapple with the impact of COVID-19. Currently, the Federal Government has closed the Australian borders (with limited exceptions), the National Rugby League and Australian Football Leagues have suspended their seasons, cafes and restaurants can only provide takeaway and home delivery services, gyms and business entertainment venues are closed to the public and if you're planning to get married, it will be in front of a small crowd, with attendance limited to no more than 5 people.
The economic and public health impact of COVID-19 is unprecedented as businesses trigger their business continuity plans and attempt to shore up supply chains and customer relationships.
So what happens if you or one of your suppliers cannot deliver on a contract? Your supply chain is in lockdown overseas and you are no longer receiving goods to deliver to your Australian customers, your key components manufacturer cannot deliver replacement parts as its equipment is out of action, and your tech support partner refuses to attend your physical sites out of fear of their staff contracting the virus.
These are all real scenarios that present risk to all parties concerned.
So how do you mitigate against such incidents? How do you protect your business in the event of a claim against you for non-delivery, or on the flipside, how do you successfully mount a claim against a defaulting party?
Does your contract help?
Along with all the usual suspects, such as payment terms, supply obligations, intellectual property, confidentiality and termination, a ‘force majeure’ clause may assist if you have one.
Once triggered, a force majeure clause will allow an affected party to be relieved from its obligation to perform, or extend the timeframe for performance of, that obligation. A force majeure clause will almost certainly have a list of specific triggering events, and may also contain a catch-all provision such as ‘and any causes beyond the reasonable control of the party’.
Triggering events include acts of God (earthquakes, storms, flood, and lightning strikes), war, terrorism, riot, insurrection and (sometimes) industrial action. Pandemic is unlikely to be listed in an existing clause although case law does support the inclusion. More about that later.
Force majeure events are required to be outside the reasonable control of a party claiming the event has occurred. Sometimes there are additional requirements negotiated between the parties, including exclusions for the acts or omissions of subcontractors as well as exclusions where the affected party could have taken reasonable steps to mitigate against the event. A force majeure clause will be construed against the party seeking to rely upon it.
From a supplier perspective a broad and comprehensive list of triggering events will assist that party to claim the benefit of the provision. The flipside is also true, with customers often seeking to narrow the scope of triggering events and imposing exclusions on when a force majeure clause can be genuinely invoked.
Once invoked, the clause will provide that the parties' obligations under the contract will be suspended until the force majeure event (and its direct effects) have ceased to prevent performance of the contract.
Most clauses will provide that if the force majeure event is not resolved within a certain time, for example 60 days, then the parties will have the right to terminate the contract or perhaps to agree on a variation. The parties should consider the knock-on effect on other provisions under the contract. For example, it may be appropriate to provide that the term of the contract will be extended by the duration of the force majeure event.
No force majeure clause? Maybe your contract has been 'frustrated'
Force majeure should be distinguished from the common law doctrine of frustration, which relieves parties of liability to one another if there has been a supervening event beyond the control of the parties which results in a radical change in the circumstances in which a contract is to be performed. It is important to remember that force majeure is not a common law doctrine but rather a commercial construct and will only operate if specifically provided for in the contract.
Frustration operates to bring a contract to an end in circumstances where an intervening, post-contract 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. Frustration applies to both parties in a contract, ending obligations on both sides. Frustration is typically not easy to establish and has a narrow scope.
A contract will generally not be frustrated if it has an operative force majeure clause that can deal with the relevant issue. Further, a contract will not be frustrated if the change is only temporary or transient.
Relevantly in the current COVID-19 circumstances, a Hong Kong case arising from the SARS epidemic illustrates this issue. In Li Ching Wing v Xuan Yi Xiong  1 HKLRD 754, a tenant was the subject of a 10-day isolation order due to SARS, and at the time was 13 months into a 24-month lease. The tenant sought to invoke frustration to discharge the lease. The court rejected the tenant’s argument because the isolation order was only of a short duration in the context of the entire lease. A force majeure clause may have been more helpful to him!
Practical considerations and tips moving forward
For those of you on the supply side who may be affected, it is important to properly understand the mechanics of your arrangement and ensure you have the necessary rights to call ‘force majeure’. Exploring other alternatives which will allow you to meet your contractual obligations is important. Such alternatives should be commercially feasible, but you will be required to work within the parameters of the agreed provision. Once you have made the determination, be on the front foot and engage with your customer early. You may be able to provide a work-around, alternative form of supply or renegotiate the obligation entirely.
So too for those on the receiving end. Again, your contract will determine the scope and applicability of the force majeure event. Engage with key suppliers early and understand what, if any, risks may apply to product and service delivery to your business. Discuss workarounds and alternative forms of supply to overcome or mitigate the impact.
Be careful if you exercise a right to terminate. While it may be a contractual right which is open to you, if not executed properly it puts you at risk of a claim of ‘repudiation’ by your supplier. Commercially the termination remedy may be unhelpful as ultimately you are likely wanting to ensure continuity of service or product delivery as a priority. Nevertheless, termination rights should always be on the table.
In the current environment we are already seeing a flurry of activity as parties quickly work out what their key contracts say about force majeure. Many suppliers and customers are already reworking contracts to provide for greater flexibility in future. For those of you that are entering into new engagements, we expect new contracts will expressly reference ‘pandemic’ or similar wording as a triggering event. There will no doubt be heated negotiations on whether foreseeable events can or even should be included.
Suppliers should expect to see additional reporting obligations, business continuity planning obligations and other similar requirements to support customers in the event of force majeure. Some contracts may include ‘step in’ rights or similar for an affected customer in addition to stronger termination options.
For suppliers seeking to mitigate risk in a force majeure situation, we expect the usual carve out in relation to payment obligations. In other words, a force majeure event does not relieve a party from liability for an obligation which arose before the event occurred, and does not affect the obligation to pay money in a timely manner before the event occurred.
We encourage you to engage in this review activity early to ensure that you are not caught short. Understand your key legal and commercial arrangements and address major supply and delivery risks. Taking time to address this issue now will allow you to position your organisation well, so you can move through COVID-19 with a minimum (or at least reduced) level of disruption.