In 2009 in the wake of the Great Recession we coauthored Contract Enforceability During Economic Crisis: Legal Principles and Drafting Solutions [i] (“Article”). The broad thesis of the Article was that the “law” would rarely provide relief to a contracting party adversely affected by fundamental market changes. In reaching this conclusion we examined a wide range of “law”: common law as reflected in the doctrines of impracticability; force majeure and economic duress; the Restatement (Second) of Contracts and the Uniform Commercial Code; international contract law as expressed in the UNIDROIT Principles and the Convention for the International Sale of Goods (“CISG”). In the article we recognized that well-drafted contract provisions might enable a party to obtain protection from market risks.
How do the principles and conclusion of our article apply to the current Covid-19 crisis? Covid-19 will be a physical tragedy for many people, but for many more it will be economic mayhem and even disaster which has the potential of being even greater than the Great Recession of 2007/2008. Unlike the Great Recession, however, the lockdown/stay-at-home orders directly impact contractual obligations.
Future contracts and contracts in the making
Well drafted contracts entered into post-crisis can and should deal with the crisis. Indeed, it could well be considered to be professional malpractice not to do so. Our article provides models of types of clauses that could easily be adapted to the current crisis. In particular, MAC (Material Adverse Condition) (also known as MAE – material Adverse Effect) clauses seem particularly well suited to the COVID-19 situation.[ii]
We noticed in our Article that “market change is expressly excluded as a material adverse condition. Moreover, courts tend to narrowly construe MAC clauses.[iii] In our knowledge, there are no instances in which a court has found a MAC has occurred as a consequence of 2008 financial crisis (or the 9/11 for that matter).
The same problem should not exist today because the COVID-19 situation is not merely a market change. However, it is possible that the seller/supplier might want to include a specific carve-out for pandemics, epidemics, pandemic, disease outbreaks or other health crisis, in which case, the Covid-19 situation would be excluded and no relief would be offered by a MAC clause. The scope and limitation of the MAC clause depend on the bargaining power of the parties.
We noticed, however, that MAE typically is not intended to address changes affecting entire industries/the economy as a whole. In fact, systemic risks are allocated to the buyer while the MAC clauses are for allocating company-specifics. (Thanks to ABA’s CLE When COVID-19 Impacts Your Deal: Evolving M&A Practices and Provisions).
Force majeure clauses could also be used to fence against the Covid-19 situation but it depends on the drafting. In our Article, we noticed that
Contracts often contain force majeure clauses. The purpose of such clauses is to allow a party to avoid a contract even when doctrines such as impossibility or impracticability do not provide relief. The typical clause specifies various events, such as war, acts of God, or strikes, as grounds for contractual excuse. If a force majeure clause is narrowly drafted, a court is almost certain not to apply it to market change. Reference was made to several cases in which changes in the market had disproportionally affected one of the parties.[iv]
Even with broadly-drafted force majeure clauses, courts have refused to given relief for failure of the market.[v]As Judge Posner wrote in 1988: “A force majeure clause is not intended to buffer a party against the normal risks of a contract. The normal risk of a fixed-price contract is that the market price will change.”[vi] The covid-19 situation, however, is different because the Covid-19 situation goes beyond a market crisis and the virus could certainly be seen as an act of god (absence exclusion).
However, there are at least two problems for broad MAC clauses and force majeure clauses as a possible remedy to the covid-19 situation. As it has been correctly pointed out 1) “overly broad ‘force majeure’ and ‘MAC’ clauses may create an illusory contract that amounts to an option by the party benefited thereby. (Jose Sariego, The Wrath of God and its Impact on Contracts – “Force Majeure” and “MAC” Clauses, available here ) and 2) if one party claims that a MAC event or a force majeure event occurred and the other disagree, the only solution is going to court (and often there is “a race to the courthouse” Id.)
Another way of dealing with the uncertainty of the Covid-19 crisis could be condition clauses, i.e., the parties could expressly agree “that the duty of one party (or, perhaps, both of them) should depend on the happening of one or more specified events.”[vii] The Restatement (Second) §224 defines a condition as “an event, not certain to occur, which must occur . . . before performance under a contract becomes due.” There is plenty of uncertainty in the Covid-19 crisis and it could be the natural realm of conditions (precedent of subsequent)[viii].
The event in question would be connected to the Covid-19 crisis. Let’s imagine that one of the department stores currently under the lockdown (forced to be closed as “non- essential business”) wants to place an order for 10,000 bathing suits from a manufacturer. Being unsure about when “the country will re-open” and not being available to risk to purchase items that are useless passed the summer, the department store could insist that its obligation to receive delivery and pay for the bathing suits is conditioned on the department store’s re-opening by June 1. This would be a “condition precedent”. Another way of doing it, would be to phrase the term as “a condition subsequent”, i.e. the department store has an obligation to accept delivery of the bathing suits and to pay for them but, if by June 1, the lockdown has not ended, then the department store is released from the obligation to accept delivery and pay.
Provided that the manufacturer is available to accept such terms, particular attention should be paid to correctly phrase the condition clause.
Courts are typically emphatic that an “express condition” must be stated in unambiguous language because express conditions must be liter- ally performed or satisfied; substantial performance will not suffice. See, e.g., MHR Capital Partners LP v. Presstek, Inc. 912 N.E.2d 43 (N.Y. 2009) (noting that courts have recognized that the use of terms such as “if,” “unless,” and “until” constitutes “unmistakable language of condition”). Id. at 813.
If conditions are not properly phrase, they would offer very little protection to the department store. However even whith proper drafting, a condition clause would not completely protect the department store. In fact, several doctrines can be used by the seller to avoid to avoid the effect of condition. First, in case the lockdown is still in place on June 1, but in the meantime the department store has successfully moved all its sale online, the seller could try and avoid the effect of the condition (i.e., could insist on buyer’s performance) using the “excuse due to immateriality” doctrine:
almost all modern courts … would actually insist on strict performance of conditions only when the conditioning events are material to the agreement of the parties. Conditions that are merely ‘technical’ ..[are] generally excused under various theories such as adverse interpretation, waiver, prevention, or avoidance of forfeiture. Id. at 817.
The success of such an excuse is uncertain but the claim would be viable.
Second, waiver and estoppel could also be excuses to a condition.
An obligor whose duty is expressly dependent on a condition may be under a duty to perform despite the nonoccurrence of that condition, if a court finds that he has, by word or conduct, “waived” the right to insist on fulfillment of the condition before performing the duty.” Id at 817.
This could happen if the buyer indicates in correspondence with the manufacturer that it is changing its way of operation (from a brick and mortar location to online) and confirming that it is still interested in the bathing suits.
Depending on the circumstance, other doctrines might apply to excuse the condition, so that the use of condition to protect a party from the uncertainty of the Covid-19 crisis is not fullproof. In other words, ultimately, parties enter into contract at their own risk in a time of crisis.
Nor the aggrieved could easily obtain damages through insurance. For example, underwriters of representation and warranty insurance (RWI) policies (which are policies designed to cover the unforeseen cost of seller’s breach of rep&warranties in an M&A) are now excluding from their coverage, business downturns due to Covid-19.[ix]
Pre-existent contracts
What about existing contracts entered into before the crisis, particularly ones without MAC clauses? Of course, the coronavirus crisis is having a fundamental effect on markets. While some of this effect is positive: for example, home goods and food products are doing well. However, much of the market effect is negative: the stock market has tanked; the transportation industry is in turmoil; stay-at-home owners leave little room for leisure travel.
In many contracts relief from the virus is irrelevant because the contract is either terminable at will (see most of employment contracts in the U.S.) or a spot contract that the parties will either form or not depending on their particular interests. For example, an airline may offer a reduced flight schedule and a passenger may choose to fly or not depending on price, availability, and customer needs. Some long-term contracts instead might be affected. This is the case of supply contracts (example: supply of raw materials to manufactures). For example, what about the situation of an order for the supply of 1000 custom-made leather jackets to a department stores that is now closed following the covid-19 situation? Could the department store renegade on the contract claiming that it cannot receive delivery of the already half-manufactured jackets because of the Government’s imposed lockdown following the covid-19 situation?
Even in the absence of a MAC clause o force majeure causes, equitable concepts such as “frustration of purpose” or “impossibility of performance”.[x]
While obtaining relief based on these concepts is generally difficult, “courts have been much more willing to grant relief when the event on which the claim of impracticability or frustration rests is some form of supervening governmental regulation rather than cases in which the event is war, natural disaster, or market change”. Id at 766.[xi] However, the “receptiveness to claims of excuse where performance is prevented by supervening governmental action” (id.) does not make the path easy to the aggrieved party, in fact “courts will still impose stringent limits on such relief in that category of frustration cases as well as any other … Those limits include the requirement that frustration be quite substantial.” Id. In particular, courts stated that “the performance must be rendered ‘virtually worthless’ and the principal purpose of the contract must be substantially undermined.” Id. Internal citation.
In the example of the supply contract for jackets, can be said that the performance has been rendered “virtually worthless” because of the lockdown? Isn’t it the case that the jackets could still be sold in the future when the covid-19 lockdown is lifted? True, the department store will not be able to get an immediate benefit from the delivery and will receive some financial disadvantage from purchasing now products that it will be able to sell only in the future, but perhaps this is not enough to avoid the contract under frustration of purpose. Different would be the situation in which the supply contract is for perishable product that the department store cannot sell because of the lockdown. The performance of the supplier here would be virtually worthless because when the lockdown ends, the products cannot be sold.
A case by case evaluation is therefore necessary and parties aggrieved by the covid-19 situation, unfortunately, have not an automatic way out just because they can play the “covid-19 card”.
Some general observations
Even if a party might have a force defense, you might want to consider the long-term commercial implications for your business before invoking force majeure. First, force majeure excuses performance while the event lasts (example: lockdown) but doesn’t excuse performance any further (to be clear: unless you have a broad definition of force majeure in your agreement, the financial difficulties following the reopening will unlikely be covered). Second, you might be excused from performing but this doesn’t mean that being excused is necessarily desirable for your business (for example: what if your customer finds another supplier in the meantime?). A better strategy sometimes could re- negotiation. For example, the other side might accept longer delivery terms or an alternative performance. Renegotiation entails some risks that need to be gingerly evaluated (possibly with professional legal advice). If renegotiation is off the table, force majeure, frustration of purpose, impracticability or other doctrines might be applicable, keeping in mind that are never a “slum dunk”
For more information, Nathan M. Crystal and Francesca Giannoni-Crystal
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[i] Contract Enforceability During Economic Crisis: Legal Principles and Drafting Solutions. (2010), Global Jurist: Vol. 10: Iss. 3 (Advances), Article 3. (“Article”)
MAC clauses are commonly used in the context of mergers and acquisitions to allocate risk between buyers and sellers in case an adverse business or economic development occurs between signing and closing. MAC clauses are also common in derivative contracts, interest rate swaps, for example. A MAC clause generally refers to a defined term in an agreement delineating what constitutes a material adverse change or a material adverse event/effect. A MAC clause is usually not a basis for immediate termination of a contract unless expressly provided. Normally, only where the affected party has failed to provide adequate performance assurance after receiving a written notice and sufficient opportunity to preserve the integrity of a transaction does a MAC clause entitle the unaffected party to terminate the contract.
However, while mergers, acquisitions and derivative contracts are the usual setting, there is no reason why the MAC clause cannot be used in other contexts, like a sale of goods. In a merger or acquisition contract, a MAC clause enables the acquirer to refuse to complete the acquisition or merger if the target suffers such a material change. In a sale of goods contract the MAC clause could provide the same right that the UNIDROIT Principles allow in case of hardship: renegotiation of terms and in case the negotiations are unsuccessful a right to go to court for adjustment (or to cancel the contract). Article.
[iii] In our Article we cited to In Re: IBP, Inc. Shareholders Litigation (789 A.2d. 14 (Del. Ch. 2001), holding that a party seeking to invoke a MAC clause and terminating a deal faces the high burden of proving that the events claimed to be a MAC
substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term hiccup in earnings should not suffice; rather the [MAC] should be material when viewed from the longer-term perspective of a reasonable acquirer.
After our article was published, an important decision by the Delaware Court of Chancery, for the first time, determined that a buyer had ever validly terminated a merger agreement pursuant to a MAC clause. Akorn, Inc. v. Fresenius Kabi AG (See more here) which was affirmed by the Delaware Supreme Court (see more here). Akorn, actually is not an exception to the narrow view that courts take on MAC clauses; simply said, the circumstances in Akorn were so extreme (overwhelming evidence of widespread regulatory violations and pervasive compliance problems” as well as the fact that target’s financial performance “dropped off a cliff”, Eric Fidel, Akorn: Establishing a Material Adverse Effect) that it should be read as the exception to the rule, not as a change in the rule.
[iv] For example, we cited, among others to United States v. Panhandle Eastern Corp., 693 F. Supp. 88 (D. Del. 1988), refusing to apply the force majeure clause to cover adverse market or economic conditions and Northern Indiana Public Service Co. v. Carbon County Coal Co, in which the court refused to give relief to the aggrieved party, even with a broad force majeure clause in the contract, and in situation in which the price of the coal had risen from $24 to $44.
[v] See, e.g., Golsen v. ONG Western, Inc. 756 P.2d 1209 (Okla. 1988), holding that the contract must be read as a whole, and the three words in the force majeure clause referring to failure of market could not override the other provisions of the contract, particularly the take-or-pay provision.
[vi] Northern Indiana Public Service Co. v. Carbon County Coal Co., 799 F.2d 265, 275 (7th Cir. 1986).
[vii] (Charles Knapp, Nathan M. Crystal and Harry G. Prince, PROBLEMS IN CONTRACT LAW: CASES AND MATERIALS (Aspen Law & Business, 9th ed. 2019) at 805.
[viii]
A condition precedent refers to an event that must exist or occur before a duty to perform will arise. A condition subsequent contemplates that a duty would be owed but subject to discharge on the happening of an event after that duty had originally arisen. Charles Knapp, Nathan M. Crystal and Harry G. Prince, PROBLEMS IN CONTRACT LAW: CASES AND MATERIALS (Aspen Law & Business, 9th ed. 2019) at 816.
The difference between the two types of conditions is that, in a condition precedent, until the conditioning event does occur, the duty does not arise, while in a condition subsequent, the duty arises but the obligor is released from the obligation if the event occurs. Depending on the circumstances, the uncertainty can be built as a condition precedent or a condition subsequent.
[ix] Michael T. Sharkey & Gina K. Eiben, COVID-19 Exclusions in Representation and Warranty Insurance Policies for M&A Transactions, available at https://www.perkinscoie.com/en/news-insights/covid-19-exclusions-in-representation-and-warranty-insurance-policies-for-manda-transactions.html
While the doctrines of impracticability of performance and frustration of purpose are separate grounds for relief from a contract, the elements of the doctrines are nearly identical. … The doctrines require the disadvantaged party to show: (1) either an extreme change in the nature of performance (performance is made impracticable) or an extreme reduction in the value of the other party’s performance so as to render it nearly worthless (a party’s principal purpose is frustrated); (2) the occurrence of an event, the nonoccurrence of which was a basic assumption of the contract; (3) without the party’s fault; and (4) the party seeking relief does not bear the risk of that event’s occurrence either under the language of the contract or the surrounding circumstances. Charles Knapp, Nathan M. Crystal and Harry G. Prince, PROBLEMS IN CONTRACT LAW: CASES AND MATERIALS, above, at 752. Internal citation and quotation marks omitted.
[xi] Example are cases in which the Government forbids export to certain countries (e.g., Iran like in Harriscom Svenska, AB v. Harris Corp., 3 F.3d 576 (2d Cir. 1993) or requires additional measures (see, e.g., M.J. Paquet, Inc. v. N.J. DOT, 794 A.2d 141 (N.J. 2002) in which OSHA’s regulation on lead played an important part).