What happens to contractual obligations during COVID-19 pandemic?

Here are tips for directors on negotiating contracts during this volatile time, from Norton Rose Fulbright head of Insurance Australia and Asia Pacific, Tricia Hobson.

With the Prime Minister announcing on 18 March that Australian measures to combat the spread of COVID-19 may be in place for at least six months, the need for Australian businesses to stabilise their supply chains and contractual relationships in order to see out the crisis is abundantly clear. These guidelines show how businesses might navigate contractual obligations during these unprecedented times.

Examine your contracts

Carefully consider all contracts to ascertain your right to suspend performance of affected obligations or otherwise exit contracts that are impossible to perform. Appropriate governance and a business-wide focus will assist in developing a consistent strategy. Remember that risk management should be a key pillar in this strategy — what are your exposures if you do or don’t exercise force majeure?

Take care before invoking a force majeure clause or claiming that a contract is frustrated, as these steps may lead your counterparty to claim you have repudiated the contract. When negotiating contracts during the pandemic, consider mechanisms to respond to a range of escalations, along with how and when any unusually flexible or restrictive provisions can be “switched off” when the pandemic abates, or can be switched back on if there is a further outbreak.

COVID-19 is likely to affect all businesses across all industry sectors. In some cases, both parties to a contract may be in breach of its terms due to COVID-19 and each will certainly have its own concerns regarding business continuity. Accordingly, many businesses will first attempt a negotiated interim solution. When exploring this option, consider how to do so without compromising your rights. For example, you may lose contractual rights if you fail to notify the counterparty promptly of your intent to exercise them.

Force majeure

If performance of a contract is affected by COVID-19, you may be able to rely on the contract’s force majeure clause, if one has been included. The purpose of this clause is to protect the parties from events that are agreed to be outside normal business risk. If successfully invoked, the clause relieves a party from the performance of its obligations under the contract, thereby avoiding a breach.

Force majeure is not a legal doctrine in Australia. It is a contractual right only, meaning that whether a force majeure event excuses performance of obligations is wholly dependent on the wording of the relevant clause(s) of the contract.

If relying on a force majeure clause to avoid what would otherwise be a breach of contract during the pandemic, consider first if a force majeure event occurred under your contract. Some contracts use a laundry list of potential occurrences and some simply refer generically to unforeseeable events beyond the control of the affected party. Clauses that reference pandemics and/or governmental action may be of particular assistance.

Acts of God

Force majeure clauses are typically interpreted strictly. This may require granular thinking. For example, some clauses refer to “acts of God” (arising exclusively due to natural causes, without human intervention, which cannot be foreseen or prevented). While COVID-19 itself may potentially be classified as an act of God, it is questionable whether governmental responses to COVID-19 would qualify.

Consider what obligations are affected, and how seriously. A party seeking to rely on a force majeure clause is typically required to mitigate the impact of the force majeure event to the extent possible, even if this proves challenging. It is also crucial to identify which contractual obligations are affected by the force majeure event, and to what degree. Force majeure provisions usually specify that the party must be “prevented” from performing its obligations, or that it must be “impossible” or illegal for it to do so; it is generally not sufficient if it would instead only be more difficult or more expensive.

Typically, invoking a force majeure clause excuses a party from performing affected obligations while the force majeure event continues. But unaffected obligations may remain enforceable. For example, it would be important to consider the implications in respect of payment obligations.

Is the contract frustrated?

If you cannot perform a contract because of a change in circumstances so radical that the situation is now fundamentally different to what the parties had in mind, the contract may be discharged for frustration. It is not frustrated if it merely becomes more difficult or expensive to perform. Because the parties’ precise arrangements and communications are highly relevant, the same incident could frustrate some contracts, but not others.

At common law, a frustrated contract is terminated automatically, but this does not affect rights and obligations accrued before termination. Discharge for frustration is governed not only by common law, but also by legislation in several states. Obtaining a complete picture of potential rights and obligations if a contract is frustrated therefore requires reference to the contract’s governing law.

Consider your brand

Be clear about the basis of your rights before invoking a force majeure clause or claiming that a contract is frustrated. Doing so invalidly may be deemed a repudiation of the contract and may give the counterparty the right to terminate and claim damages for the loss of the benefit of the contract. To ensure a consistent strategy is employed with full recognition of the ramifications, including the various reputational and conduct risks, consider what internal controls will apply to such decisions and whether a business-wide approach can be implemented.

In the current crisis, both the government and business sectors have stressed the need for business and relationship continuity where possible. This thinking also applies to exercising force majeure. Working through the possible consequences of a decision is critical. For example, what might be the status of your business relationship with your counterpart post-force majeure? Is there a possibility of brand damage if you are perceived to exercise force majeure “unfairly”?

Regulated businesses that are considering force majeure exercise need to be aware that regulators will be looking closely at commercial decision-making. How a business conduct risk is managed will be a matter of acute concern for many regulators as they pursue their risk-based supervision mandates.

Avoiding and resolving disputes

The most common area of dispute is whether the contract’s force majeure clause in fact captures the event that has occurred. Accurately and contemporaneously documenting both the direct effects of the event (including their duration) and your communications with the counterparty are critical. At the height of the crisis, a party may give acknowledgements of its consequences from which they might seek to resile after the crisis has passed.

Generally, a refusal to accept that there is force majeure (or a claim that it is applicable which is rejected) will constitute a dispute that must be resolved using the process specified in the contract (if any). Ideally, this will require good faith negotiations, and possibly a mediation, before court or arbitral proceedings can be commenced. Even if it does not, federal and state court legislation and rules generally oblige parties to explore settlement options before the issue of proceedings.

Resolution of disputes of this nature by informal means or mediation is consistent with the current business and societal imperative to work cooperatively to maintain normal activity and preserve economic structures as far as possible. If an appeal to your counterparty in those terms does not work, it might be worth pointing out that the courts are all basically closed for the duration.

Negotiating new contracts

Don’t rely on frustration for new contracts. A contract is not frustrated if the parties could reasonably have foreseen the change in circumstances. Exactly when the implications of COVID-19 became sufficiently foreseeable to defeat a claim of frustration could well become the subject of future litigation. However, COVID-19 and its potential associated disruptions are at least now clearly foreseeable.

Don’t leave everything to force majeure

It is impossible to know exactly how COVID-19 may continue to affect Australian businesses. We recommend including contingencies (such as cascading provisions dealing with different scenarios) to respond to various COVID-19 related escalations. This approach minimises the risk that you cannot rely on a specific force majeure event, and also allows the parties to agree to tailored solutions rather than relying on a comparatively generic force majeure clause. In effect, terms are drafted setting out the rights and obligations of the parties during the interim period and provide a roadmap back to normality once the pandemic abates. Exactly what events to account for in such provisions will depend on the industry and the nature of the contract, but may include:

• One or both businesses are required to close or operate in a different manner under governmental “lockdown” directives, or elect to close in accordance with non-binding governmental advisories.
• One or both businesses need to temporarily cease operations because of an infection or may choose to do so on a precautionary basis.

Getting back to normal

The current climate is not permanent, but restrictions may ease only gradually and could be reintroduced if a subsequent outbreak occurs. As part of any contractual negotiations, consider whether any unusually flexible or restrictive terms will revert to market standard once the crisis abates. If so, what should your contract say about how it will be determined that sufficiently normal conditions have returned?

Each nation, state and territory, will have its own recovery trajectory, so any international or interstate touchpoints in the contractual arrangement may affect this determination. Will emergency provisions be re-introduced if there is a further outbreak? How will these be triggered under the contractual terms?

Tricia Hobson is Norton Rose Fulbright head of Insurance Australia and Asia Pacific and co-head of its Cyber and Incident Response Practice.