Many legal uncertainties accompanied the pandemic's arrival in March 2020. As businesses closed and events were cancelled, the legal community wondered how contractual legal concepts such as force majeure, frustration, material adverse event and best efforts might apply in the context of COVID-19.
This blog will briefly explore how Courts have interpreted these contractual clauses against the background of the COVID-19 pandemic in 2020.
- The specific factual circumstances are crucial. The Courts have been unwilling to simply accept the mere presence of the COVID-19 pandemic as resulting in a presumed inability to carry out contractual obligations.
- The Courts have closely assessed the particular impact, if any, of the pandemic on the particular relationship. For example, when evaluating whether COVID-19 constitutes a material adverse effect, courts will consider whether the target business has been disproportionately affected by the pandemic.
- Other relevant considerations include the timing of the alleged breach, the specific wording of the clause at issue, the sufficiency of the parties' evidence regarding the financial impact of COVID-19, and the nature of governmental measures in response to the pandemic.
- If any trend can be gleaned it is that the Courts will not lightly set aside contractual obligations – despite the challenges posed by the pandemic.
Most contracts include a force majeure clause with the objective of allocating risk in the event of an extraordinary and intervening event.
In Hengyun International Investment Commerce Inc. v 9368-7614 Quebec Inc., 2020 QCCS 2251 (Hengyun), the Quebec Superior Court considered whether a commercial tenant, a fitness centre, could be relieved of its obligation to pay rent due to its inability to operate during a provincially mandated lockdown.
In making its decision, the Court considered the doctrine of force majeure as well as the doctrine of “superior force” in the Quebec Civil Code. The Court concluded that COVID-19 was a force majeure or superior force which prevented the landlord from fulfilling its obligation to provide the tenant with peaceable enjoyment of the premises (at para 101). Since the lease specifically provided that the tenant could only operate as a gym, which was an activity prohibited by provincial decree, the Court concluded the landlord could not insist on payment of rent for the period that it was not able to perform its obligation to provide peaceable enjoyment (at para 106).
However, in Durham Sports Barn Inc. Bankruptcy Proposal, 2020 ONSC 5938, Justice Gilmore held that a force majeure clause could not relieve the tenant business of its obligation to pay rent during a COVID-19 shutdown.
Justice Gilmore found that, due to the wording of the lease, the landlord's obligation to provide quiet enjoyment was subject to the payment of rent by the tenant. Justice Gilmore also concluded that while government legislation enacted during the shutdown prevented eviction by landlords, it did not suspend the payment of rent (at para 57). Justice Gilmore also found that Hengyun was not applicable because of the different wording of the force majeure clause as well as the fact that the doctrine of superior force does not operate in Ontario.
The COVID-19 pandemic has no precedent; and boilerplate force majeure clauses typically do not expressly include a pandemic. However, the above causes demonstrate it is possible for a party to benefit from a force majeure clause in the context of COVID-19 if the party can show the pandemic causally rendered the contract impossible or near-impossible to perform. The result will largely depend on the specific wording of the clause and the nature of legislation, decrees and public health orders.
The Doctrine of Frustration
Where the contract contains no applicable force majeure clause, parties may look to the doctrine of frustration as an excuse for non-performance of their contractual obligations. In order for frustration to apply, the contract must become impossible to perform in the sense that the reason for entering the transaction has been destroyed by the intervening event.
In FSC (Annex) Limited Partnership v ADI 64 Prince Arthur LP, 2020 ONSC 5055, the parties were partners in a joint venture regarding a luxury condominium. When the parties had difficulty working together, FSC (Annex) Limited Partnership (FSC) exercised the buy/sell provision included in the limited partnership agreement. On January 9, 2020, ADI 64 Prince Arthur LP (ADI) elected to purchase FSC's interest in the project and agreed to close the purchase on April 8, 2020. However, on March 25, 2020, ADI claimed that the buy/sell provision was frustrated by the pandemic.
Justice Koehnen concluded that, although the evidence demonstrated that the ability to borrow money had become more limited than before the pandemic, the limitations on financial liquidity did not amount to frustration (at para 25).
Justice Koehnen observed that ADI had only approached a small number of lenders during the three months before the pandemic hit. Therefore, ADI did not make sufficient efforts to protect itself from the economic downturn, the risk of which was well-known. Although the pandemic itself was unprecedented, restrictions on the availability of credit are not uncommon and “occur regularly as part of the ebb and flow of economic cycles” (at para 25).
In New City/Safety Mortgage Fund Inc. v Pacific Point Holdings Ltd., 2020 BCSC 1792, mortgagors and guarantors in a foreclosure proceeding argued that the mortgage contracts were frustrated by COVID-19 and the government's emergency measures to contain the outbreak. Master Elwood concluded that there was no evidence the contract was frustrated by the COVID-19 outbreak because the mortgages were defaulted on prior to the outbreak (at para 48).
The above cases demonstrate the importance of timing in the factual analysis. If a party's failure to adequately perform contractual obligations occurred before the onset of the pandemic, it is highly unlikely the court will invoke the doctrine of frustration.
Material Adverse Effect
In light of the changed circumstances resulting from COVID-19, many businesses may look to “material adverse effect” clauses to terminate obligations in a mergers and acquisitions context.
In Fairstone Financial Holdings Inc v Duo Bank of Canada, 2020 ONSC 7397, the Court considered whether a buyer was entitled to refuse to close an acquisition due to the impact of COVID-19 on the target business. The buyer argued that COVID-19 had or would result in a material adverse effect, breach of ordinary course covenant and an “Amortization Event.”
Justice Koehnen concluded that the closing conditions were met and that the seller had not experienced a materially adverse event or operated outside of the ordinary course, and that no Amortization Event was reasonably expected to arise. Although Justice Koehnen concluded the pandemic had a material adverse effect on the target business, respective carve-outs for a failure to meet forecasts or estimates, “worldwide, national, provincial or local conditions or circumstances” and “changes in the markets or industry” applied (at para 89-104).
The Court also concluded that the pandemic did not have a materially disproportionate adverse impact on the target business relative to others in the industries or markets in which it operates (at para 152). Finally, the target business's pandemic response measures were not outside the ordinary course. The business remained the same and the changes made were the result of systemic challenges rather than challenges unique to the business. The Court also found the changes were made in good faith and were consistent with what other businesses were doing across Canada (at paras 197-206). Additionally, the business was entitled to rely on an exception which would permit it to operate outside of the ordinary course with the purchaser's prior written consent (at paras 296-303).
In Rifco Inc. (Re), 2020 ABQB 366, the buyer of outstanding shares purported to terminate the arrangement agreement on the basis that COVID-19 and the recent collapse of oil prices had given rise to a material adverse effect. The seller rejected the notice of termination as invalid and applied to the Court for a final order approving the plan of arrangement pursuant to s. 193 of the Alberta Business Corporations Act, RSA 2000, c B-9.
Justice Grosse determined it would be premature for the Court to exercise its jurisdiction to supervise the implementation of the approved plan because there was a live dispute between the parties as to whether the arrangement agreement had been properly terminated (at para 18).
The Court found that although the seller's evidence suggested the pandemic and its aftermath would not reasonably be expected to be material and adverse to its financial condition, the buyer's evidence and statements from the seller's circular gave rise to a dispute as to what the reasonably expected impact of the pandemic would be on the business (at paras 44, 45). The circular stated a concern that its margins would no longer be robust enough to survive a significant economic recession and that any sustained period of delinquencies, defaults, repossession, losses or increased servicing costs would adversely affect operations (at para 45). The purchaser's analysis suggested that higher unemployment rates resulting from COVID-19 closures would increase the number of defaulted loans in seller's loan receivable portfolio and that the severity of loss on defaults would be expected to increase (at para 45).
In light of the conflicting evidence, the Court concluded there were substantial facts in dispute and that it could not make a just determination of the issues on the current record (at para 51).
When evaluating whether COVID-19 constitutes a material adverse effect, Courts will consider whether the target business has been disproportionately affected by the pandemic. Since most businesses face similar challenges as a result of COVID-19, this may be a difficult standard to meet. The above cases also demonstrate the importance of carve outs from material adverse effect clauses.
Contracts often require parties to use “best efforts” to undertake an obligation. In regard to COVID-19, the question becomes whether the pandemic prevented parties from taking reasonable steps to fulfil those obligations.
In Ruparell v J.H. Cochrane Investments Inc. et al, 2020 ONSC 7466, the Court considered whether COVID-19 was an intervening event in regard to a “best efforts” clause.
In the spring of 2020, the parties were in negotiations regarding the purchase sale of the defendant's auto dealership business and the land associated with the business. The letter of intent required the parties to use “commercially reasonable best efforts” to close by April 15, 2020. On April 13, 2020, the plaintiff informed the defendants that he was considering withdrawing from completing the transaction because of the economic impacts of COVID-19 on his business interests.
On April 16, 2020, the plaintiff made a new offer for the share price which included a lower price and financing with a vendor take-back mortgage to reflect his concerns about the pandemic. On April 24, 2020, the parties exchanged terms under the new offer in an informal term sheet. Between April 26 and 28, 2020, the parties revised the share purchase agreement in accordance with discussions regarding the new offer.
However, before the final share purchase agreement could be signed, the defendants received a better offer from another dealership. When the plaintiff did not increase his price, the defendants agreed to sell to the other dealership. The plaintiff brought an action for specific performance for the defendants to close the transaction.
Justice Leiper found that the COVID-19 pandemic was an intervening event regarding the “best efforts” clause and that the parties had no obligation to continue negotiations after April 15, 2020 (at paras 34-39). However, Justice Leiper found that the parties had formed a binding agreement on April 24, 2020, and that the defendants broke the agreement by agreeing to sell to the other group (at para 71). Justice Leiper concluded an award of damages was the appropriate remedy (at para 84).
In Munter v Gilchrist, 2020 ABQB 595, the Court considered whether the corporate directors' decision to reduce rents in response to COVID-19 constitutes oppressive conduct.
The corporation was the commercial landlord for two businesses, a furniture store and a spa. The defendant directors of the corporation were also the directors and controlling minds of the furniture business. When the pandemic struck in late March, 2020, a provincial public health order required the spa to shut down. However, the furniture store was not required to shut down and operated continuously through the pandemic. The plaintiff shareholders applied for relief from oppression under s. 242 of the Business Corporations Act, RSA 2000, c B-9, claiming that the rent reduction had caused them financial damage.
Justice Mah granted the application due to the defendants' failure to provide information about the furniture store's actual financial situation or how it had been affected by the pandemic (at para 10). Justice Mah concluded the defendants had failed to establish through credible evidence that the rent reduction was necessary to avoid bankruptcy and therefore in the company's best interest (at paras 10-11). Justice Mah held that the defendants were not forthcoming with any information about government rent subsidies for retail businesses the store could have received (at para 11). Justice Mah also found that the defendants were in a conflict of interest at the time the rent decision was made and that they made decisions preferring interests of the furniture business over those of the corporation (at para 23).
Although contract law in the context of COVID-19 continues to evolve, the jurisprudence from 2020 demonstrates that the pandemic is not a “free pass” to avoid contractual obligations.
The case law suggests that the ability to invoke contractual clauses due to COVID-19 is a largely fact driven analysis. In 2020 cases, Courts have focused on the specific terms in the agreement as well as the unique facts and circumstances at play between the parties.
Relevant considerations include the timing of the alleged breach, the specific wording of the clause at issue, the sufficiency of the parties' evidence regarding the financial impact of COVID-19 and the nature of governmental measures in response to the pandemic.
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.