Force majeure clauses
A force majeure clause is a contract provision found in many commercial contracts that excuses a party’s non-performance of its obligations when extraordinary events beyond the parties’ control arise. Many courts have construed force majeure clauses narrowly, such that a party’s performance under a contract will ordinarily be excused only if the event preventing the party’s performance is explicitly mentioned in the clause itself. While some force majeure clauses may specifically identify “flu, epidemic, serious illness or plagues, disease, emergency or outbreak” as events that would excuse a party’s performance, most force majeure clauses include more general language covering “acts of God,” “acts of government,” “matters beyond the parties’ control” and other similar catch-all phrases. The relief under a force majeure clause, therefore, will depend on the specific language in your contract and the underlying facts and circumstances.
The WHO’s classification of the coronavirus as a “pandemic” likely would trigger a force majeure clause that expressly accounts for “pandemics,” “epidemics” or “viral outbreaks” (depending, of course, on the precise contractual language at issue). A force majeure clause that mentions “acts of government” more generally also could arguably apply to the coronavirus now that cities and states across the U.S. are ordering the closure of “nonessential businesses” and implementing travel, movement, and large-gathering restrictions. But force majeure clauses that are silent on “pandemics” (and similar public-health related outbreaks) or “acts of government” are likely to be insufficient for a force majeure defense based on the coronavirus crisis unless courts lower the historically high bar for invoking force majeure to account for current market realities.
Generally speaking, a party invoking the protections of a force majeure provision must demonstrate that:
- the event at issue falls within the scope of the force majeure clause;
- the precise event preventing full performance under the agreement was unforeseeable in light of the contract;
- it could have performed but for the triggering event;
- the failure to perform could not have been avoided or overcome through alternative means; and
- it complied with the contract’s notice requirements.
Even if a party can establish these elements, it typically cannot invoke force majeure if it did not take steps to mitigate the damage and performance is merely impracticable or economically difficult rather than truly impossible (unless the governing law or contract at issue applies a different standard).
For a full examination of force majeure and the novel coronavirus, please see our related alerts.
Commercial impracticability
What happens if you are a seller of goods and your contract does not contain a force majeure clause or the clause does not expressly account for circumstances or events similar to the coronavirus outbreak? When this is the case, the seller may be excused under U.C.C. § 2-615 from performance based on the doctrine of commercial impracticability.1 While there are several differences between force majeure clauses and the doctrine of commercial impracticability, the main difference is a force majeure clause allocates to one party the risks arising from the occurrence of a specific contemplated event, while commercial impracticability allocates the risks arising from events the parties neither contemplated nor allocated.
A number of courts have applied a three-part test in analyzing whether the defense of commercial impracticability under Section 2-615(a) is available to a non-performing seller:
- the seller must not have assumed the risk of some unknown contingency;
- the nonoccurrence of the contingency must have been a basic assumption underlying the contract; and
- the occurrence of that contingency must have made performance commercially impracticable.
The first element is a question of risk allocation, requiring courts to determine whether the risk of the event or occurrence was allocated to either party by written agreement or through the parties’ course of performance, course of dealings, and/or trade usage (see U.C.C. § 1-303). It bears noting that this latter category, usage of trade, is defined so broadly under Section 1-303(a) that it encompasses any practice or method of dealing that is so regularly observed in a particular place, vocation or trade as to justify an expectation that it will be observed for every similarly situated transaction. Thus, if the seller agreed to assume the risk of the event or occurrence by agreement, practice or custom, then the excuse of non-performance under Section 2-615 would not be available.
To satisfy the second element, the contingency must not have been foreseeable. That is because, if the occurrence of the disruptive event was foreseeable, then its nonoccurrence could not have been a “basic assumption” underlying the contract. Consequently, if a seller foresees a risk but does not include a contract provision against assuming that risk, then the seller will not be able to invoke a commercial impracticability defense. See Bende & Sons, Inc. v. Crown Recreation, Inc., Kiffe Prods. Div., 548 F. Supp. 1018, 1022 (E.D.N.Y. 1982) (“Although it did not appear [the parties] ... ever contemplated a train derailment ... common sense dictates that they could easily have foreseen such an occurrence”). Not surprisingly, the case law in this area is highly fact-specific, and will depend on whether the event was “sufficiently foreshadowed at the time of contracting to be included among the business risks” that could potentially impact performance. See U.C.C. § 2-615, official cmt. 8.
The third and final element, “commercial impracticability” of performance, is a rigorous test that is not much easier to meet than the test applicable to the common law doctrines of impossibility and frustration of purpose (discussed below). For example, increased cost alone does not excuse performance “unless the rise in cost is due to some unforeseen contingency which alters the essential nature of performance.” See U.C.C. § 2-615, official cmt. 4; see also Moyer v. City of Little Falls, 134 Misc.2d 299, 301-302 (N.Y. Sup. 1986) (excusing performance in light of a 666 percent price increase due to the unforeseeable creation of a monopoly). Nor is a rise or a collapse in the market in itself a justification for finding performance impracticable, as Official Comment 4 to Section 2-615 describes such an event as “exactly the type of business risk which business contracts made at fixed prices are intended to cover.” Id.
Some of the most recognized commercial impracticability decisions arose from the unexpected closure of the Suez Canal from November 2, 1956, to April 9, 1957, after the Egyptian president, Gamal Abdel Nasser, nationalized the canal and took over its control. Many shipping companies that entered into contracts prior to the closure sought to excuse their performance obligations under commercial impracticability based on the increased costs to ship goods around the Cape of Good Hope. Despite the added distance and expenditure, courts refused to excuse these shippers from their obligations because of the foreseeability of political instability in the Middle East negatively affecting the Suez Canal and the availability of alternative shipping routes. Those decisions have led some commentators to say that the commercial impracticability defense is difficult, if not impossible, to establish.
In contrast, however, impracticability has been held to exist in situations where performance is physically impossible. For example, in Goddard v. Ishikawajima-Harima Heavy Indus. Co., 287 N.Y.S.2d 901 (1st Dep’t 1968), a court found impracticable a manufacturer’s performance on a contract to furnish specific types and sizes of boats pursuant to written orders due to the destruction of the manufacturer’s factory by fire. In addition, “a severe shortage of raw materials or of supplies due to a contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply” will generally excuse performance if the unforeseen event or circumstance “either causes a marked increase in cost or altogether prevents the seller from securing supplies necessary to his performance.” U.C.C. § 2-615, official cmt. 4. One could see how the coronavirus outbreak and the resulting closures could lead to (or have already led to) such extreme circumstances in numerous industries.
Assuming the seller satisfied Section 2-615(a)’s three elements discussed above, Sections 2-615(b) and (c) impose additional obligations on a seller seeking to excuse non-performance. Starting with Section 2-615(b), if only a part of the seller’s ability to perform is affected, the seller must “allocate production and deliveries among his customers,” including regular customers not under contract and its own requirements, “in any manner which is fair and reasonable.” But what is “fair” and what is “reasonable”? U.C.C. § 2-615 is silent on the question, but Comment 11 to Section 2-216, in part, provides guidance:
An excused seller must fulfill his contract to the extent which the supervening contingency permits, and if the situation is such that his customers are generally affected he must take account of all in supplying one.... Customers at different stages of the manufacturing process may be fairly treated by including the seller’s manufacturing requirements.... However, good faith requires, when prices have advanced, that the seller exercise real care in making his allocations, and in case of doubt his contract customers should be favored and supplies prorated evenly among them regardless of price. Save for the extra care thus required by changes in the market, this section seeks to leave every reasonable business leeway to the seller.
U.C.C. § 2-615, official cmt. 11.
Although this comment does not require strict, pro-rata allocation, it clearly prohibits a seller from favoring buyers that offer to pay higher prices for goods. That said, the rule accords a significant degree of deference to the seller’s business judgment. A seller, therefore, may base its allocation on factors such as customer loyalty, past performance, historic deliveries, historic contract amounts, and projections of future sales, without necessarily violating Section 2-615(b)’s allocation rules as a matter of law. Because case law in all or nearly all jurisdictions offers no definitive guidance as to what factors are determinative in deciding whether a seller’s allocation under Section 2-615 is “fair and reasonable,” the analysis will likely be a fact-intensive inquiry that turns on the specific circumstances of a particular case.
Turning to Section 2-615(c), the seller must notify the buyer “seasonably” that there will be delay or non-delivery and, when allocation under subsection (b) is required, give a quantification of the estimated quota that will be available for the buyer. The Code defines “seasonable notice” as “within the time agreed” or “if no time is agreed, within a reasonable time.” Under U.C.C. § 1-205, a “reasonable time” depends on the “nature, purpose, and circumstances,” creating yet another fact-intensive inquiry not necessarily suitable for summary disposition. If faced with “seasonable” notice from a seller that it expects delays or total non-performance and the non-performance substantially impairs the value of the contract, the buyer may either (1) modify the contract in a manner agreeable to both parties; or (2) terminate the contract and discharge the seller from any further obligation. See U.C.C. § 2-616(1)(a). If the buyer does nothing, the contract lapses after 30 days.2 Id.
Impossibility and frustration of purpose
What if your contract does not contain a force majeure clause covering COVID-19 and you are not a seller of goods who can avail itself of the doctrine of commercial impracticability under U.C.C. § 2-615? The common law defenses of impossibility and frustration of purpose may excuse non-performance, but they are extremely difficult to invoke. Under New York law, for example, the defense of impossibility is only available when “the destruction of the means of performance by an act of God” makes performance of the contract objectively impossible. Kolodin v. Valenti, 979 N.Y.S. 2d 587, 589 (1st Dep’t 2014). Stated differently, performance must be made impossible by “an unanticipated event that could not have been foreseen or guarded against in the contract.” Kel Kim Corp. v. Cent. Mkts., 70 N.Y. 2d 900, 903 (1987).
The doctrine of frustration of purpose functions similarly to impossibility, but focuses on whether the unforeseeable event at issue destroys the purpose of the contract rather than whether the event has made a party’s contractual performance impossible. For the doctrine to apply, the “frustrated purpose must be so completely the basis of the contract that without it, the transaction would have made little sense.” PPF Safeguard, LLC v. BCR Safeguard Holding LLC, 924 N.Y.S.2d 391, 394 (App. Div. 2011). One of the overarching questions with respect to frustration of purpose, just like impracticability and impossibility, is whether the intervening event was foreseeable and could have been provided for in the contract.
There are two main hurdles to successfully invoking the defense of frustration of purpose. First, courts interpret a contract’s “purpose” broadly, and, thus, the mere fact that an event has prevented a party’s “expected” way to perform is likely insufficient. Second, frustration has to be near total, such that one party’s performance would be essentially worthless to the other. E. Allan Farnsworth & Zachary Wolfe, Farnsworth on Contracts § 9.09 (4th ed 2019). It is not enough that a transaction was previously expected to be profitable, but is now unprofitable. Id. It also bears emphasis that cancellations and disruptions in supply chains may not be construed as the type of “cataclysmic events” that render a contract entirely “valueless” for frustration to apply. Wal-Mart Stores, Inc. v. AIG Life Ins. Co., 872 A.2d 611, 621, n.35 (Del. Ch. 2005).
Conclusion
As the coronavirus pandemic continues to unfold, businesses should take proactive steps to carefully review agreements to understand their rights and obligations as well as those of their counterparties. If businesses are anticipating or have already experienced supply chain interruption due to the coronavirus outbreak, a general familiarity with the principles described above (and any notice, termination, and dispute resolution provisions in their agreements) should help them evaluate the viability of a claim of non-performance based on force majeure, commercial impracticability, impossibility or frustration of purpose.
Our Reed Smith Coronavirus team includes multidisciplinary lawyers from Asia, EME and the United States who stand ready to advise you on the issues above or others you may face related to COVID-19.
For more information on the legal and business implications of COVID-19, visit the Reed Smith Coronavirus (COVID-19) Resource Center or contact us at COVID-19@reedsmith.com
- Section 2-615 applies only to sellers, and makes no mention of a buyer’s ability to rely on commercial impracticability as a ground for suspending performance.
- If “reasonable grounds” exist for insecurity that your counterparty will be able to perform, you might consider invoking U.C.C. § 2-609 and seek assurances of continued contractual performance. The “reasonable grounds” standard is a high one, and typically requires some obvious or express indication that performance per the contractual terms will not occur.
Client Alert 2020-141
