For CFOs, anticipating the “known unknowns,” or unforeseen events that could impact business performance, is a fact of life. In a global economy, where organizations are dependent on their overseas suppliers, these events now include diseases and quarantines, such as the coronavirus.
Last December, a pneumonia outbreak in Wuhan, China was unknown to the world. China responded to “COVID-19” with a quarantine of unprecedented scope, which has caused worldwide supply chain disruptions. As the virus spreads, and suppliers fail to ship products, we are likely to see a rise in contractual defaults as counterparties are unable to perform their obligations on a timely basis.
Did your supply chain colleagues anticipate the arrival of a coronavirus in their contracts? Does a global pandemic excuse your performance? Let’s look at how the law might answer these questions.
Force Majeure: A Contractual Excuse?
“Force majeure” (from the French “superior force”) refers to an event that contracting parties agree could occur but whose timing and impact they cannot control. A force majeure clause allocates risk between a buyer and a seller if one of several defined events occurs and performance becomes impossible or impracticable.
It is a way of agreeing, in advance, what will happen if catastrophe strikes and the parties cannot perform. To invoke a force majeure clause, the non-performing party must establish that it could have performed if the force majeure event had not occurred.
It is important for CFOs to note that force majeure is a creature of contract, not a legal doctrine. When a court interprets the scope of a force majeure provision, the words matter.
This is a problem for a party impacted by the coronavirus, because while a typical force majeure clause will refer to “acts of God,” “war,” “terrorism,” and “disaster,” you are not as likely to find explicit references to “disease,” “epidemics,” or “quarantines.”
Courts tend to limit “acts of God” to earthquakes and floods, and catch-all phrases, like “any other emergency,” to emergencies stemming from the events expressly described in the force majeure provision. Without a specific reference to disease, therefore, a force majeure clause will not excuse a party who cannot perform.
Impossibility: A Legal Excuse?
When force majeure is no help, a defaulting party might turn to the law.
There is no duty to perform an obligation if performance becomes impossible or impracticable due to an unforeseen supervening event. Courts will also apply the doctrine of “commercial frustration” to excuse a delay if performance, although not impossible, would become so expensive that the value of the contract consideration is effectively destroyed.
Unlike force majeure, impossibility and economic frustration are legal defenses to breach of contract. If a party is arguing either, that means it has not reached an agreement with its counterparty on how to handle the delayed performance.
In the United States, most contracts for the sale of goods are governed by Article 2 of the Uniform Commercial Code (UCC). International manufacturing and supply agreements are not covered by the UCC but are often based on model forms containing analogous provisions.
Article 2-615 of the UCC codifies the impossibility excuse, saying that delay in delivery is not a breach if performance “has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made….” The buyer may, at its option, elect to terminate the contract within 30 days of receiving notice of the delay.
CFOs take note: While the non-performing party may feel encouraged by these legal excuses, courts exercise considerable restraint when applying them. After all, certainty of contract is paramount to the proper functioning of a capitalist economy. Performance is not “impossible” simply because it becomes more costly, for example.
Moreover, the intervening event must have been truly unforeseen at the time of contracting — an “unknown unknown,” not a “known unknown.”
On this front, the non-performing party might actually benefit from a force majeure clause that is silent on global pandemics and quarantines, because it suggests that the parties did not foresee the threat coming at the time of contracting.
Planning for What Comes Next
The first companies to report supply chain disruptions caused by COVID-19 had direct links to Chinese manufacturing. Apple’s mid-February report that it would miss its revenue guidance for the March quarter is one highly publicized example.
As the virus impacts more countries, however, domestic businesses might have the unpleasant surprise of learning that a supplier-of-a-supplier-of-a-supplier cannot make a delivery because of travel restrictions in some distant land. Supply chain disruptions like this should have businesses reviewing their contracts with vendors and customers to see what remedies they have if shipments are delayed or canceled.
The legal doctrines of impossibility and frustration come into play only in a litigation scenario, and in most situations both sides will want to avoid a court fight over what was or was not unforeseen at the time of contracting.
While it is important for parties to understand their legal rights, it is preferable to avoid litigation, especially when each side is already losing money from the non-performance. Better still, parties should address contingencies caused by pandemics through a force majeure clause.
When negotiating a force majeure provision, the seller (as the party with non-payment performance obligations) will typically want to capture as many events as possible. The buyer will want to limit the definition to things that are truly out of the seller’s control, and it will want to be able to terminate the contract if the seller cannot perform in a reasonable amount of time.
In most circumstances, instead of permanently excusing performance and ending the relationship, the parties might benefit from flexibility — for example, granting the frustrated party additional time for performance or allowing it to perform at a different rate.
The effects of COVID-19 are a wakeup call to CFOs charged with anticipating and mitigating risks.
Relegated to the fine print, force majeure is seldom top-of-mind when parties are negotiating a new supply deal. The definitional language is often stale, cut and pasted from earlier agreements, and given little thought. The current outbreak should remind parties to revisit this clause during the next negotiation.
David Mawhinney is an associate with law firm Bowditch & Dewey, who practices in the areas of commercial litigation, restructuring and insolvency.