The latest strain of coronavirus is not only a health concern. It is also affecting contracts, insurance policies and other agreements. Businesses are relying on force majeure clauses and other contractual devices to protect themselves from the fallout.
Another day, another twist in the coronavirus saga. Australia’s news has moved from the devastating bushfires to coronavirus without an interval. What started as a health issue is now squeezing the world economy. Stock markets plummeting. Panic-buying. And as more cases are confirmed each day, people are staying off the streets and away from shops.
It is hard to think of any economic sector which remains unaffected, or will not be adversely affected soon.
The legal consequences are potentially significant. What happens to contracts and other legal agreements when a supplier cannot deliver? Or when a worker cannot provide specialised skills in a project? Or when a trip is cancelled? Force majeure clauses, the legal doctrine of frustration and material adverse change clauses may be used to protect a business – whichever side of the contract you are on.
What is novel coronavirus?
The latest strain of novel coronavirus is also known as COVID-19. Now that it is identified in humans, the World Health Organisation has labelled the disease a public health emergency of international concern.
Being an island nation, Australia has not experienced the impact of the virus at the same levels as other countries such as Iran, China and Italy. However, the effects are here. Think about all the toilet paper hoarding. People are worried.
Medical scientists are scrambling to develop a vaccine. And while we wait, the world economy is suffering. Several companies in Australia have recently entered voluntary administration as a direct result of the economic impact of coronavirus.
Why will coronavirus have a legal impact?
With millions of Chinese workers now isolating themselves to try to arrest the spread of the virus, the knock-on effects are enormous.
There is now an issue with international shipping congestion. If you ordered a sofa late last year or you have ordered a manufacturing input from China, perhaps you are still waiting for it to arrive from China. Why? With the Chinese government imposing hygiene standards on manufacturers, safety guidelines must be met before workers are authorised to go back to work. The delay in manufacturing is causing a delay in exporting. It is not hard to see how, for example, Australian manufacturers who operate a just-in-time production line could be affected economically.
Think about those nails your cabinetmaker used in your new kitchen. They probably came from China. What happens when the local supply runs out?
Australia, like the rest of the world, relies heavily on Chinese production. With a massive slowing of production rates, global product supplies will dry up. Supply slows, spending slows, the economy slows.
What happens to the agreements which were negotiated or made before the virus took hold? If the obligations cannot be met, what happens? Force majeure? Change clause? Frustration?
The answer is in the law. But there are limits as to how it will help a party directly affected by unfavourable circumstances.
How a force majeure clause can help a business trapped in unforeseen circumstances
One way the law tries to accommodate unforeseen circumstances is through the use of a force majeure clause in a contract or other commercial agreement. These clauses are sometimes also known as Act of God clauses.
Force majeure is French for superior force.
The basic principle behind a force majeure clause is that an unavoidable or unforeseeable event, beyond the control of a party, prevents the party from fulfilling the terms of the contract or agreement.
It may allow the party to keep the money or the benefit of the work done, but only if they give notice to all other parties that they intend to breach or suspend the contract using the force majeure clause. If the wrong call is made, the party communicating the intention to breach or suspend the contract may be liable for an anticipatory breach of contract. Careful analysis of the clause applied to the specific circumstances is needed.
Force majeure clauses are common in contracts and commercial agreements. Sometimes the force majeure events are set out as a detailed list. But more often, the clause will have a general description of how a force majeure may be recognised, with some examples of the types of events that would qualify.
When an agreement is suspended under a force majeure clause, termination is sometimes allowed after an extended period.
The problem is that most force majeure clauses do not specify a coronavirus situation. However, they do contemplate a natural disaster. But would a natural disaster include COVID-19? In the end, it is a matter of interpretation. How do the parties interpret the clause? How would a court interpret the clause? And more importantly, is it worth litigating? There is no one-size-fits-all answer to this, except to say that it depends on the circumstances. Unsatisfactory, but true.
How does Chinese law deal with force majeure?
China legislates for force majeure. It is part of the enacted laws of the land.
To activate a force majeure clause under Chinese law, the circumstances must be unforeseeable, unavoidable and insurmountable. In February 2020, the Chinese government declared coronavirus a force majeure and issued force majeure certificates. Now, any Chinese company with a force majeure certificate can invoke the force majeure laws. They are not liable for a breach, and they are not liable if they cannot fulfil the terms of their agreement. If litigating a breach of contract with a party seeking to rely on the Chinese law of force majeure, it will be crucial to determine which laws apply – Chinese law or the law of Australia. If Chinese law does not apply, the certificate will be of limited effect.
This said, the declaration by the Chinese government is a significant statement from a powerhouse economy about the seriousness of the situation.
Use of the force majeure legislation is limited to Chinese agreements that were made before the event. In this case, the event is the outbreak of COVID-19.
Other force majeure issues to consider
For any companies (regardless of whether agreements were made in China), other force majeure issues arise. Consider this scenario:
- Company A has an agreement with its supplier, Company B
- They have a force majeure clause in their agreement
- Company A has another agreement with company C, which buys company A’s product
- Company A’s agreement with Company C does not contain a force majeure clause
- Due to a force majeure event, Company B cannot supply company A
- Company A cannot produce the product and cannot meet its obligations to Company C
Company A has a big problem. How does it fulfil its obligations to company C when it is impossible to do so? This type of issue can leave businesses legally exposed and vulnerable to legal action and even insolvency.
In this scenario, Company C could take legal action:
- For specific performance of the contract
- To claim costs
- To seek liability for damages
- To demand termination of the contract
They are serious issues. This type of action could make or break a company, especially in an uncertain economy.
And then there are other considerations. For example:
- How do you enforce a force majeure clause?
- How do you protect your company’s reputation?
- How do you deal with insurance issues arising from a force majeure event?
- In your supply chain, how do you deal with other parties who rely on a force majeure clause in other jurisdictions?
Most likely, the answers are not straightforward. Working through the issues is a complex task, and you will need practical advice from experienced commercial lawyers. That is where we can help.
Reviewing your agreements for force majeure
The COVID-19 outbreak is a good reminder to review all commercial contracts and other agreements, especially force majeure clauses. In particular, you should check:
- What events are covered by the force majeure clause
- What is the effect of the clause? For example, is a party exempt from performing contract terms if the force majeure clause is relied upon? Or is performance delayed?
- What steps are required to enact the clause? For example, is written notice required?
- Are you required to take steps to mitigate your loss?
- What happens if the obligations are not met? For example, will the clause trigger a guarantee or indemnity?
- Will a failure to perform one contract impact other contracts with other parties?
- Are there any risks of insolvency in your supply chain? Do you need to look for other suppliers?
- Do you need to tighten your credit terms and increase efforts to collect payments from debtors?
The sooner you conduct a review, the better.
How a change clause can help a business trapped in unforeseen circumstances
Force majeure clauses are not always used in troubled times. In limited circumstances, change clauses are also used in agreements.
Change clauses are also known as material adverse change (MAC) clauses.
MAC clauses allow a party to withdraw from an agreement because of a fundamental change in the business, operations or financial conditions.
But to employ a MAC clause, you may need to establish that your business has suffered an ongoing decline. In other words, a short-term event may not be enough. As COVID-19 only became an issue in late 2019, it may be that it will not qualify unless it morphs into a persistent long-term problem.
How frustration of contract can help a business trapped in unforeseen circumstances
Frustration of contract is a well-known concept in contract law, yet challenging to establish.
Frustration can happen when there has been an event after the contract is signed. Through no fault of any of the parties, the result is that the terms are impossible to perform. Another scenario is that the event somehow changes the obligation into something very different from what was agreed.
Frustration is probably most commonly seen in employment or contractor agreements. For example, if an employee cannot work because they are quarantined, or they are stuck in a COVID-19-affected country, their employment contract may be frustrated.
Usually, there is no frustration if the contract has a force majeure clause dealing with the issue.
If a contract is frustrated, it will automatically terminate. All obligations cease, and no party is entitled to damages. This said, parties may be able to claim relief from the financial consequences of a frustrated contract through a claim for restitution.
What to do next
If you are concerned about the robustness of your commercial agreements, it is worth conducting a risk assessment and putting in place an action plan. Force majeure clauses are more effective and easier to use than MAC and frustration claims. It is essential to give serious consideration to whether your force majeure clauses are adequate and whether they need legal review. If your agreements do not have force majeure clauses, consider whether to include them.
We recommend that you:
- Check all force majeure clauses, especially to work out whether they impact other clauses in the agreement
- Work out any notice requirements for any termination or suspension clauses
- Record any failures to perform, and impact suffered
- Consider whether there is any other way to meet the agreement terms
- Work out potential consequences for activating a force majeure clause, and also if there is a default
- Consider whether you will be successful in activating the clause
- Keep open the lines of communication with the other parties
- Stay up to date with government requirements and communications
- Check your insurance policies to work out whether operation of a force majeure clause is covered
If you are considering entering into a new agreement with another party, strongly consider negotiating a force majeure clause which specifically contemplates epidemic and pandemic scenarios.
As specialists in force majeure clauses, we understand the surrounding business issues of supply chains, economic impact and insolvency. We can help your business protect itself against the unexpected. Contact us today to discuss your force majeure issue. Find out how we can help you.