COVID-19 and Your Contracts

This bulletin discusses the following issues in view of the COVID-19 pandemic:

• Whether a force majeure clause in a contract might apply to COVID-19 situations
• When a contract has been frustrated or rendered impossible to perform
• What the obligation to mitigate means

On March 11, 2020, the World Health Organization declared the outbreak of COVID-19, otherwise known as coronavirus, a pandemic. By March 16, 2020, travel and business restrictions imposed by governments, including in Canada, were becoming commonplace.

As the rapidly-spreading virus disrupts markets and supply chains around the world, businesses are increasingly at risk of being unable to perform their contractual obligations. Since January 2020, more than 5,600 “force majeure certificates” have been issued by the China Council for the Promotion of International Trade (CCPIT) to Chinese companies that have failed to comply with international contract obligations due to the virus.

In this bulletin, we discuss the extent to which COVID-19 may be invoked as an excuse for non-performance of contractual obligations, and the immediate steps that companies should take to prepare for possible disruptions in contractual performance caused by COVID-19.

FORCE MAJEURE

Most commercial agreements provide for parties to be excused from their contractual obligations in the event of serious unforeseen circumstances. Often referred to as “force majeure” clauses, they generally discharge a contracting party when a supervening event, beyond the control of either party, makes performance impossible. While force majeure clauses differ in their terms, the common thread between them is the occurrence of something unexpected and beyond reasonable human foresight and skill. As such, the following analysis is intended to apply only to agreements entered into before the outbreak of COVID-19 became a known or foreseeable event.

In the common law jurisdictions of Canada—the focus of this bulletin—force majeure is a creature of contract. It can be invoked only where provided for in an agreement, and its application and effect are determined through contractual interpretation. In Quebec, force majeure is also part of the Civil Code of Quebec, so its application does not always require a contractual foothold.

A party seeking to rely on a force majeure clause must first establish that the intervening event falls within the contract’s definition of force majeure. Most force majeure clauses provide a list of specific triggering events. Terms such as “epidemic” and “disease”—and certainly “pandemic”—will likely apply to the COVID-19 outbreak. Where COVID-19 is not captured by a specific or analogous term, it may nevertheless be covered by more open-ended language in the contract.

For example, in the event that a government responds to the spread of COVID-19 by declaring a state of emergency or closing its borders to trade, such action may fall under a definition of force majeure that includes “government or administrative action, such as a decision or order preventing or hindering performance.” Some contracts include even broader catch-all language such as “other events beyond the reasonable control of the parties,” which would almost certainly include the current COVID-19 outbreak. However, such assessments must be conducted on a case-by-case basis and will depend on the language of the contract and the factual circumstances.

An event that qualifies as a force majeure will not provide parties with freedom to be excused from contractual performance. The party invoking force majeure must also establish that the event sufficiently impacted its performance. Most force majeure clauses set out the degree of requisite impact, ranging from the more onerous standard of performance being “prevented,” to lower standards such as being “hindered” or “delayed.” However, where the required impact is not specified in the agreement, Canadian courts have typically applied a high threshold, only excusing performance where it is rendered essentially impossible. Notably, the fact that an event has made performance merely more expensive or unprofitable is insufficient to trigger a force majeure clause.

There must also be a substantial causal tie between the force majeure event and the party’s failure to perform its contractual obligations. In the case of the Chinese companies referred to above, CCPIT force majeure certificates, for example, would be considered as evidence that a particular event occurred, but would be insufficient to satisfy a force majeure clause without evidence that the non-performance was caused by that event. Similarly, whether the disruption of the supply of goods constitutes a force majeure will depend on whether supply of those goods could have been secured from another source. Whether the impact of COVID-19 on the availability of employees to perform contractual work amounts to a force majeure likewise may depend on whether company policies implemented during the outbreak, such as quarantining or remote work, were necessary, and whether in fact performance was impossible. These are factual questions which will be unique to each individual circumstance.

It should also be noted that many force majeure provisions contain strict notice requirements. If a party intends to rely on a force majeure clause, the notice requirements in the contract should be reviewed closely and followed strictly.

Where successfully invoked, the effect of a force majeure clause is determined by what is contemplated in the agreement. Most force majeure clauses will suspend a party’s performance of a contractual obligation for the duration of the force majeure event, but not permit termination.  Other clauses will permit termination later, but only if the force majeure event persists for a specified period of time. Some force majeure clauses may partially excuse performance or permit the counterparty to procure products or services elsewhere during the force majeure event. In all cases, the contract as evidence of party intentions will be key.

FRUSTRATION

In the absence of an applicable force majeure clause and in very limited circumstances, a party may be relieved from its obligations by claiming that the contract is “frustrated.” Frustration applies as a matter of law where, through no fault of the parties, an unforeseen event renders performance of the contract radically different from what the parties had bargained for. Unlike the flexibility of force majeure, which can be determined by the parties as expressed in their contractual terms, frustration automatically results in both parties being discharged from their obligations.

Given its significant impact, the threshold for frustration is a very high bar. While performance need not be entirely impossible, the party’s reason for entering into the transaction must be destroyed by the intervening event. Even dramatic price changes and market fluctuations are not likely to result in a contract being frustrated. However, if the impact of COVID-19 drastically changes the character of contractual obligations, for example, in the event of government-imposed restrictions preventing travel or trade, it is possible that the contract would be considered frustrated.

MITIGATION AND COOPERATION

In any situation where losses are likely to be incurred, contractual parties have a duty to mitigate those damages. Force majeure and frustration are last resorts which will not be applied if parties have not exhausted the options available to them to perform their obligations under the contract. When seeking to invoke a force majeure clause, a party must show that there were no commercially reasonable alternatives that could have mitigated the effect of the event and its impact on the other party. This duty to mitigate includes a duty to avoid or minimize not only any losses, but likely also the occurrence of the event itself. Similarly, parties who stand to lose the benefits of a contract due to the other side’s failure to perform their obligations are required to mitigate their damages. Damages for breach of contract will only be recoverable to the extent a claimant has taken reasonable steps to prevent further losses.

While not explored in this bulletin, there are a number of other possible contractual implications of COVID-19 which should be considered, specific to the type of contract in question and its terms. Many contracts contain “material adverse event” or “material adverse change” clauses, which may be triggered by an event such as the COVID-19 outbreak, depending on the wording of the clause. Parties may be able to renegotiate terms or raise prices due to increasing costs, depending on the situation.

Businesses should review their contracts in detail to assess the unique ways the COVID-19 outbreak are impacting their contractual relationships. Moreover, when considering whether and how to carry out their contractual obligations, parties should keep in mind their overriding duty to perform contracts in good faith. This is likely the lens through which courts will consider a dispute over any of these contractual implications, even as the precise meaning of that duty remains under consideration by the Supreme Court of Canada.

CONCLUSION

The impact of COVID-19 is rapidly evolving and there are no universally applicable answers. All commercial parties should review their key contracts and insurance policies to determine their rights and responsibilities given the pandemic, including their obligations to notify counterparties if performance will be delayed or made impossible by events beyond their control. Parties should remember their duties to mitigate and perform in good faith.

To help navigate the challenges posed by the COVID-19 outbreak, Blakes has consolidated resources on a range of topics relating to the coronavirus and its business and legal implications.

For further information, please reach out to a member of our Litigation & Dispute Resolution group or your usual Blakes contact at any time. We will get through this together.

Please visit our COVID-19 Resource Centre to learn more about how COVID-19 may impact your business.