COVID-19 and contract defenses

by Rushing McCarl Aug. 19, 2020

The novel coronavirus (COVID-19) poses a significant legal challenge for any organization, and the potential areas of liability are far-reaching. In this update, Rushing McCarl will discuss some possible defenses to COVID-19-related failures to perform under a contract. This update is tailored to medium-sized businesses and focuses primarily on force majeure provisions.

Force Majeure Provisions

Unforeseen circumstances will sometimes make performance of a contract impossible or unfeasible. Force majeure (“act of God”) provisions have been developed and included in many contracts to account for and manage this risk. These provisions excuse nonperformance when specified extraordinary circumstances prevent a party from performing a contractual duty.

Before enforcing force majeure provisions, courts consider whether (1) the event preventing performance qualifies as a force majeure event under the contract; (2) the risk of nonperformance was foreseeable and capable of being reduced or mitigated; and (3) performance was actually impossible. Richard A. Lord, 30 Williston on Contracts § 77:31 (4th ed. 2019) (“What types of events constitute force majeure depend on the specific language included in the clause itself.”).

Courts strictly construe force majeure provisions, and the first element of the test is crucial—namely, if the event was not listed or otherwise anticipated in the contract’s force majeure provision, then courts may be reluctant to excuse nonperformance.

A force majeure provision specifically covering pandemics, viral infections, bacterial infections, or other epidemics will likely be triggered by COVID-19, while a general provision denoting acts of God may not.[1] In other words, it is unlikely that the existence of the pandemic alone will be enough to trigger relief without specific pandemic-related language in the contract.[2]

The second element of the test will knock out a force majeure defense if the event could have been foreseen and the damage mitigated. Therefore, even if COVID-19 satisfies the first element of the analysis, if it can be shown that the event was foreseen or the damage not mitigated, courts may be reluctant to offer relief from contractual obligations.[3]

The third element of the test — requiring that the performance be impossible — will disqualify economically prohibitive performance as opposed to impossible performance. The California Supreme Court held in Butler v. Nepple, 54 Cal. 2d 589 (1960), that financial hardship does not qualify for force majeure relief from contractual obligations (discussing the application of a force majeure provision to a nationwide steel manufacturing strike).

Further, mere increase in expense does not excuse the performance unless there is an extreme and unreasonable difficulty, expense, injury, or loss involved (Oosten v. Hay Haulers Etc. Union, 45 Cal. 2d 784, 788 (1955); 6 Williston on Contracts, rev. ed., § 1968, pp. 5524-25).

Common Law Defenses to Failure to Perform

While many contracts include force majeure provisions, not all agreements have them, and the provisions themselves may not be drafted to cover pandemics. In these cases, the common law may offer some defenses for failure to perform.

The common law defenses of impracticability and frustration of purpose may offer some relief to parties who are unable to perform a contractual duty due to COVID19-related developments.

Impracticability

The Restatement (Second) of Contracts states that “extreme impracticability of performance may properly be regarded as having the same effect as strict impossibility of performance.” Restatement (Second) of Contracts § 261 (Am. Law Inst. 1981). Performance will be found to be impossible if “it can only be done at an excessive and unreasonable cost, for which the parties had not bargained.” 17 Am. Jur. 2d Contracts § 643 (2020). Put another way, performance may be excused when (1) some unexpected event occurs; (2) the parties to the contract assumed would not occur; and (3) the occurrence of this event makes performance impossible/impracticable.

The key to this analysis is that the event was unexpected and that it was assumed that the event would not occur. So, while the destruction of the contract’s subject matter may be unexpected and assumed not to occur, market setbacks resulting in a loss will not. Restatement (Second) of Contracts § 261.

While jurisdictions vary as to the standard by which courts judge the impossibility of performance, California courts may excuse performance when it would entail unreasonable expense. Habitat Trust for Widlife, Inc. v. City of Rancho Cucamonga, 175 Cal. App. 4th 1306, 1336 (Cal. Ct. App. 2009).[4] As a result, parties in California may have a defense for failure to perform where the performance of the contract requires unforeseen extraordinary expense. Counsel should conduct a careful analysis of the law and facts to determine the possible application of the doctrine of impracticability.

Frustration of Purpose

Frustration of purpose occurs where an unforeseen event makes the reason for the contract moot. The event must frustrate or thwart the contract’s principal purpose; the event must be unforeseen, and its nonoccurrence must have been an assumption of the contract; and the event must not be the fault of the party asserting the defense. Hon. Michael M. Baylson et al., 8 Bus. & Com. Litig. Fed. Cts. §89:36 (4th ed. 2019).

Courts use a broad interpretation when defining a party’s purpose in a contract. The fact that a contract may not be as profitable as was intended may not count as frustration of purpose. Essentially, the frustration of purpose should be extensive and total. E. Allan Farnsworth & Zachary Wolfe, Farnsworth on Contracts §909 (4th ed. 2019).[5] Counsel should undertake a careful analysis of the law and the facts to determine if frustration of purpose may be a defense to a failure to perform.

 


Rushing McCarl provides this information for educational purposes only. It should not be construed as legal advice, and readers should not act on it without seeking advice from an attorney.

 

Footnotes

[1]     On March 11, 2020, COVID-19 was classified as a pandemic by the World Health Organization. Shortly thereafter, governors across the United States began issuing shelter-in-place orders. These orders effectively shut down nonessential businesses across the country.

[2]     There may be other contractual language in force majeure provisions that trigger a defense. For example, some provisions may include natural disaster, national emergency, or governmental acts preventing performance. Counsel should carefully analyze the contract to determine whether the first element of a force majeure provision is triggered.

[3]     As states open and close in response to COVID-19, the mitigation element is especially important.  The current restrictions in place across the United States are a patchwork of federal, state, and local law. As cases surge in different jurisdictions, and authorities respond in varying ways, it is crucial for businesses and counsel to keep abreast of the restrictions.

[4]     Many jurisdictions, including New York, require actual impossibility and will not excuse nonperformance just because it is financially prohibitive.

[5]     The applicability of insurance coverage for business interruption due to COVID-19 should be analyzed by in-house or other counsel. It should be noted that many policies exclude viral or bacterial outbreaks from business interruption coverage, but the issue of coverage should be considered on a case-by-case basis.