United States: Contract Exculpatory Provisions In The Time Of Covid

1. FORCE MAJEURE

force majeure (fors ma-zh?r) [Law French "a superior force"] (1883) An event or effect that can be neither anticipated nor controlled; esp., an unexpected event that prevents someone from doing or completing something that he or she had agreed or officially planned to do. " The term includes both acts of nature (e.g., floods and hurricanes) and acts of people (e.g., riots, strikes, and wars). - Also termed force majesture; vis major; superior force. Cf. ACT OF GOD; VIS MAJOR.¹

Force majeure is a contract term. Therefore, it is usually governed by state law. If your client does not have force majeure language in the contract, force majeure may not be claimed as a defense for breach or grounds for relief. In the United States there is no common law concept of force majeure. Impossibility, impracticability, and frustration of purpose are the correlative common law concepts for excuse of contract performance, and those are discussed below.

A force majeure provision normally only appears in contracts where at least one party has an extended performance obligation. Examples include contracts for services, leases, distribution, strategic alliances, joint ventures, reseller agreements, manufacturing agreements, sales agencies, long lead time purchase orders, technology agreements such as cloud hosted software services and hosting services, and contracts for construction and construction related disciplines such as engineering, design, architecture, and procurement.

Force majeure rarely appears in contracts that contemplate performance by both parties when the contract is signed such as a purchase of goods, or in merger, acquisition or asset purchase agreements. I surveyed 106 merger & acquisition deal documents in my library, and only four had a force majeure clause applicable to performance, and 17 referenced force majeure in the material adverse effect or material adverse change clause, which is addressed later in this paper.

Fundamentally, a force majeure clause is intended to release or excuse a party's contractual obligations, or delay and extend the time for performance, when

Since a force majeure clause excuses or delays one or more contract party's performance, at least temporarily, the language is strictly interpreted and applied.² To invoke force majeure, the event must qualify under the language of the contract; is the event giving rise to nonperformance specifically listed as a qualifying force majeure in the contract?³ In addition, the event must be beyond the control of the parties, not anticipated, foreseeable, or expected, and the event must be unavoidable. If the event could have reasonably been anticipated and avoided, you may not invoke force majeure.⁴

The burden is on the party claiming force majeure to demonstrate that an act of God or one of the listed events occurred, and that the event was beyond the control of the party.⁵ Let's examine the three basic requirements.

Extraordinary Event

Force majeure language often includes a list of possible occurrences, any of which would be a force majeure if it delayed or prevented a party's performance, and that list usually includes the phrase "act of God." Courts have interpreted "act of God" so many times over the years that a somewhat standard meaning has developed. An "act of God" is an event caused by the violence of nature so extraordinary that the history of climatic variations and other conditions in the area provides no reasonable expectation or warning of the event.⁶

Variations include:

The judicial definition of "act of God" excludes human activity, and thus a force majeure clause that mentions only acts of God will not include, and explains the reason for, the common list of other activities the parties deem to be force majeure, such as labor action, terrorism, blockades, and war.

Beyond Reasonable Control

Force majeure language will not excuse nonperformance unless the event was beyond the party's control and without its fault or negligence.¹⁰ For example, in 2004 NHL Commissioner Gary Bettman (on behalf of team owners) invoked a league-wide lockout that ended the 2004-2005 NHL season. Bouchard Transportation sued the New York Islanders because Bouchard could not use their luxury suite at the Nassau Coliseum, so they wanted their money back.¹¹ The suite lease had a force majeure clause excusing the Islanders' performance for any "...cause or causes beyond Lessor's control which shall include, without limitation, all labor disputes."

Bouchard argued that a lockout is within the Islanders' control because the league and owners locked out the players. The court disagreed, holding

Foreseeability / Unforeseeable

If the occurrence is reasonably foreseeable, the courts typically take the position that the promisor has assumed the risk.¹² Often the contract language will specify that the event must be unforeseeable:

However, if the contract language does not state that the event must be unforeseeable, courts will often require unforeseeability anyway. This varies by state. Some states require any force majeure event, even if expressly listed, be unforeseeable. Other states apply the unforeseeability requirement only to the catch-all "other similar events" phrase. VICI Racing, LLC v. T-Mobile USA, Inc., 763 F.3d 273 (3d. Cir. 2014) includes a comprehensive discussion of this issue, comparing treatment of the 'foreseeability' issue in various jurisdictions.

VICI Racing is an interesting case that involved the sponsorship of a Porsche racing team by T-Mobile. VICI suffered a crash while racing that put its car out of commission for an extended period, so T-Mobile terminated its sponsorship, because its logo was not out on the track anymore - it wasn't getting what it paid for.

VICI sued T-Mobile for its money, and T-Mobile asserted breach of contract as a defense (no T-Mobile logoed Porsches on the racetrack). VICI defended the breach of contract claim by asserting force majeure, and in fact VICI had complied with all the force majeure notice requirements under the contract.

The contract between VICI and T-Mobile included the following force majeure language, that does not mention foreseeability:

T-Mobile argued that force majeure is not a valid defense, because crashing a race car is entirely foreseeable. This argument led to the court's comprehensive discussion of the judiciaries' common law requirement of 'unforeseeability' in connection with force majeure claims, observing that:

Then, in an exemplary show of judicial restraint, the court observed that:

Then the court, applying Delaware law, held that Delaware does not automatically read a nonforeseeability condition into a force majeure clause, but rather interprets the specific language of the contract. After analyzing the nonforeseeability requirement in various jurisdictions, including Delaware, the court "declined to reach the issue," because T-Mobile hadn't raised it at trial.

Selected state foreseeability requirements:

Drafting Force Majeure Language

Before getting into general force majeure drafting, I want to address the 'unforeseeability' issue with two opposite examples:

1. FORCE MAJEURE. The parties shall be excused from liability for non-performance of this Agreement arising from any event beyond the party's control, whether or not foreseeable by either party, including but not limited to, labor disturbance, war, fire, accident, adverse weather, inability to secure transportation, governmental act or regulation, epidemic, pandemic, quarantine... or other causes or events beyond either party's control, whether or not similar to those enumerated above.
2. FORCE MAJEURE. The parties shall be excused from liability for non-performance of this Agreement arising from any unforeseeable event beyond the party's control, including but not limited to, labor disturbance, war, fire, accident, adverse weather, inability to secure transportation, governmental act or regulation, epidemic, pandemic, quarantine... or other causes or events beyond either party's control, whether or not similar to those enumerated above.

Generally, there are two different styles of force majeure clause: (1) the comprehensive list with catchall, and the (2) general delay clauses used most commonly in government and construction contracts, and in the Uniform Commercial Code for purchase of goods.

The risk of a comprehensive list style of force majeure clause is that interpretation is narrowly construed and "only if the force majeure clause specifically includes the event that actually prevents a party's performance will that party be excused."¹⁵ In some states, this may be true even if the language includes a catch-all phrase. For example, in New York, the court in Kel Kim Corp. v. Cent. Mkts. Inc., 519 N.E.2d 295, 70 N.Y.2d 900, held that the force majeure clause must specifically include the event that prevents the party's performance, even though the force majeure language had the common language "or other similar causes beyond the control of such party."

Here is a sample of a thorough, comprehensive force majeure clause:

On the other end of the spectrum, the construction-related contract forms provided by the American Institute of Architects (AIA) have a very broad "delay" provision, that provides relief only to the Contractor, and not to the Owner. The standard AIA delay provision is:

Under this provision, the Contractor gets to extend its performance schedule because of a delay beyond its control, which is often important for the Contractor to avoid liquidated "delay damages" for failing to keep schedule. Under the AIA standard forms there is no relief for the Owner, but the forms also typically give the Owner the right to suspend the work, change the schedule, or terminate the contract, when Owner wants to. Consequently, the delay language is one of the most frequently altered from the AIA standard forms, to add a more standard force majeure provision that might benefit all parties.

Likewise, if the contract is for the sale of goods, UCC § 2-615 (C.R.S. § 4-2-615) provides:

Like the construction contract 'delay' language, the UCC provision benefits only the seller and not the buyer, and it will often be preempted by a standard force majeure clause in the buyer's purchase order or purchase contract, particularly for long lead time items, or umbrella or long term recurring purchase contracts.

For a very good discussion of the history of force majeure language and excellent drafting options and suggestions, see Negotiating and Drafting Contract Boilerplate (Stark, 2003). Tina Stark devotes an entire chapter to force majeure (Chapter 11, Force Majeure).

Notice

Narrow construction means that force majeure notice requirements in the contract must be strictly followed.¹⁶ Giving notice of force majeure is somewhat of an art form and there are entire articles written solely on giving notice of force majeure.¹⁷

Force Majeure Remedies - and - "Lack of money" or "...other than the payment of money when due"

The remedy for a force majeure will usually be stipulated in the force majeure language, and typically allows the affected party to suspend or delay its performance for the period of the force majeure, provided that it uses reasonable efforts to mitigate and ameliorate the effect, if to do so is within its power. Except where force majeure is used in the context of material adverse effect/change (discussed below), it is rare for a force majeure clause to provide termination as an option.

But then there is always bankruptcy court, where anything can happen. In re Hitz Restaurant Group¹⁸ was a landlord-tenant dispute where the landlord moved to enforce payment of post-petition rent. The restaurant, which was shut down for in-person service because of COVID-19 orders, argued force majeure under its lease and the court agreed that government mandated closure of restaurants to in-person dining because of COVID-19 qualified as force majeure under the lease, except that the force majeure language had the common carve-out "Lack of money shall not be grounds for force majeure."

The landlord argued that the restaurant can still occupy the premises and conduct take-out and delivery service and therefore the restaurant's failure to perform is merely from a "lack of money." The restaurant countered that lack of money is not the cause of its failure to pay rent, instead arguing that "Governor Pritzker's executive order shutting down all "on-premises" consumption of food and beverage in Illinois restaurants is the proximate cause of its inability to generate revenue and pay rent."

In a footnote, the Court addressed the interpretation of a "lack of money" or "other than the obligation to pay money when due" phrase in a force majeure clause:

The force majeure clause in the Hitz lease stated:

In spite of the clear statement in the contract that a party affected by force majeure "shall be excused from performing," the Court decided that "...the force majeure clause partially excuses Debtor's obligation to pay rent for April, May, and June 2020. Nevertheless, Debtor is not off the hook entirely." The Court then conducted an equitable analysis to reduce the restaurant's obligation to pay rent in proportion to its reduced ability to generate rent, and decided that the force majeure event reduced the restaurant's ability to generate revenue by 75%, and thus the restaurant must pay 25% of the amount due under the rent for the three relevant months, even though the restaurant chose to shut down entirely, rather than offer take-out and delivery services.

Cancellation of Indebtedness (Tax! Did you think of that?)

Throughout the economic and financial disaster of COVID-19 landlords, lenders and other creditors have been negotiating reduction and/or deferral of rent, costs, fees, debt service and other payments, and amending and modifying loan documents, to avoid a force majeure declaration by the obligor, help their tenants, borrowers, and customers survive and thus survive themselves, and avoid what will most often be futile litigation.

However, changes to payment and debt obligations can trigger phantom taxable income to the debtor when:

• Payment obligations are relieved (or deemed relieved)
• An amendment (a "modification" under the IRC) to loan documents results in a deemed exchange of the original debt instrument for a modified debt instrument (a "significant modification" under the IRC includes a change in the payment schedule comprising a material deferral of schedule payments or the maturity date; substitution or alteration of collateral; change of yield greater than 25 basis points or 5% of the annual yield), or
• The creditor accepts property (including a new debt instrument) in full satisfaction of an existing debt.¹⁹

Do not let your client be surprised by an unexpected tax bill resulting from loan modifications.

2. IMPOSSIBILITY / IMPRACTICABILITY

If your client's contract does not have a force majeure clause, you may nevertheless be able to utilize the common law doctrines of impossibility and impracticability.

Impossibility

The 'impossibility' doctrine evolved under common law because historically under English common law contracts were strictly enforced regardless of what or who may have prevented a party's performance.²⁰ The common law doctrine of impossibility "allows a party to suspend or avoid performance when a supervening event beyond its control makes performance of the contract no longer capable of being performed."²¹ However, this doctrine would be applied only if performance was truly impossible, regardless of cost or time.

Impracticability

"Impracticability of performance or frustration of purpose that is only temporary suspends the obligor's duty to perform while the impracticability or frustration exists but does not discharge his duty or prevent it from arising unless his performance after the cessation of the impracticability or frustration would be materially more burdensome than had there been no impracticability or frustration."²²

Impracticability is widely considered to be a slightly lower standard, and therefore easier to meet, than impossibility. States are not uniform in their application of these principals; some states recognize impracticability as grounds for relief, while other states like New York require the higher impossibility standard, unless the contract is for the sale of goods, in which case the doctrine of commercial impracticability is codified in the Uniform Commercial Code § 2-615 - Excuse by Failure of Presupposed Conditions.

Colorado courts recognize the doctrine of impracticability, holding that "Impracticability rather than absolute impossibility is enough to establish "impossibility of performance."²³

To prevail on a defense of commercial impracticability, a party must show (1) an unforeseeable supervening event made performance impracticable, (2) the nonoccurrence of the event was a basic assumption in entering the contract; (3) the event was not the party's fault; and (4) the party did not assume the risk of the event.²⁴

Like force majeure, performance will not be excused if the event preventing performance was expected or was a foreseeable risk at the time of the contract's execution.²⁵

3. FRUSTRATION OF PURPOSE

Frustration of purpose is similar to impracticability and impossibility but focuses on whether the event has destroyed the purpose of the contract, rather than whether it has made a party's contractual performance unviable. If the unforeseeable event has significantly altered the circumstances of a contract such that performance would no longer fulfill any aspect of its original purpose, then the contract has been "frustrated." However, frustration as a defense to breach of contract is asserted less often than the principals discussed above, because courts interpret a party's contract "purpose" broadly, and the "frustration" must be total; not merely inconvenient, difficult, or unprofitable.²⁶

On July 16, 2020 The Gap, Athleta, Banana Republic, Janie & Jack, and Old Navy sued Brookfield Properties Retail Inc. requesting a declaratory judgment that they do not have pay rent for 145 stores, and should be refunded rent from March 16, 2020 until they can reopen.²⁷ The complaint is a good read and states, inter alia:

4. OTHER COVID-19 CONTRACT HOT BUTTON ISSUES

M&A Material Adverse Effect / Material Adverse Change

Most acquisition, merger and asset purchase agreements use some variation of the defined term "Material Adverse Effect" or "Material Adverse Change" to (1) provide the buyer a reason to terminate the transaction, and (2) to qualify the Seller's representations and warranties (e.g. "Seller represents and warrants that since the Effective Date there has been no change in operations of the business that would have a Material Adverse Effect on the Seller or its business"). Sellers are often able to exclude a force majeure event from the MAE/MAC definition, which absolves seller from liability for breach of reps and warranties and would otherwise place the risk of an intervening force majeure event on the buyer, except that the buyer can usually terminate the transaction if there has been a material force majeure event before closing. Examples:

Since March 2020 many deal documents are specifically listing COVID-19 in their exceptions to MAE/MAC definitions:

Asset Purchase Agreement between Orgenesis Inc. and Tamir Biotechnology, Inc. (April 12, 2020):²⁸

Agreement and Plan of Merger between Turning Point Brands, Inc. and Standard Diversified Inc., dated April 7, 2020:²⁹

M&A Earnouts

A post closing earnout is a typical (complex) feature of any acquisition, merger or asset purchase agreement where the parties cannot agree on the value of the acquired entity or asset. If the seller insist the business is worth more than the buyer is will to pay at closing, the parties might agree that a lower price will be paid at closing, and the buyer will pay more for the business in the year or two after closing if the business generates as much revenue, and is as profitable as the seller claims. Additional payment might be triggered by one or many post-closing financial achievements, such as a specified increase in revenue, reaching an EBITDA target, an agreed increase in sales/customers, or even completing a project in process or getting important contracts in the seller's pipeline.

Earnouts are great for litigators! Typically, the buyer won't pay because the milestone or requirement was not achieved, and the seller claims it would have been achieved but for the seller's obvious incompetence in operating the business after closing.

There are two obvious developments in earnouts as a result of COVID-19:

1. Earnouts are becoming more common because the seller believes the current value of its business is artificially suppressed because of COVID-19 and will be much higher once the pandemic subsides, and the buyer won't pay more because of the obvious uncertainty surrounding the length of both the pandemic and the resulting COVID-19 recession; and
2. Litigation will probably increase surrounding pre-COVID-19 earnout deals; sellers will want to claim force majeure (if in the contract) or equitable grounds to extend the earnout milestone measurement periods or reduce the milestones to avoid giving buyer a windfall as a result of the intervening, but temporary, financial suppression caused by the pandemic. Buyers will not agree.

Financial and Performance Covenants in Loan Agreements

As early as the second week in March transactional and finance lawyers began fielding calls from lenders and borrowers to amend loan documents to amend and change financial performance covenants and waive breaches; by April 2020 a huge percentage of borrowers were in breach of their financial covenants or soon would be, since financial performance covenants normally cover monthly or quarterly periods. For example, by April 1, 2020 the author had amended a large borrowing facility to waive all financial covenants until the business was allowed to re-open and had been open at normal capacity for one-month; but if the closure lasted longer than a specified date, the borrower would be deemed to be in default.

For purposes of cancellation of debt income discussed above, an addition, deletion or alteration of customary accounting or financial covenants is NOT a significant modification that triggers income tax.³⁰

Footnotes

1 Black's Law Dictionary (11th ed. 2019)

2 See Contract Performance During COVID-19 by Mike Cross in July 2020 Colorado Lawyer for a good article on contract interpretation and rules of contract construction applied to force majeure clauses.

3 30 WILLISTON ON CONTRACTS § 77:31 (4th Ed.).

4 Pawnee Land & Canal Co. v. Jenkins, 1 Colo. App. 425, 29 P. 381 (1892).

5 R & B Falcon Corp. v. American Exploration Co. 154 F. Supp. 2d. 969 (S.D. Tx. 2001)

6 See 1 Am. Jur. 2d Act of God § 1.

7 Northwestern Mut. Ins. Co. v. Peterson, 280 Or. 773, 572 P.2d 1023 (Or. S.Ct. 1977).

8 Watts v. Smith, et al., 226 A.2d 160, 162 (D.C.1967).

9 Black's Law Dictionary 33 (6th ed. 1991).

10 United States v. Brooks-Callaway Co., 318 U.S. 120, 63 S.Ct. 474, 87 L.Ed. 653 (1943).

11 Bouchard Transp. Co., Inc. v. N.Y. Islanders Hockey Club, LP, 40 A.D.3d 897, 836 N.Y.S.2d 654, 655 (2d Dep't 2007).

12 See Magnetic Copy Services, Inc. v. Seismic Specialists, Inc., 805 P.2d 1161 (Co. Ct. App. 1990); J. Calamari & J. Perillo, Law of Contracts § 13-18 at 569 (3d ed. 1987); Glidden Co. v. Hellenic Lines, Ltd., 275 F.2d 253 (2d Cir.1960).

13 "...force majeure clauses are aimed narrowly at events that neither party could foresee or guard against in the agreement (see In re Cablevision Consumer Litig., 864 F. Supp. 2d 258, 264 (E.D.N.Y. 2012) (stating force majeure clauses "are construed narrowly and will generally only excuse a party's nonperformance if the event that caused the party's nonperformance is specifically identified")). Where ambiguity exists, New York courts may refuse to rule as a matter of law whether an alleged event is covered under a force majeure clause (see Phibro Energy, Inc. v. Empresa De Polimeros De Sines Sarl, 720 F. Supp. 312, 318 (S.D.N.Y. 1989)).

14 Stroud v. Forest Gate Dev. Corp., 2004 WL 1087373 (Del. Ch. May 5, 2004).

15 Reade v. Stoneybrook Realty, LLC, 63 A.D.3d 433 (2009).

16 Toll Bros., Inc. v. Sienna Corp., 2009 WL 961379 (D. Minn. 2009).

17 See Heep et. al., "Best Practice With Notices for Force Majeure Events" https://www.troutman.com/insights/best-practice-with-notices-for-force-majeure-events.html (2020)

18 No. 20-B-05012, 2020 WL 2924523 (Bankr. N.D. Ill. June 3, 2020),

19 Treas. Reg. § 1.1001 et seq.

20 Wladis, "The Development of the Doctrine of Impossibility of Performance in English Contact Law," 75 Georgetown L.J. 1575 (1987).

21 17A Am. Jur. 2d Contracts § 655 (2010).

22 Restatement (Second) of Contracts, § 269 (1981).

23 City of Littleton v. Employers Fire Ins. Co., 453 P.2d 810; 169 Colo. 104 (1969).

24 L.W. Matteson, Inc. v. U.S., 61 Fed. Cl. 296 (2004).

25 Korea Life Ins. Co., Ltd. v. Morgan Guar. Trust Co. of N.Y., 269 F. Supp. 2d 424, 447 (S.D.N.Y. 2003); Davis v. Dawson, Inc., 15 F. Supp. 2d 64, 115 (D. Mass. 1998).

26> FARNSWORTH ON CONTRACTS § 9.09 (4th ed 2019).

27 See The Gap, Inc., et al. v Brookfield Properties Retail, Inc., et al., Circuit Court, Cook County, Illinois County Department, Chancery Division, Case No. 2020CH04984.

28 See Dunaevsky "Mostly Dead but Slightly Alive: M&A Deals of 2020" https://woodruffsawyer.com/mergers-acquisitions/merger-deals-2020-coronavirus/ (2020)

29 Id.

30 Treas. Reg. § 1.1001 et seq.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.