For global clients with contracts governed by US law, now is the time to consider the key provisions of existing contracts (as well as contracts under negotiation) and to take practical steps to safeguard legal and contractual rights. Care needs to be taken, however, because sometimes familiar phrases – like force majeure and impossibility – have similar, but different meanings in different jurisdictions. Knowing how the US applies these concepts is critical for those with contracts governed by the law of a US state. As reviewed below, there are key nuances of which companies should be aware.
As importantly, there are legal tools – such as a request for adequate assurances – that are unique in the United States and may offer contracting parties strategic options that they do not have in other countries.
Force majeure contractual provisions may relieve a party from the consequences of failing to comply with an obligation where that failure is due to an unforeseeable event outside of the party’s control. Such provisions may allow for termination of the contract without any resulting liability. Unlike in many civil law jurisdictions, in the United States force majeure is only available if the provision is included in the parties’ contract.
Force majeure provisions tend to be narrowly construed in the US and will generally only excuse a party’s non-performance if the event that caused the non-performance (e.g., a global pandemic) is itself specifically identified in the clause. Broad “catchall” language in force majeure clauses that describe a general category of events will be even more narrowly interpreted by US courts.
In general, US courts will conduct a fact-intensive analysis to determine whether force majeure should apply in a given situation in light of the relevant contract and commercial issues at stake. Thus, the same event that triggers a force majeure defense under one contract may not be available under a different contract given the multiple factors relevant to the party’s ability to perform its obligations.
Key considerations include whether:
- viruses/epidemics are explicitly listed as force majeure events;
- COVID-19 may be proven to have, in fact, caused the inability to perform;
- there is a duty to mitigate or the event can in some way be overcome to enable partial performance; and
- the force majeure provision contains specific notification requirements.
The non-performing party bears the burden of proof to demonstrate that the contract cannot be performed because of the alleged force majeure, or, in US legal terms, that the failure to perform was proximately caused by the event. When events affect profitability (e.g., changes in market demand) but not performance, they are unlikely to excuse non-performance. In addition, where a contractual obligation may be partially fulfilled, such as by allocation of materials among customers, failure to make a reasonable allocation (i.e., electing to supply one customer over another) can break the chain of causation and result in requested force majeure relief being denied. Similarly, force majeure may not provide relief with respect to any parts of a contract that can still be performed.
Notification requirements are critical, and failure to provide notice if required under the force majeure provision may preclude relief.
Absent a contractual force majeure provision, a party may still be able to excuse performance under other common law doctrines, such as impossibility or frustration (described below).
Material Adverse Change and Material Adverse Effect Clauses
US contracts may also contain “material adverse change” (“MAC”) or “material adverse effect” (“MAE”) clauses permitting unilateral termination in certain circumstances. Often, in the commercial context, parties will negotiate the definition of a MAC or MAE in the contract and specify the rights and obligations that follow. In general, however, the standard under which the event or occurrence alleged to cause an MAE will be reviewed is very high, and parties should not simply assume that a global pandemic – even of the scale of COVID-19 – will automatically excuse performance or permit a party to terminate the contract.
In the context of M&A transactions, the occurrence of a MAC or MAE provides the acquirer, at least in theory, with a right to terminate the agreement (and not be required to close the transaction). In practice, though, the ability to terminate a transaction based on the occurrence of an MAE is incredibly rare, and the standard by which both Delaware and New York courts judge whether an MAE has occurred is incredibly high. Furthermore, most acquisition agreements typically contain a lengthy list of exclusions, the occurrence of which will not constitute an MAE (effectively, shifting the risk of one of the enumerated exceptions to the acquirer).
As with force majeure provisions, the precise wording of the clause is particularly important in assessing whether COVID-19 might qualify as a MAC or MAE.
Frustration or Impossibility
Even if a contract does not contain a force majeure provision or MAC/MAE clause, the governing US state law of the contract may excuse performance if, through no fault of the non-performing party, a party’s principal purpose is substantially frustrated.
The frustration doctrine is narrow and will not be available:
- if the contract provides, expressly or impliedly, for the risk of supervening events that have occurred;
- simply because a contract has become less economically lucrative; or
- if the circumstances were foreseeable.
Whether a party can invoke frustration as a result of the COVID-19 outbreak will turn on the length and intensity of the disruption, and whether this can be overcome with time.
Performance may also be excused when a supervening event has made the performance of a contract impossible. As with frustration, the doctrine of impossibility is applied narrowly. For example, under New York law, the impossibility doctrine excuses a party from performing its obligations “only when the destruction of the subject matter of the contract or the means of performance make performance objectively impossible.”
A request for “adequate assurance” is a contractual tool that is unique in the United States. Companies facing increasing uncertainty about contractual performance may also use – or face – a demand of adequate assurance. This doctrine allows a party with reasonable grounds to believe that its counterparty will be unable to perform, to demand that the counterparty provide “adequate assurances” that the counterparty will perform its contractual obligations. The doctrine aims at protecting both parties from the possibility of undue hardship when the willingness or ability of a party to perform declines materially between the time of contracting and the time for performance.
If a counterparty fails to provide adequate assurance following a proper demand, the demanding party may treat this as a contractual repudiation and terminate the contract. However, if the counterparty does provide adequate assurance of performance, the demanding party must then resume performance to avoid its own breach of contract.
The adequate assurance doctrine has its roots in the Uniform Commercial Code (“U.C.C.”), which governs contracts for the purchase or sale of goods. Several states, including New York, have recognized that adequate assurance of performance may also be demanded in the context of non-U.C.C. contracts.
Any party to a contract can request adequate assurances from a counterparty when reasonable grounds for insecurity arise, and when the U.C.C. or US state law allows for parties to that particular type of contract to demand adequate assurances. In general, the reasonableness of grounds for insecurity is a question of fact.
A strong demand for adequate assurance should:
- specify the grounds for insecurity, presented in such a way that a reviewing court would find these grounds to be reasonable;
- be unequivocal and request assurance of the performance agreed upon in the contract, rather than demanding amendment to the agreement or performance of new or different obligations; and
- be made in good faith.
Whether an assurance of due performance is adequate is also a fact intensive inquiry. Courts will consider several factors, including the parties’ relationship and prior dealings, the cause of the uncertainty, the non-performing party’s reputational risk, and the time given to provide assurance.
In response to a demand for adequate assurances, a party may be able to argue:
- that the demanding party does not have the right to demand adequate assurance, given the nature of the contract; or
- that the demanding party did not properly demand adequate assurances.
Given the universal effects of COVID-19, it is possible that a large number of contractual counterparties will invoke the adequate assurance doctrine. As courts are often protective of contracts and contractually-based expectations, they may seek to narrow this common law doctrine in the interest of equity.
Other Relevant Contractual Provisions
Contractual terms that previously flew “under the radar” may now prove relevant in light of the extreme circumstances created by the COVID-19 outbreak.
Certain representations and warranties and covenants agreed to by the counterparties may prove relevant in the context of disputes regarding performance. Remedy provisions and severability clauses may also be key when assessing strategic options.
- Review contracts with US counterparties and consider the specific wording of force majeure, MAC / MAE, or other relevant provisions.
- Be aware of any relevant notification requirements and provide notice as required.
- Strategize whether you may benefit from demanding adequate assurance and, alternatively, consider your options in terms of responding to a potential demand for adequate assurance from your counterparty.
- Document efforts to perform contractual obligations and/or the impact of COVID-19 related events that prevented performance (e.g., a factual chronology and internal audit trail of corporate decision making), where applicable.
- Determine whether the impact of COVID-19 can be mitigated, particularly in advance of the outbreak spreading to a new locality (e.g., by transferring functions to different locations, securing alternate suppliers, and planning for employees to work remotely).
- Consider whether the governing law of the contract provides legal remedies beyond the terms of the contract.
With over 200 lawyers in the US, Freshfields regularly advises clients on their most critical business and legal issues. We are happy to discuss any particular COVID-19-related issues that are impacting – or will impact – your business. Additionally, by utilizing Freshfields’ AI review technology, we can assist clients by quickly identifying and extracting key contractual provisions, including force majeure, material adverse change, and change in law. If you would like to discuss any COVID-19 issues, including technology-assisted contract review, please speak to your usual Freshfields contact.