Contracts in the Age of Coronavirus

COVID-19 Impacts Contracts and Obligations: Performance Excused?

Whether a business may suspend or terminate performance of some or all of its contractual obligations due to impacts of COVID-19 is perhaps as novel a question as the coronavirus is itself a virus causing disease. However, just as science is relying on past data, law leans on precedent.

Together with our Commercial Litigation and Business Counseling and Transactions practice groups, our firm continues to provide guidance to businesses in connection with events “out of the reasonable control” of and not “reasonably foreseeable” to contracting parties at the time of contracting.

I: Excusing Performance on Account of Intervening Events: Contract-Based & Other Doctrines

The novel coronavirus, also known as COVID-19, is significantly disrupting businesses, such as (without limitation) factories, retail establishments and offices, causing them to close, reduce or otherwise modify their operations amid numerous and varying government-imposed restrictions, executive order, travel bans, stay-at-home orders and quarantines. These sudden and realities are straining many business relationships and leaving many business owners in unchartered territory, wondering whether they can suspend performance of certain obligations and, if so, on what specific basis and with what repercussions.

Given that contracts created many of the effected relationships and obligations, many of those same contracts provide guidance - generally in provisions (and in some contracts, whole sections) referred to as (or essentially serving the purpose of) force majeure clauses or events - on how and in what manner the parties to them are to bear the risk of loss because of COVID-19 and its affects. In other cases, such as where a written contract does not exist or where a contract exists but is silent, common-law (or certain statutes, in civil law jurisdictions) fills the void, providing established legal theories for excusing a party's non-performance or termination of a contract. Whether suspending or even cancelling contracts in response to COVID-19 will expose businesses to significant liability will likely be a case-by-case determination - and specific cases should be brought by clients to their counsel for evaluation - but certain general rules relied on by judicial systems to adjudicate these issues will be considered and so some of those rules, also referred to as legal doctrines - are summarily addressed herein.

Silverman & Sardar LLP can assist in reviewing a businesses' contracts and providing guidance with respect to force majeure clauses and events, as well as common-law based excuses for non-performance, such as, the doctrine of commercial impracticability under the Restatement of Contracts. This doctrine has been referred to by some courts as the doctrine of “impossibility of performance” or “frustration of purpose”, while other courts have suggested that these three doctrines are not synonymous with, but distinguishable from each, other.

A. CONTRACT BASED: FORCE MAJEURE CLAUSE

Written contracts usually contain many sections addressing dozens of issues, but a contract, at its core is generally intended to create an enforceable relationship that allocates risks, obligations and duties among the contracting parties. The basic purpose of a force majeure clause or other provision of similar import - if present in a written contract - is to allocate among the parties to the contract the risk of non-performance of certain of those duties or obligations based on certain events, and to relieve a party from its contractual duties when its performance has been prevented by an event beyond its control or when the purpose of the contract has been frustrated. The force majeure clause often also limits damages where circumstances beyond the parties' control have frustrated their reasonable expectations; however, the party claiming a force majeure event excused its performance will generally have the burden of establishing that force majeure applies, and must also demonstrate its efforts to perform its contractual duties despite the occurrence of the event. On the other hand, where the parties' integrated agreement does not contain a force majeure clause, there is no basis for excusing performance or terminating a contract on the basis of a force majeure defense.

B. COMMON LAW: DOCTRINES EXCUSING NON-PERFORMANCE / PERMITTING TERMINATION

Where there is no basis for a force majeure defense, perhaps because no written contract exists or the subject written contract is silent on the issue of force majeure, the common-law (or in civil law jurisdictions, the statutory law) speaks up, filling the void and providing established legal doctrines for excusing a party's non-performance or permitting termination of a contract. The Doctrine of Commercial Impracticability under the Restatement of Contracts is one such common-law based excuse for non-performance. This doctrine has been referred to by some courts as the doctrine of “impossibility of performance” or “frustration of purpose.” Other courts have suggested that these three doctrines are not synonymous with, but distinguishable from, each other. We will address each of these doctrines below.

1. Commercial Impracticability under the Restatement of Contracts

The first common-law doctrine excusing a party's performance under contract to be addressed herein is Commercial Impracticability under the Restatement of Contracts.

Section 261 of the Restatement Second, Contracts defines what courts have characterized as impossibility as impracticability, and respecting such states the basic rule of impracticability as follows:

"Where, after a contract is made, a party's performance is made impracticable without his fault by the occurrence of an event the nonoccurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary."

A party may be excused from its performance obligation on the ground of impracticability if an unforeseen event beyond the party's control impacts its ability to perform. The party asserting that its performance is impracticable must not have caused this event, and the unforeseen event must alter the essential nature of the parties' agreement. The doctrine applies where the agreed performance has been made impracticable by the occurrence of a contingency, the non-occurrence of which was a basic assumption of the contract at the time it was made.

The party asserting the defense of impracticability has the burden of demonstrating that: firstly, an event made performance impracticable; and secondly, the asserting party's action(s) or inaction(s) did not cause the event. The doctrine of impracticability is inapplicable where the party claiming impracticability may be deemed to have assumed the risk that a foreseeable occurrence would impact its ability to perform. Accordingly, performance must be made impracticable because of circumstances unforeseeable at the time of contracting.

Impracticability - like impossibility - discharges the obligation to perform if such performance was impacted by subsequent governmental action. For example, if the performance of a duty is made impracticable by having to comply with a governmental regulation or order issued after contracting, that regulation or order is an event the non-occurrence of which was a basic assumption on which the contract was made.

2. Impossibility of Performance

The second common-law doctrine excusing a party's performance under contract that is addressed herein is Impossibility of Performance.

In New York, the vitiation of a contract based upon impossibility of performance is rarely imposed; however, when imposed, it excuses a party's performance. For the doctrine of impossibility to excuse a party's performance at least one or both of the following circumstances must be true: (1) the destruction of the subject matter of the contract or the means of its performance makes performance objectively impossible; or (2) performance is rendered impossible by an act of God.

Courts have instructed that the defense of impossibility should be applied narrowly and only in extreme circumstances because the purpose of contract law is to allocate risks. The doctrine comes into play where: (i) the contract does not expressly allocate to either party the risk of the occurrence of the event that made the performance impossible; and (ii) discharging the contractual duties of the party rendered incapable of performing would comport with customary risk allocation and can reasonably be inferred as intended by the parties at the time of contracting.

Impossibility excuses performance when unenforceable supervening circumstances render performance impossible. Impossibility must have been the result of an unanticipated event that could not have been: (i) foreseen; or (ii) guarded against in the contract.

The Court of Appeals in Stewart v. Stone, 127 N.Y. 500, 507, 28 N.E. 595, 596 (1891), provides an example. In Stone, the plaintiff agreed with the defendant factory owner that the defendant would make certain dairy products from milk provided by the plaintiff. The defendant could not perform the contract after a fire destroyed its factory. On the plaintiff's suit for damages, the Court of Appeals noted the general rule that when faced with an unforeseen event, a defendant must perform or pay damages unless he has protected himself against such contingency by stipulation in the contract; however, the Court then specifically noted that the continued existence of the defendant's factory could be viewed as having been understood by the parties as an implied condition to the defendant's obligation to perform such that the destruction of the defendant's factory constituted a failure of condition which excused performance. The Court of Appeals held that if, at the time of contracting, it was known to or contemplated by the parties that fulfillment of the contract would be dependent upon the continuance of or existence at the time of performance of, certain things or conditions essential to the performance of the contract (i.e.: in Stone, the factory) and those things or conditions ceased to exist prior to the time of performance, the performance had become impossible and was excused.

3. Frustration of Purpose

The third common-law doctrine excusing a party's performance under contract to be addressed herein is Frustration of Purpose.

In New York, the doctrine of frustration of purpose - an ancient concept rooted in the common law - arises when both parties can perform but, as a result of unforseeable events, performance by one party would no longer give the other what induced the other party to make the bargain in the first place.

The doctrine offers a defense against enforcement when the reasons for performing the contract have ceased to exist due to an unforeseeable event which destroyed the reasons for performing the contract. Frustration of purpose excuses performance when a virtually cataclysmic, wholly unforeseeable, event renders the contract valueless to one party. Frustration of purpose discharges a party's duty to perform where an unforeseen event has destroyed the underlying reason for performing the contract.

“Impossibility” and “frustration of purpose” refer to two distinct doctrines in contract law.

The Second Circuit in U.S. v. General Douglas MacArthur Senior Village, Inc., 508 F.2d 377, 381 (2d Cir. 1974), has explained the distinction as follows:

[I]mpossibility may be equated with an inability to perform as promised due to intervening events, such as an act of state or destruction of the subject matter of the contract. … Frustration of purpose, on the other hand, focuses on events which materially affect the consideration received by one party for his performance. Both parties can perform but, as a result of the unforeseeable events, performance by party X would no longer give party Y what induced him to make the bargain in the first place. Thus frustrated, Y may rescind the contract.

The frustrated party not only has a defense to a claim of breach but also can seek to rescind the contract. The frustration defense is available only when the circumstances that constituted the foundation for the entire contract have ceased to exist.

The doctrine of frustration of purpose is a narrow one which does not apply unless the frustration is substantial. A party cannot claim frustration of purpose if it receives substantially what it bargained for under the contract. The focus is upon whether there has been a material effect upon the consideration received by the party claiming frustration. The fact that the occurrence of an event has made performance more onerous does not mean that a frustration of purpose has occurred. A party may not unilaterally abrogate a contract merely upon a showing that it would be finally disadvantageous to perform it; were the rules otherwise, it would place all commercial contracts in jeopardy. It is not enough that the transaction had become less profitable for the affected party or even that it would result in a loss. For example, an increase in a party's obligation by $10 million due to a precipitous drop in the stock market did not provide a defense of frustration of purpose.

In contrast, a promisor can be relieved of its obligations when: (i) the parties contacted based upon the assumption of facts; (ii) neither party reasonably could have been expected to guard against the non-occurrence of the assumed facts; and (iii) the facts turned out differently than what the parties had assumed. The frustrated purpose must have been so completely the basis of the contract that, as both parties understood, without it, the transaction would have made little sense.

The event that causes the frustration must have been unforeseeable at the time of contracting. Accordingly, a party will not be relieved of its contractual obligations on the basis of an intervening contingency when it would have been reasonable to provide for such contingency in the contract. Furthermore, the defense of frustration of purpose is not available if the frustrating event was foreseeable or was caused, directly or indirectly, by the action of the party asserting the defense.

Frustration is no defense where the contract did not provide safeguards for a reasonably foreseeable intervening event; in such a case, the doctrine seems to point its proverbial finger to the contracting parties, charging them with the failure to safeguard against reasonably foreseeable intervening events. In sum, if the contingency is reasonably foreseeable and the contract fails to provide protection in the event of its occurrence, the defense of frustration of purpose is not available. For example, frustration was not permitted as a defense to a claim of breach of a contract of sale for an exclusive right to offer a musical group's recordings after file-sharing services made those recordings available for free on the internet because, at the time of contracting, the parties knew of the risks posed by the file-sharing services. The outcome perhaps would have been different and the defense of frustration of purpose available if services for internet based file-sharing was then (at the time of contracting) not yet in existence.

II. Conclusion

COVID-19 have had and will likely continue to have significant impacts on businesses and their many relationships and contracts. Disputes will inevitably arise over which party is to bear the risk and liability of performance and non-performance as a result of specific circumstances and terms written in contracts' force majeure clauses and/or those of similar import, over whether one or more common law doctrines for excusing performance is applicable and further over what the applicable and appropriate related penalties, fees and damages are and will be.

Silverman & Sardar LLP can assist in reviewing a contract and providing guidance with respect to force majeure clauses and events contained and/or described therein, as well as common-law based excuses for non-performance, such as, those premised on the doctrine of commercial impracticability, impossibility of performance or frustration of purpose. We can also review the relative advantages and disadvantages of cooperating during this 'Age of Corona' with contract counter-parties in an effort to achieve maximal results in both the short and long terms.

The content contained herein is information that is not intended as legal advice or an opinion on specific circumstances.