COVID-19: Force majeure risk and opportunity

Force majeure clauses in contracts are now being carefully scrutinised, given that they might be invoked by organisations who are unable to perform under their contracts due to the impacts of, or responses to, COVID-19.

The potential reach of invoking the often-overlooked contractual force majeure term in light of the COVID-19 pandemic is significant. Governments continue to escalate measures aimed at containing the spread of the virus, including quarantine and isolation requirements, immigration and travel restrictions, and limitations on public gatherings. Many companies have seen the need to shift their workforce into compulsory leave or require people to work from home. Businesses are facing impacts on supply chains, including delays due to quarantine, shipping delays, port checks, changes to workforce availability due to illness and isolation requirements, and potential breached contracts.

As an overview of this possibility, by early March 2020 the China Council for the Promotion of International Trade (CCPIT) was reported to have issued more than 1,600 force majeure certificates to Chinese companies seeking to avoid legal claims for contracts totalling $15 billion and spanning all sectors of the economy.₁

The potential reach of force majeure

Whether a force majeure clause hinders or helps your organisation as it deals with the impacts of COVID-19 depends on whether your organisation has a dramatic increase or decrease in demand due to the escalating restrictions on commerce and personal liberties as well as the health impacts starting to ripple through the population.

For example, there has been a dramatic increase in demand in medical and health-related items, broadband and subscriptions to online and video-conferencing platforms, and other self-isolation-related goods and services. Where an organisation in these sectors relies on a supply chain that may be impacted by COVID-19, one supplier (or more) in that chain calling up the force majeure clause will likely have significant impacts which could cascade into a complete inability for that organisation to meet obligations under a contract, let alone any increase in demand.

More widely, however, there has been a dramatic decrease in demand for all discretionary spending such as retail, entertainment and any non-essential services and goods. The impact of restrictions on commercial and personal liberties is impacting every element along traditional supply chains.

For-profit organisations have been negatively impacted to various degrees by government measures to combat the pandemic and the accompanying economic free fall.

Not-for-profit organisations who rely on fundraising events and/or patronage are unable to function as usual and sporting events are being cancelled around the world.

Any organisation with institutional debt may find itself in breach of banking covenants, which inadvertently trigger penalties. For others, such as those in building and construction in some states in Australia, the licence to operate turns on certain minimum financial requirements for licensing. More broadly construction sites could shut down due to changes in government policy given the close proximity in which people work on these sites.

In these circumstances of restrictions and decreased demand, a force majeure clause may work in an organisation’s favour, relieving it of contractual obligations it can no longer fulfill due to the impacts of COVID-19.

How does a force majeure clause function?

A force majeure clause is often found in commercial contracts. Typically, a force majeure is an event or circumstance beyond the control of a party to a contract, which was not reasonably foreseeable.

How force majeure clauses are drafted can vary, and it will be important for organisations to understand each parties’ rights and obligations under these clauses in light of the COVID-19 pandemic. Force majeure clauses are ordinarily drafted to relieve parties to a contract from their contractual obligations without any liability should a force majeure event occur. Often the clause will stipulate what happens in the event of a force majeure event – so while there may be an exclusion of liability, the parties may still have some obligation. For example, in some circumstances the contract may be suspended rather than terminated or require a party to mitigate losses of themselves or the other.

Although there are many different ways of drafting force majeure clauses, the clause will often be drafted to include ‘acts of God’ (common examples include fires, explosions, earthquakes, drought, tidal waves and floods), war or invasion, strikes, epidemics (which would include a pandemic) or legislative or administrative interference (such as an embargo or refusals grant a licence).

The force majeure must be a legal or physical restraint on the activity of one or both parties to deliver under the contract – not merely an economic one. That is, one party not being able to afford to pay the other under the terms of a contract would not generally be a force majeure event. Even a collapse in the market for a commodity and the consequent dramatic decline in price would not generally fall within the meaning of force majeure.

What does a force majeure clause look like?

A force majeure clause is drafted to include three main elements:

1. Trigger – a list of events that trigger the clause;
2. Procedure – a statement of whether the trigger automatically leads to pre-determined consequences, or whether a procedure must be followed, such as taking steps to mitigate the impact of the force majeure event, or a requirement that the party give notice to tell the other party it is relying on the force majeure clause as answer to any non-performance of the contract; and
3. Consequences – whether there are any performance obligations that remain between the parties despite the force majeure event (for example, is a force majeure event an excuse for non-performance, an extension of time or something else) and whether the clause operates for the benefit of both parties to the deal.

Understanding each of these elements and whether the contract can no longer be performed is an important part of safeguarding any organisation and understanding an organisation’s legal position in the context of the COVID-19, its impact and flow on effects.

It must be remembered that the mere existence of a force majeure event does not necessary mean that the parties to the contract will have an excuse for non-performance – it all turns on how the contract is drafted.

What happens if your organisation is unable to complete its contractual obligations because of COVID-19?

To invoke a force majeure clause, directors and their management teams will need to consider the following four sets of questions:

• What goods or services does the organisation buy, sell or offer?
  - What are the key contracts under which the organisation has an obligation to deliver goods or services to another?
  - Are there any key or material contracts on which the organisation relies in order to deliver goods or services?

• Does COVID-19 fit within the force majeure clause?
  - What is the trigger/event to enliven the force majeure clause under each key contract?
  - Why is the delivery of the organisation’s contractual obligation no longer possible due to the trigger/event?
  - Does the jurisdiction of each contract potentially impact the force majeure clause?

• What happens if the force majeure clause is invoked?
  - Does the organisation still have obligations under the contract?
  - If the organisation’s supply chain is disrupted through a force majeure clause, how does that impact on any outstanding obligations under key or material contracts particularly as each contract cascades into the other?

• When (and how) does the organisation need to give notice?
  - Timeliness may be very important when calling up a force majeure clause as some clauses may require that written notice be given ‘within a reasonable time’ (or a specified time period) to take advantage of the clause. If an organisation fails to comply with these requirements, it may lose the right to call on the force majeure clause;
  - If there is a form of notice that is required to invoke the force majeure clause, any notice ought to be drafted to meet the specific requirements under the contract.

An organisation’s ability to perform a contract may include:

• reliance on supplies which are no longer available or unable to be delivered for an unknown period of time or not at all due to production/manufacturing shutdowns; and/or
• employees being quarantined either due to illness or due to mandatory requirements to stay at home which reduces your organisation’s capacity or capability to perform works (particularly if the services are unable to be performed remotely).

Consequently, organisations, through their boards and management teams, should monitor the day-to-day government announcements and other changes in circumstances, whilst keeping an eye on their organisation’s contracts so that that they do not lose the potential to invoke force majeure, if necessary.

What happens if an organisation you have contracted with is exercising a force majeure clause in relation to your organisation?

The first step is to check the procedural requirements in the force majeure clause. Consider whether any time limits have been complied with or whether the counterparty is taking steps to mitigate the effects of the event (if that is required of them under the contract).

Contracts performed over a long period of time are often heavily time and resource dependent. Programs of work and delivery of goods and services are tightly scheduled to meet practical completion deadlines. For these types of contracts (often construction related), consider whether certain material or documents ought to be collected to substantiate (or negate) the impact of force majeure.

What is the status quo? 

If there may be a dispute regarding the impact of a force majeure event on a particular contract, document the status quo of the project/works. This could include site records, photos of works completed and detailed diary/project management notes.

Ongoing obligations

If a force majeure clause does not automatically release a party from its contractual obligations and instead requires a party to perform certain actions – such as an obligation to mitigate loss - that party ought to document and capture the costs of specific actions to mitigate their losses. This includes, where possible, capturing how any mitigation measures impact any programme of works from a time perspective. Time disruptions can result from supply chain failure or delay, changes to working arrangements or illness of employees and subcontractor availability. 

Beyond the legal rights of any organisation in the context of a force majeure clause, questions to consider should also include:

• Even if there are some questions about the applicability of a force majeure clause in a contract, is it reasonable to accept that performance has been prevented by COVID-19?
• Even if the organisation has a legal right to use a force majeure clause in any particular contract or contracts, must it be used?

In both of the above cases, boards and management should be asking whether this is the time to think about the longer-term relationship and be empathetic to other businesses if the opportunity arises.

In the current circumstances asserting that a force majeure clause is not available to a counterparty may not be supported by a court’s interpretation if parties choose to litigate. In fact, a force majeure clause may be given a very narrow interpretation given that these types of clauses are often interpreted against the person seeking to rely on it. If there is uncertainty in its drafting, the force majeure clause may be interpreted by a judge very differently to a more commercial interpretation of the clause. Needless to say, there may be some reputational risk to an organisation for being seen as overly legalistic in the current health and economic climate – and this ought to be taken into consideration as well.

What if you don’t have a force majeure clause?

Force majeure clauses are a creation of contract law, so force majeure does not have meaning in common law.

There is a much narrower concept called the doctrine of frustration, which applies in limited circumstances if the performance of a contract is radically different from what was contemplated by the parties when entering into the contract, and the events or change in circumstances were not the fault of the contracting parties. For example, if the contract involves personal service or the identity of a party is a material factor, the contract would be frustrated if the party dies or becomes permanently incapacitated. By contrast, turmoil in the domestic or international economy, leading to company failure, shortages of raw materials or labour, or problems in financing developments, would not generally amount to ‘frustration’.

In some jurisdictions, the common law rules have been modified by legislation: Frustrated Contracts Act 1978 (NSW), Frustrated Contracts Act 1988 (SA), and Australian Consumer Law and Fair Trading Act 2012 (Vic).

If a contract is frustrated, all future obligations cease and the loss lies where it falls. This results in parties not being entitled to claim for damages unless a liability accrued prior to frustration.

It is important to be cautious ahead of asserting frustration, as it could be seen as an anticipatory or repudiatory breach of the contract. This means that the other party might terminate and sue for damages by claiming breach of contract. Before relying on the doctrine of frustration to excuse non-performance, you should carefully consider how the events affect the contract and obtain legal advice.

When can’t you use a force majeure clause?

A force majeure clause will not be available if:

• the trigger was already in existence at the time the contract was made, since the event would be reasonably foreseeable;
• the effects of the event were the result of a party’s acts or omissions; or
• a party could have reasonably anticipated the force majeure and taken steps to guard against it (so in this regard, any commercial contract entered into from March 2020 will not benefit from any epidemic/pandemic provision in a force majeure clause)

How to move beyond force majeure

If a force majeure clause is invoked, both parties essentially walk away from any further obligations under the contract (subject to any ongoing obligations within the clause itself or any accrued rights/obligations before the force majeure event). However, it may not suit either party to walk away from an agreement even if there is an opportunity to do so.

The relevant trigger event, such as quarantine measures, might only cause a temporary interruption to the performance of the contract, which means that extensions of time may be sufficient to allow the agreement to continue.

The contract may include a requirement to mitigate the consequences of the force majeure (for example, seeking out alternative suppliers of goods and services). The clause might also give the parties the opportunity to renegotiate a deal to take into account a force majeure trigger/event such as COVID-19.

Directors should consider their organisation’s existing contracts with third parties under which their organisation has obligations for any rights or protections such as a force majeure clause. They should consider material or significant contracts of supply of goods/services to ascertain the impact of non-delivery which may be specific to suppliers and the current conditions. The current climate affords a number of measures which should be considered in order to move beyond the binary activation/non-activation of force majeure clauses. For example, the organisation’s insurance arrangements might provide the opportunity for a claim made to assist the organisation in the current circumstances.

There may be a commercial outcome which would be agreeable to all parties. It is obviously important for boards to understand their organisation’s legal position. However, in this time of social and economic crisis, it may be as, if not more, important for directors to work with management to ensure their organisation leans into opportunities for employee wellbeing, social stability and economic growth.

There are some obligations that will continue irrespective of the current economic climate such as maintaining work health and safety standards. Further, any contract should be read as a whole and therefore clauses such as material adverse change or change in law should also be taken into consideration.

Organisations should also consider any potential reputational damage that may arise from pursuing legal remedies. In the context of crisis management strategies being considered within the COVID-19 pandemic, organisations should continue to learn from previous governance lessons and leverage the opportunity to build stakeholder trust given the as yet unclear business landscape arising out the current circumstances.

Questions directors and management teams should be asking

• What contracts might be impacted by COVID-19 and what are the force majeure clauses in each of those contracts?
  - Are there any other provisions in these contracts, beyond force majeure, which may be called upon to relieve or excuse continued performance under the contract?
  - If so, what are the organisation’s options to address the impact of these clauses?

• Are there any COVID-19 impacts on whether regulatory compliance within the organisation may be compromised?
  - If so, how can the possibility of non-compliance be mitigated?
  - Can compliance be met in an alternative or innovative way?
  - Are there matters which may need to be reported to regulators?
  - If so, what are the triggers for any self-reporting?

• Are there any contracts that are critical to the organisation meeting contractual obligations with others?
  - If so, how would a claim for a force majeure event impact the organisation’s ongoing or upstream obligations?
  - Are there any ways to source alternative providers for any part of the organisation’s supply chain?
  - What data or information does the organisation need to collect to show the impact of force majeure on the performance of its contractual obligations?

• What systems or processes are necessary for the continuity of business operations of the organisation?
  - If there was disruption or a force majeure event in relation to those systems/processes, what are the alternatives available?
  - Are there any work arounds?

• What are the indicators that the force majeure event is over or recovery is on its way?
  - Can these indicators be used to craft an alternative to walking away from the contract in the event that COVID-19 comprises a force majeure event?

• After understanding the legal rights of the organisation under any contract, is this course of action the right thing to do?

1  C Lind, 2020, “As coronavirus cases rise globally so too do risks for international businesses and transactions”, Syracuse Journal of International Law and Commerce, [blog], 9 March, https://jilc.syr.edu/2020/03/09/as-coronavirus-cases-rise-globally-so-too-do-risks-for-international-businesses-and-transactions/, (accessed 3 April 2020).

About the author

Jennifer Robertson FAICD is managing director of Board Matters, a practising lawyer, governance consultant and company director. She consults with many corporate clients and facilitates the Company Director Course for the Australian Institute of Company Directors.

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The Australian Institute of Company Directors is committed to strengthening society through world-class governance. We aim to be the independent and trusted voice of governance, building the capability of a community of leaders for the benefit of society. Our membership includes directors and senior leaders from business, government and the not-for-profit sectors.

Disclaimer

This document is part of a Director Tool series prepared by the Australian Institute of Company Directors. This series has been designed to provide general background information and as a starting point for undertaking a board-related activity. It is not designed to replace a detailed review of the subject matter. The material in this document does not constitute legal, accounting or other professional advice. While reasonable care has been taken in its preparation, the Australian Institute of Company Directors does not make any express or implied representations or warranties as to the completeness, currency, reliability or accuracy of the material in this document. This document should not be used or relied upon as a substitute for professional advice or as a basis for formulating business decisions. To the extent permitted by law, the Australian Institute of Company Directors excludes all liability for any loss or damage arising out of the use of the material in this document. Any links to third-party websites are provided for convenience only and do not represent endorsement, sponsorship or approval of those third parties, or any products and/or services offered by third parties, or any comment on the accuracy or currency of the information included in third party websites. The opinions of those quoted do not necessarily represent the view of the Australian Institute of Company Directors.