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Non-Performance of Contractual Obligations During the COVID-19 Pandemic

03/23/2020
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The economic uncertainty caused by the outbreak of the COVID-19 pandemic has impacted businesses and commercial relationships worldwide.  As COVID-19 continues to spread, businesses may experience disruptions that make it difficult or impossible to fulfill their contractual obligations.  Under certain circumstances, those disruptions may justify non-performance.  One such escape hatch is a force majeure clause, which is a provision contained in many commercial contracts that may suspend or excuse performance when an extraordinary event has occurred that is beyond the parties’ control.  The scope and applicability of any force majeure clause, however, is very specific to the language of the individual contract and the degree to which COVID-19 affects a party’s ability to perform.

In the absence of a force majeure provision, statutes and common law doctrines may provide relief depending on the context.  Statutes governing the sale of goods, for example, may include provisions that mirror force majeure concepts that may be invoked to excuse performance.  Although common law doctrines excusing performance exist, they are narrowly confined and rarely applied.  Therefore, they are often the last line of defense against a breach of contract claim.

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What is a Force Majeure Provision?

The purpose of a force majeure provision is to allocate the risks associated with certain disruptive events among the parties to a contract.  The term “force majeure” (French for “superior force”) is not a defense to a breach of contract claim.  Rather, it is a contractual provision that excuses or temporarily suspends performance of contractual obligations upon the occurrence of certain extraordinary events.  Therefore, the mere occurrence of an extreme and unforeseeable event that could be considered a force majeure, or “act of God,” is not by itself sufficient to relieve a party of its contractual obligations absent a force majeure provision (unless a statute or one of the narrow common law exceptions discussed below applies).  There will undoubtedly be much discussion of whether COVID-19 qualifies as an “act of God” or a “force majeure,” but that discussion is meaningless in the abstract and without reference to a specific provision in a contract.

The Particular Terms of the Contract Will Govern

For example, a force majeure provision may merely suspend a party’s obligation to perform its obligations until the event subsides, but in some cases, it may result in a rescission of the contract altogether.  A well-drafted force majeure provision will normally define the categories of events that excuse or suspend a party’s performance of its contractual duties.  Often those categories include natural disasters, such as floods, earthquakes, wildfires, hurricanes, and other naturally occurring destructive events, as well as man-made impediments to performance, such as acts of war, acts of terrorism, labor strikes, and civil unrest.  The list may be a closed-set of events, or it may be a broader, open-ended list since it is difficult, if not impossible, to exhaustively list each and every unforeseeable disruptive event.

Many contracts also include an obligation to provide notice to counterparties that a force majeure event has occurred, and there may be timing requirements for such notices.  It is imperative, therefore, that any parties affected by the economic repercussions of COVID-19 carefully review their contracts to determine their rights and obligations and those of their counterparties.

“Acts of God” versus “force majeure

While the terms “force majeure” and “acts of God” are often used interchangeably to describe the same type of contractual provision, there is a subtle difference.  Beware of the contractual provision that excuses performance merely for “acts of God.”  In Illinois, there is precedent suggesting that the phrase “acts of God” is a narrower class of events than those that fall under the “force majeure” umbrella.  The former only includes naturally occurring events, while the latter is broader and includes man-made events such as labor strikes.  That distinction should be immaterial with respect to COVID-19, which likely falls within the class of naturally occurring “act of God” events.  Although, if the distinction between an “act of God” and a “force majeure” were to arise in the context of COVID-19, it would not be surprising to see a dispute about whether the triggering event was the naturally occurring infectious disease epidemic or a government’s quarantine mandate in response to it.

Commercial Contracts Likely to be Impacted by COVID-19

Commercial Lease Agreements

Although the full scope of the economic effects of COVID-19 remain to be seen, expect to see frequent lease payment defaults, particularly in the restaurant and bar industries, retail, and the travel and hospitality industries due to government-mandated restrictions that have already directly impacted those businesses.  Although commercial lease agreements may include force majeure provisions, they often offer little relief to tenants defaulting on rent payments.

For instance, some commercial lease terms provide that the landlord is the only party with the right to invoke the force majeure provision.  Even if the tenant is not excluded from invoking the force majeure clause, the provision is often limited to non-monetary obligations, such as landlord build-out obligations.  In the event that the payment of rent is not expressly carved-out from the force majeure provision, there may be language elsewhere in the lease that prevents its application by providing, for example, that the tenant’s obligation to pay rent is independent and not subject to any other terms that would excuse the payment of rent.  Thus, a careful reading of the terms of the lease is critical to determining whether a commercial tenant must continue to pay rent despite a force majeure clause.

Although the situation is still fluid, government assistance for industries that have been particularly hard-hit by COVID-19 may provide some relief.  For instance, many jurisdictions are considering or have already implemented a temporary halt to enforcing evictions and/or foreclosures in light of COVID-19.  If evicting a commercial tenant is not an option, landlords may be incentivized to agree to rent abatement or deferment.

Contracts for the Sale of Goods

Article 2 of the Illinois Uniform Commercial Code, which applies to the sale of goods, has codified a defense to a breach of contract claim based on non-performance even when that contract does not contain a force majeure provision.  810 ILCS 5/2-615.  The UCC defense is premised on the foreseeability of a force majeure­-type event, but also incorporates the common law doctrine of impossibility or impracticability of performance.

In order to invoke the UCC defense, performance must have become commercially impracticable because of unforeseen supervening circumstances not within the contemplation of the parties at the time of contracting.  The party asserting the UCC defense must demonstrate that a basic assumption of a contract has changed in a non-foreseeable manner.  In evaluating the defense, Illinois courts will look to two things: (1) the foreseeability of the occurrence of the event in relation to the contract’s terms and (2) the degree of impracticability in relation to performance.  Performance will qualify as “impracticable” only when it remains impracticable after the party has used reasonable efforts to surmount the obstacles to performance.  For example, severe shortages of raw materials or supplies due to a contingency such as war, embargo, local crop failure, or the unforeseen shutdown of major sources of supply that prevents the seller from securing the supplies necessary for its performance would likely make performance “impracticable” under Illinois law.

Unforeseen events that merely cause a market increase in costs associated with performance, however, presents a more difficult analysis.  A party seeking to excuse its performance under those circumstances must show that it can operate only at a loss and that the loss will be so severe and unreasonable that failure to excuse performance would result in “grave injustice.”  Given the vast supply chain interruptions caused by COVID-19, the UCC defense will likely be asserted often in breach of contract claims resulting from the COVID-19 pandemic.[1]

Loan Agreements

Borrowers will likely attempt to use any force majeure clause in a loan agreement as grounds to extend payment deadlines or to negotiate a modification to the loan extending or temporarily suspending borrower payment obligations.  A famous example of this strategy was Donald Trump’s 2008 lawsuit against his lender, Deutsche Bank, on the grounds that the global financial crisis and plummeting real estate prices constituted a force majeure event that extended payment deadlines under his construction loan for the Trump Tower in Chicago.  That case settled before a court could weigh in, but expect borrowers to adopt a similar strategy in the wake of the COVID-19 pandemic by requesting extensions of payment deadlines under similar force majeure theories.

Non-Contractual Common Law Bases for Excusing Performance

Illinois law recognizes certain defenses to performance of contractual obligations in very limited circumstances.  Although all share similar features, the defenses of impossibility or impracticability of performance and commercial frustration are different defenses with different requirements.

Impossibility of performance may be grounds for rescission of a contract, which is a legal remedy that effectively cancels the contract and puts the parties back in their original pre-contract positions.  Impossibility of performance is only grounds for cancelling a contract when performance on the part of one party has become objectively impossible due to destruction of the subject matter of the contract or by operation of law.  It applies where one party to a contract finds that the purposes for which the contract was made have become impossible to perform on one side.

Illinois courts narrowly construe the impossibility of performance doctrine because the purpose of contract law is to allocate risks that might affect performance, and thus, performance should be excused only in extreme circumstances.  To apply, the events or circumstances rendering the performance impossible must not have been reasonably foreseeable at the time of contracting, the party seeking rescission must not have contributed to the circumstance preventing performance, and the party seeking to excuse performance must demonstrate that it has tried all practical alternatives available to permit performance.  Moreover, if the impediment to performance is removable, the impossibility of performance defense is not available.

Similarly, commercial frustration will render a contract unenforceable if a party’s performance under the contract is rendered meaningless due to an unforeseen change in circumstances.  The frustrating event at issue must not have been reasonably foreseeable at the time of contracting, and the value of the performance must have been totally or near totally destroyed by the frustrating cause, thus thwarting the purpose of the contract.  The underlying rationale of the commercial frustration doctrine is that, at the time of contracting, the parties assumed the continued existence of a particular state or condition upon which performance was premised.  Historical examples of the commercial frustration doctrine in action include contracts made during peacetime (and with the implicit assumption that peacetime would continue during performance) to ship materials to specific ports, which were subsequently rendered obsolete or impossible to perform by unforeseen embargoes or war.

The defense of commercial frustration, like impossibility of performance, is an extreme exception to the rule that contracts are to be enforced as written, and thus, has been rarely successful in Illinois.  For example, Illinois courts have refused to apply the impossibility of performance and/or commercial frustration defenses in the following circumstances:

  • The financial crisis of 2008 did not excuse a party’s obligation to secure financing. YPI 180 N. LaSalle Owner, LLC v. 180 N. LaSalle II, LLC, 403 Ill. App. 3d 1 (1st Dist. 2010.
  • Changed interest rates and the lack of a “stable economic environment” did not excuse performance. Farm Credit Bank v. Dorr, 250 Ill. App. 3d 1 (5th Dist. 1993).
  • Changed prices and market fluctuations did not excuse a party’s performance. Ill. Gas Co. v. Energy Cooperative, Inc., 122 Ill. App. 3d 940 (3rd Dist. 1984).
  • Changes to the law that did not render the contract void did not excuse a party’s performance. -Am. Water Co. v. City of Peoria, 332 Ill. App. 3d 1098 (3rd Dist. 2002).
  • Insolvency of one of the parties to the agreement did not render the performance impossible. Felbinger & Co. v. Traiforos, 76 Ill. App. 3d 725 (1st Dist. 1979).

Given COVID-19’s widespread impact on commerce, Illinois courts may be more receptive to the impossibility of performance doctrine and commercial frustration defense.  Shelter in place orders and other regulations on business activity may provide a basis to assert those common law remedies, since there is authority in Illinois that non-performance is excusable if it has become illegal due to governmental regulation that the parties had not contemplated at the time of contracting.

Understanding the various circumstances and legal theories under which performance of contractual obligations may be suspended or excused will be crucial given COVID-19’s unprecedented disruption to commerce and the commercial litigation that is bound to follow.  Parties still at the bargaining table should refocus their attention to the language and scope of their force majeure clauses to properly allocate risks and ensure that when the unforeseeable strikes, their interests are protected.

Whether you have concerns about the terms of your current contracts or are in the midst of negotiating the terms of a contract, HMB’s business-focused attorneys can help protect your interests and further your business goals.

Key Take-Aways:

  • A“force majeure” is purely a creature of contract.  Absent a contractual provision defining what constitutes a force majeure event, an extraordinary event does not excuse or suspend contractual obligations (absent applicable statutes that provide force majeure defenses to performance and common-law doctrines that excuse performance under limited circumstances).  Depending on the language of the force majeure provision, the COVID-19 pandemic may fall within its scope and suspend or excuse performance.
  • Some force majeure provisions require parties to provide notice to their counter-parties within a specific period of time.  If COVID-19 is covered by your force majeure provision, you may have to notify your counter-party promptly.
  • Understand the remedy provided by your force majeure provision, which can vary greatly.  For example, force majeure provisions may merely suspend performance for a definite period of time (e.g., for the duration of COVID-19 or any shelter in place order) or they may rescind the contract altogether.
  • In a contract for the sale of goods, look to the applicable statute to determine whether a defense exists to performance even in the absence of a force majeure provision.  The Illinois UCC, for instance, may provide a defense in certain circumstances caused by COVID-19.
  • Shelter in place orders and other government-imposed restrictions on business activity may be grounds to assert common law doctrines that excuse performance of contractual obligations, despite the fact that Illinois courts have historically construed those common law doctrines narrowly.
  • COVID-19’s widespread and unprecedent impact on international commerce may result in further governmental intervention that could provide relief to particularly hard-hit industries.  Although policy changes may not alter a party’s contractual rights and obligations, they may impact enforcement mechanisms, such as a temporary moratorium on foreclosures and evictions, or they may provide financial relief in the form of tax deferment to mitigate the economic fallout.

The ongoing issues related to the spread of the Coronavirus (COVID-19) have had and will continue to have a significant impact on individuals, families, businesses and markets. Visit our collection of resources providing guidance during these fast-changing circumstances. Please reach out to your lead team member to answer specific questions.

[1] In relation to international sales contracts, the United Nations Convention on Contracts for the International Sale of Goods (CISG art. 79) also provides a defense to breach of contract that excuses a party’s performance of contractual obligations in circumstances that could be referred to as a force majeure event.  This defense, however, only excuses performance while the obstruction exists.

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