Background
As a starting point, contracting parties are at common law required to perform their agreed obligations. Excuses for non-performance exist but are narrowly interpreted and applied.
A contract may include an express force majeure provision. If it does, that provision will allocate the risk of non-performance or delayed performance. The terms of the force majeure clause read in their entire context are determinative. There is no force majeure provision implied by common law.
The common law also recognizes, as excuses for non-performance, impossibility and frustration. These supervening events are also narrowly applied and, if applied, vitiate the entire contract rather than simply allow delayed performance.
Force Majeure
In every business transaction, extreme events, commonly referred to as force majeure events, which are beyond the control of one party, may arise and prevent that impacted party from performing the contract. If the contract is silent on force majeure, a court renders its decision whether to excuse an impacted party's performance based on the separate excuses for non-performance consisting of impossibility and frustration.
Inclusion of a force majeure clause in a contract is important because it is not otherwise enshrined as a principle of law at common law, although it is codified in the Québec Civil Code of Québec, CQLR, c. C-1991. If there is no force majeure clause in a contract, a party will not be relieved of its obligations under the contract and will remain liable to the other party for its performance notwithstanding the occurrence of an intervening event beyond its control even when that party's ability to perform is significantly impaired or rendered impossible. Where performance is impaired or impossible and the contract contains no force majeure clause, the breaching party could also be liable to pay liquidated damages in lieu of performance (if the contract includes a liquidated damages provision).
Assuming that the contract includes a force majeure clause, the next steps are to analyze it in detail.
Step 1:
Identifying whether a pandemic or epidemic is a specified force majeure event. Many contracts will include one or more of the following as specified force majeure events:
Performance hindered or delayed by the outbreak of 2019 novel coronavirus disease (COVID-19)
Comment:
- This makes COVID-19 a specified force majeure event. Suppliers in a strong negotiating position should consider adding it to existing force majeure clauses if they have the opportunity.
- If a supplier fails to include this specific clause in a contract concluded after the outbreak of COVID-19, it will likely be held to have assumed the risk of the effect of the outbreak on its own contractual performance.
Public health emergency or communicable disease outbreak
Comment:
- It will be a question of fact whether the outbreak of COVID-19 constitutes a relevant public health emergency.
- COVID-19 is a communicable disease. But this still leaves open the issues of causation and notice.
Pandemics or epidemics
Comment:
- The Concise Oxford Dictionary, 10th Ed. defines "pandemic" as "an outbreak of a disease over a whole country or a large part of the world". On March 11, 2020, the World Health Organization officially declared that COVID-19 had become a worldwide pandemic.
- However, fitting into a specified force majeure event is only the first step in the analysis. Other critical steps include causation and notice.
Quarantines
Comment:
- The Concise Oxford Dictionary, 10th Ed. defines "quarantine" as "a state, period or place of isolation for people or animals that have arrived from elsewhere or been exposed to contagious disease".
- While a quarantine may affect individuals, it may not affect the supplier as a whole.
Government or administrative action, such as:
- A decision or order preventing or hindering performance.
- Changes in laws or regulations.
Comment
- This is a possible argument, especially if there is a relevant state-imposed lockdown.
- It would not avail a contractual counterparty that is a government or government-owned entity.
- Hindering or delaying performance is broader (or more supplier-friendly) than preventing performance.
Failure of upstream suppliers
Comment:
- COVID-19 may cause a disruption in the upstream supply chain.
- If the force majeure clause provides for upstream supplier defaults or delays, the impacted party may have an excuse for delayed performance while it finds another supplier, provided it takes reasonable steps to do so.
Other events beyond the reasonable control of a party.
Comment:
- Much will depend on the rest of the force majeure clause and the contract generally.
- For example, must the event prevent performance or only hinder or delay performance?
- Was the event foreseeable or unforeseeable?
- Was the contract concluded before or after the first outbreak of COVID-19?
- Force majeure clauses tend to be narrowly interpreted to exclude circumstances that do not clearly fall within the clause and to exclude events that are not truly beyond the party's control.
The Supreme Court of Canada has described the operation of a force majeure clause as "generally [operating] to discharge a contracting party when a supervening, sometimes supernatural event, beyond control of either party, makes performance impossible. The common thread is that of the unexpected, something beyond reasonable human foresight and skill" (Atlantic Paper Stock Ltd. v. St. Anne-Nackawic Pulp & Paper Co., 1975 CarswellNB 26 (S.C.C.)).
It is not enough that the supervening event makes performance more expensive. For example, in Domtar Inc. v. Univar Canada Ltd., 2012 CarswellBC 1000 (B.C. S.C.), Univar supplied caustic soda to Domtar. The global price of caustic soda rose, and Univar attempted to charge a higher price relying on the force majeure clause, arguing that it could not provide the caustic soda at the capped price stipulated in the contract. The court held that Univar was still able to purchase caustic soda, even if it was more expensive, and it could not, therefore, rely on the force majeure clause to justify a price change. This means that impacted parties, even if they can rely on a force majeure event, must mitigate the delayed performance by working around the impediment if that is feasible. This could mean finding an alternative source of supply. Just because there are additional costs arising from the force majeure event does not enable the supplier to pass the incremental costs onto its customer. Stated otherwise, a force majeure provision is not a price escalation clause.
Step 2:
If the force majeure clause, objectively interpreted, covers the COVID-19 outbreak, the rest of the analysis must be completed. Again, the specific contract between the parties governs. That said, the parties should consider the following issues:
- Notice. Force majeure clauses typically contain written notice provisions to ensure certainty if a party invokes its right to rely on a force majeure excuse for non-performance or delayed performance. If so, written notice must be given following the occurrence of the triggering force majeure event. Failure by the impacted party to provide notice within this time period void the party’s force majeure rights. When proper notice is given within the relevant time frame, the force majeure rights will be deemed to have commenced retroactively from the start of the force majeure event.
- Causation. A force majeure clause generally requires that the impacted party establish that the force majeure event has affected its performance to the extent required by the language of the contract, which varies from contract to contract, but usually requires that the impacted party's performance be either:
- prevented (a more onerous standard for the impacted party to meet); or
- hindered or delayed (a less onerous standard on the impacted party).
- Mitigation. In this context, mitigation refers to mitigating the effects of the force majeure event. It has nothing to do with mitigation of contractual damages. The force majeure clause typically includes an express duty to mitigate, so far as possible, and remedy the situation in good faith, with due diligence or with all reasonable dispatch. The Alberta Court of Appeal determined in Atcor Ltd. v. Continental Energy Marketing Ltd., 1996 CarswellAlta 642 (Alta. C.A.) that the impacted party is required to mitigate the force majeure event itself and the effect of the force majeure on the counterparty. It held that this duty to mitigate is limited to a standard of commercial reasonableness.
- Consequences on contractual performance. If the impacted party successfully invokes a force majeure clause, the clause usually provides that the initial effect is only to delay performance by the impacted party for the duration of the force majeure event. Often, the contract will set out a much longer period before either party has the right to terminate the contract entirely. Also, whether the force majeure event affects a liquidated damages provision for late delivery depends on the drafting of the contract as a whole (particularly on how the liquidated damages and force majeure provisions work together).
Impossibility
The contractual obligations of a party can be excused if its performance becomes objectively impossible because of a supervening event beyond its control.
In general, impossibility will discharge a party where, without its fault:
- In a contract requiring the personal performance of the promisor, the promisor dies or is incapacitated. This could include quarantine of an individual or his or her illness due to COVID-19.
- In a contract where performance requires the continued existence of a specific thing, that thing perishes or is otherwise unavailable for performance.
- Performance is subsequently prevented or prohibited by operation of law.
For a party to use this excuse successfully, performance must be impossible, not just financially unappealing or more difficult, regardless of any amount of time, money or energy spent. For instance, performance may be excused when the subject-matter of the agreement is destroyed, or a party's means of performance is prevented. If the contract is to be performed in a region where there is a state-imposed lockdown, performance may well be impossible for the affected party. With impossibility, performance is excused entirely, not merely suspended.
However, performance cannot be excused when the means of performing merely become more expensive to implement.
Frustration
Frustration is a limited excuse that applies when, due to a supervening event, a party's principal purpose for entering the transaction is destroyed or obviated. With this excuse, performance is not impossible but one party's reason for undertaking the transaction no longer exists. Frustration can excuse performance only if:
- The party seeking to be excused can no longer accomplish its purpose for the transaction.
- Both parties knew of the frustrated party's principal purpose for entering into the contract.
- A qualifying supervening event caused the frustration.
The party's contractual relationship is materially different because a supervening event has altered the inherent meaning behind one party's performance obligations. Put differently, to claim frustration, there must be a cessation or non-existence of a certain state of things forming the foundation of the agreement. Unlike impossibility, performance remains possible with frustration, but is excused when one party would no longer receive the expected value of their counterparty's performance (see Capital Quality Homes Ltd. v. Colwyn Construction Ltd., 1975 CarswellOnt 852 (Ont. C.A.) and Bang v. Sebastian, 2018 CarswellOnt 17240) (Ont. S.C.J.)).
This is a high bar to meet, and it applies only in narrow circumstances. Force majeure and impossibility appear to be more promising arguments in the case of COVID-19.
Insurance Issues
Whether the disruption or delay caused by the COVID-19 outbreak gives rise to an insured risk depends on the terms of a client's insurance policy, particularly its coverage for business interruption. That said, the following observations may be made:
- Business interruption insurance may not cover COVID-19. A stand-alone policy covering this risk is unlikely.
- In most cases, business interruption insurance covers loss of income that a business sustains as a direct result of physical damage to insured property, such as a building damaged or destroyed by fire or flood. COVID-19 does not result in physical damage even though it may result in a loss of income.
- Insured parties should examine their policies to see whether:
- there is an extension of coverage for interruption caused by non-physical events, such as, ideally, the outbreak of an epidemic; or
- conversely, there is a specific exclusion.
- The coverage may not extend to all types of loss.
- If there is actual or potential coverage for losses attributable to COVID-19, the policy will require the insured to:
- give prompt notice to the insurer; and
- take steps to mitigate its loss or damage.
Material Adverse Effect
In mergers and acquisitions (M&A) transactions, and some contracts for the supply of goods and services, the term "material adverse effect" (MAE) or "material adverse change" (MAC) is used as a materiality threshold to measure the negative effect of certain events, either on the transaction, or on one of the parties, generally the vendor. In an M&A transaction, a MAE clause can be used to qualify the vendor's representations and warranties (referred to in this Legal Update as a representation) in a purchase agreement, or as a condition to closing, either through a:
- Bring down. A bring down is a condition that requires the representations and warranties to be true and correct as of the closing date. It is a representation that no MAE has occurred since a specified date (generally, the balance sheet date).
- Specific MAE closing condition. This allows the purchaser to terminate the deal if the vendor, or the target corporation or business, suffers an event that causes an MAE on the vendor, or the target corporation or business.
An MAE definition typically has two parts. The first part sets out a wide net that captures the widest possible array of events, which can potentially qualify the vendor's representations (if qualified by MAE), or the purchaser's right to walk away from the deal.
For example, this part of the MAE definition could read:
"Material Adverse Effect" means any event, occurrence, fact, condition or change that is materially adverse to (a) the business, results of operations, condition (financial or otherwise) or assets of the [Corporation/Business], or (b) the ability of [Vendor/the Corporation] to consummate the transactions contemplated hereby; …"
The outbreak of COVID-19 should fit the first part of this definition as an "event", a "condition" or a "change". It is a question of fact whether this event, condition or change, while undoubtedly adverse, is materially adverse to the business, results of operations, condition or assets of the target corporation or business.
The Canadian case law is sparse and does not yet deal with the phenomenon of an epidemic.
The US has a much richer case law interpreting and applying MAE clauses. US courts appear to have rarely allowed purchasers to invoke MAE causes. In Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch.), affirmed 2018 WL 6427137 (Del. S.C.), the Delaware court held that the MAE must be expected to affect the target corporation on a long-term basis.
It remains to be seen whether COVID-19 will be considered durationally significant in the sense required in the MAE jurisprudence.
The second part of the MAE definition consists of various agreed upon carve-outs. Those that may be most salient to the assertion of an MAE based on COVID-19 include:
- Conditions generally affecting the industries in which the target operates, other than those that have a disproportionate effect on the target.
- Any changes in financial or securities markets in general.
- Any changes in applicable laws.
Therefore, even if COVID-19 is materially adverse to the target corporation or business, it will not constitute a defined MAE unless none of the enumerated carve-outs applies.
To date, purchase agreements that are filed on SEDAR, and, therefore appear in the Practical Law What's Market database (subscription required) do not reflect a change in the drafting of MAE clauses to account for the outbreak of COVID-19. While it is too early to say whether COVID-19 will be durationally and financially significant, this remains an intensely fact-specific matter to be analyzed or considered in the context of each specific M&A transaction.
Wayne Gray is Practice Lead, Corporate and M&A, at Practical Law Canada