Contractual stress in an infected world: The impact of COVID-19 on commercial contracts

27 March 2020

Viruses do not discriminate.  The impact of the current global crisis is severe and, as the infection rate rises exponentially in Australia, our economy and health system are under immense pressure.  With mandatory self-isolation, a spike in unemployment and the closure of non-essential services comes deep uncertainty.

How contractual rights, duties and obligations will be interpreted, satisfied and performed in these challenging times is one of many areas of uncertainty for business.  Even if your business is in a strong financial position, you may feel the effects as customers struggle, supply chains break down and materials or services become scarce. 

Perhaps the change in circumstances is so dramatic that the original terms of a bargain or agreement you struck are no longer viable. 

It is essential that businesses are aware of the terms of their commercial contracts to ensure informed action can be taken to mitigate loss.  No matter how dire the circumstances, there are always options and decisions to be made.  Such decisions may have significant financial consequences.  On top of the deep human impact, the survival of entire industries is under threat as the harsh reality of this pandemic sets in.

What if I can no longer comply?

If you are unable to perform your commercial obligations for any reason, such as a lack of staff, supplies, cash-flow or sickness, or perhaps an inability to access your premises or work site, you risk damages claims, and potentially termination of your contracts, on the basis of breach or non-performance.

So, what can you to do safeguard yourself or your business?  The first step is to read the terms of your contracts.  There will be options and opportunities, which may, subject always to the unique contractual terms, provide some welcome relief.

A superior force at play?

The expression force majeure means a “superior force”.  The impact of any “superior force” on a commercial contract can be managed by a force majeure clause, which is triggered where one or more parties are unable to satisfy their obligations due to some exceptional, unforeseen event that they cannot control.  Such events are usually referred to as “force majeure events” throughout a contract and common examples include extreme weather patterns, war, “acts of God”, government action and pandemics. 

The concept of force majeure is not recognised at common law in Australia, which means the concept only applies if a relevant provision appears in the contract.  The scope of its application is governed by the terms of that provision.  For this reason, it is imperative that force majeure clauses are drafted to reflect the intention of the parties.  For example, the definition of “force majeure event” is critical in the sense that it determines which events will trigger the clause.  The definition will vary between contracts, with some including a general clause to capture any event beyond the reasonable control of the parties and others setting out a specific list of events.  It follows that the broader the definition, the more likely COVID-19 will be considered a force majeure event.  However, a “catch-all” phrase may not be as effective as it appears because it could be interpreted in a limited way by reference to surrounding terms and context.  Provisions referring to illness, epidemics, pandemics, government action and “acts of God” are likely to be particularly relevant in the current circumstances. 

Force majeure clauses typically provide relief to a party by excusing the performance of obligations to the extent the force majeure event prevents such performance.  Relief will typically not be available if the party is capable of performing its duties, no matter how onerous, costly or inconvenient they may be.  In order to rely on a force majeure clause, and subject to its terms, a party will usually be required to give notice of the event to the other party, provide evidence supporting its claim that performance is no longer possible and take reasonable steps to mitigate the effect of the force majeure event.  Relief might include the suspension of obligations unable to be completed by virtue of the force majeure event, the avoidance of liability for non-performance or delay or termination if the event continues for an extended period of time.

Often, the utility or otherwise of a force majeure clause will depend on a full understanding not only of the way the provision is drafted, but full detail of the factual circumstances leading to the inability to perform.

These are frustrating times

In the absence of a useful force majeure clause, there is still a chance the law will provide some relief.  The common law recognises a concept known as “frustration”, which is also recognised in state legislation.[1]  Frustration provides for the automatic termination of a contract if an unforeseen event occurs subsequent to its formation, which leaves performance impossible, pointless, more difficult or more costly.  However, the threshold to establish this kind of relief is high.  If a contract is frustrated, termination will occur from the date of the frustration.

To prove frustration, a party must demonstrate that the event has unexpectedly resulted in a situation fundamentally or radically different from what was contemplated when the parties entered into the contract.  Frustration will arise if it is clear the object of the contract has been destroyed or performance is only possible in a manner that differs from the original agreement.  The fact that performance will result in hardship is not enough and obstructions causing delay that are temporary in nature are unlikely to reach the high threshold (depending, of course, on the terms and circumstances of the contract).

What else might be triggered?

Contracts may include other mechanisms to relieve, alter or remove obligations in specified circumstances.  Triggers linked to a “material adverse change” or “material adverse event” are not uncommon.  The intent and effect of these provisions will depend on the contract, but they may, for example, allow a buyer to pull out of a transaction or allow a supplier to increase the price at which goods are sold.  These mechanisms are very common in finance contracts, where they often allow a lender to require immediate repayment of a loan or enforce related security agreements.  However, lenders are likely to be cautious in seeking to enforce these provisions in the current climate and in light of the banking royal commission.

What can we learn from COVID-19?

The major lessons relate to planning and risk management.  If your contracts do not provide relief for unforeseen events such as COVID-19, now is the time to consider including such clauses in future agreements.  The drafting of these clauses is important, and the relevant definitions should cover the particular kind of event that the parties wish to safeguard themselves against. 

For businesses currently struggling to perform under a contract, or those who foresee issues in the near future, your options will depend on the terms of the particular contract entered into.

 

This article provides general comments only.  It does not purport to be legal advice.  Before acting on the basis of any material contained in this article, we recommend that you seek professional advice.

 

 

Authors:

Daniel Jenkinson, Principal in our Transactions Team

Email: djenkinson@dmawlawyers.com.au
Phone: +61 8 8210 2265

 

Annabel Nettle, Lawyer in our Disputes Team

Email: anettle@dmawlawyers.com.au
Phone: +61 8210 2291

 

[1] In South Australia, the Frustrated Contracts Act 1988 (SA).