Impact Of Coronavirus On Contractual Obligations: Force Majeure, Frustration And Material Adverse Change Clauses

1. Introduction

COVID-19, and the unprecedented shutdown of a large number of sectors and industries, is having a significant impact on businesses, international supply chains and the UK and global economy. At the time of this alert, it is unclear how long the suspensions in business operations will continue, or what the long-term implications will be. Businesses affected by COVID-19 should consider their legal position if, as a result, they are unable to perform any of their contractual obligations or a counterparty to a contract claims that they are unable to perform their respective obligations. This note is intended to provide an overview of English law as it affects all parties to an agreement when one party has difficulty complying with its contractual obligations, providing guidance of how English courts will consider the relevant provisions and how best to address the drafting of such provisions accordingly.

English Law Contractual Position

The general position under English contract law is that where there is an enforceable obligation to perform, such obligation is absolute. Therefore if one party is unable to perform or fulfil its contractual obligations due to the impact of COVID-19, it will potentially be in breach of contract.

However, there are some key exceptions to this rule, namely those provided by:

• force majeure clauses;
• the common law doctrine of frustration; or
• material adverse change clauses.

2. Force Majeure

Force majeure clauses typically operate to limit a party's liability when extraordinary events or circumstances occur which are beyond their control, and which prevent such party from performing their obligations under the relevant contract.

Force majeure is not a recognised concept under English common law; the protection given by such a clause only arises by virtue of the agreement of the parties in the contract and therefore the rights given must always be clearly and fully defined in the contract. There are a few key points to consider when reviewing these clauses.

Interpretation of Force Majeure clauses

Force majeure provisions are typically interpreted strictly (narrowly) by the English courts; therefore the meaning of the words in the provision is key when considering whether a specific event falls within scope of the provision. These provisions will typically (a) list specific events, and (b) contain a general "sweep-up" provision such as "…and any other event which is beyond the reasonable control of the affected party…". Sweep-up provisions should not be assumed to automatically relieve a party from the obligation to perform as a result of a pandemic like COVID-19. A court would likely construe such a provision such that it would first identify the event causing the failure to perform and then assess whether that event was beyond the affected party's control - with a pandemic like COVID-19, it is likely that the failure to perform is the result of a directly applicable event such as staff illness or Government order, for example - the former is unlikely to excuse performance whereas the latter is likely to be more enforceable.

With regard to specific events, traditionally, force majeure provisions have covered “acts of God” such as hurricanes, floods, volcanic eruptions, and war (i.e. where performance is rendered impossible by the intervention of the event in question). However, more recently, these clauses have tended to be broader in scope and may also cover events such as cyberattacks, commodity shortages, or collapse in markets and, in more recent times, pandemics and epidemics (i.e. where performance is not necessarily impossible, but also where it is impractical or not commercially viable). Note that where the force majeure clause indicates that performance must be rendered impossible, the burden of proof will be higher.

The following should also be noted when interpreting force majeure provisions:

• lack of certainty: A force majeure clause which is too vague or uncertain is, like any other contractual provision under English law, likely to be held void for uncertainty; and ¹
• mere change in economics: A change in economic or market conditions which affects the profitability of an agreement or the ease of a party to undertake its obligations will generally not be considered a force majeure event.

Particular care will also need to be taken where a force majeure clause has been included in:

• standard terms and conditions of a business (unless it is 'reasonable' and covers events which are outside a party's control); or
• consumer contracts (in which case, it must be 'fair' and 'transparent' and is usually referred to as "events outside our control", as the term ‘force majeure’ may not be understood by consumers).

Creating an enforceable force majeure provision

An effective force majeure clause will need to be considered in light of the relevant circumstances and should do three things:

• Clearly define the event objectively – Is there specific reference to an event such as an epidemic, pandemic or contagious disease, for example?
• Explain the effect on the rights and obligations of the parties – since there is no general concept of force majeure in English law, the effect of a force majeure provision will vary depending upon what each contract says. An effective force majeure provision will detail exactly which rights and obligations of the parties are affected, in what way and how long for.
• Detail the consequences for the contract – outline what the effect for the wider contract is if the force majeure event continues. A well drafted contract will integrate the force majeure provision into the other terms of the contract including the termination provisions.

Reliance on force majeure

When considering the impact of a particular event on the ability of a party to perform its obligations, there are a number of matters which the parties will need to consider (noting that the precise application will always turn on the drafting of the provision):

• Was the party prevented, hindered or delayed (depending on the construction of the clause) from performing the contract because of the relevant event? - "prevented" means legally or physically impossible² whereas inclusion of terms such as "hindered" or "delayed" are broader and potentially easier to prove.
• Was a party prevented, hindered or delayed from performing its obligations for reasons beyond its own control?
• Were there no reasonable steps that could have taken to avoid the relevant event or its consequences (i.e. mitigation)?
• There is no requirement that the force majeure event be unforeseeable, however, if the event is foreseeable, then there is an increased likelihood that the relevant party had an opportunity to take steps to avoid or mitigate the consequences of the event.
• If a force majeure provision contains notification requirements and/or a requirement to update the other parties regularly following the occurrence of the force majeure event, such obligations should be adhered to the fullest extent possible.
• The force majeure event must typically be the only cause of the default and therefore, where there is another cause of failure, the force majeure clause may not be effective. Ultimately, this will be dependent on the construction of the contract and specific wording of the force majeure clause.

Force Majeure as a Defence

It is not uncommon for parties to a contract to use an intervening event such as COVID-19 as a defence when attempting to walk away from contractual obligations which they had no intention of performing or which have become commercially unviable to perform as a result of the event. In line with the general practice of construing force majeure clauses narrowly, the courts have tended to reject such defences.

A recent 2019 case, Classic Maritime³, demonstrates that the party seeking to rely on the force majeure provision must demonstrate that the claimed event of force majeure was the direct cause of its failure to perform its contractual obligations.

In the case of Classic Maritime, a charterer was required to deliver iron ore pellet shipments from Brazil. The charterer claimed that a dam burst in November 2015, which made it impossible to ship the iron pellets, meaning it was unable to perform its obligations and therefore sought to rely on the force majeure provisions of its contract.

However, the judge at first instance held that the charterer had no intention of meeting its contractual obligations and the Court of Appeal concluded that the charterer could not seek reliance on the force majeure provisions, even though performance of the contract was rendered impossible by an event beyond its control.

Parties then must be able to prove that they were “able and willing” to perform their contractual obligations and may also need to demonstrate steps taken by them to mitigate the effect of the force majeure event.

3. Frustration

Where a contract does not contain a force majeure clause, it may be possible to rely on the doctrine of frustration. While difficult to establish, frustration is an English law concept which can limit the liability of "innocent" parties following an event which renders performance impossible or transforms the obligation into a drastically different obligation from that undertaken on entry into the contract. It does not need to be included as an express term in the contract. The English courts have held contracts to be frustrated in very limited cases, so this is usually a doctrine that is usually only relied on by an affected party as a last resort.

A contract may be frustrated where a supervening event occurs after a contract has been formed, which is:

• so fundamental that it strikes at the root of the contract;
• entirely beyond contemplation of the parties at the time they entered into the contract;
• is not due to the fault of either party; and
• renders further performance impossible, illegal or radically different to what was originally contemplated by the parties.

4. Material Adverse Change Clauses

A material adverse change (MAC) clause is a "sweep-all" provision designed to capture unpredictable and unforeseen events or circumstances which affect one or more parties to a contract and would otherwise be difficult to cater for specifically in the documentation. MAC clauses are typically seen in (a) lending transaction documents; (b) acquisition agreements; and (c) long-term supply contracts (especially in the oil and gas industry).

Purpose of MAC clauses

The purpose of a MAC clause is to relieve the party relying on it from performing its obligations under the contract. Using the transaction examples above: (a) in lending, a lender will seek to rely on a MAC clause if a borrower’s circumstances significantly change to the extent that they are unlikely or unable to repay financing. Using the MAC clause, a lender may seek further security, exercise any draw stop rights, and/or accelerate repayment of a loan; (b) in acquisition agreements, a buyer will seek to rely on a MAC clause if the circumstances of the target company or asset(s) significantly change between the signing of the agreement and completion, a buyer will use a MAC clause as a “get out” option to remove its obligations to complete the acquisition of said company or asset(s); and (c) in other commercial contracts, a party relying on a MAC clause, may rely on this clause to terminate the contract in question.

In general, though MAC clauses can be found in several types of agreements as noted above, they are rarely relied upon in practice. This is because there is limited court guidance on when a MAC clause can be relied on (which tends to be dependent on the specific wording of the clause)⁴ and parties are wary of wrongfully relying on a MAC clause and potentially being liable for repudiatory breach of contract.

Interpretation of MAC Clauses

Although much will turn on the specific wording of a MAC clause, the case of Grupo Hotelero provides some limited guidance on how courts will interpret MAC clauses. The case noted that:

• Courts will narrowly interpret the scope of a MAC clause.
• In terms of materiality, a change will only be considered "material" if (a) it affects a company's ability to perform its obligations under the relevant agreement; (b) the change is "significant"; and (c) the adverse change is not temporary in nature.
• A MAC must also involve a change of circumstances caused by the event; a party cannot trigger MAC clauses on the basis of circumstances it knew about at the time of agreement, unless these circumstances have themselves materially changed.
• Evidence of general external economic or market changes (such as the 2008 economic crisis) would not in itself constitute a MAC, as a party may perform better (or worse) than the rest of its sector. The party seeking to rely on the MAC clause must show that the event has specifically caused a material adverse change in the other party.

Narrow Interpretation

The Grupo Hotelero case indicates that a generic MAC clause or a clause that is limited to the “financial condition” of a company will not be broadly interpreted to cover areas not explicitly referred to such as “acts of God or natural disasters” including pandemics like COVID-19 or changes in “economic and market conditions” which adversely affects a party’s “business, operations, assets, liabilities, condition (whether trading or otherwise), prospects or operating results”. This will have to be expressly listed in the MAC clause to be covered.

Material Change

Where an agreement contains an express MAC clause, the parties should consider the following matters:

• Does the change affect a party's ability to perform its obligations under the relevant agreement?
• Is the change significant? What constitutes significant will largely depend on the nature and size of the deal and business. In the case of Levison v Farin, the court held that a 20% drop in the net asset value of a company would be material for a warranty on no MAC in net asset value⁵. Depending on the business’s sector, certain businesses (for example those in face-to-face industries) are likely to be significantly impacted by the COVID-19 outbreak as a result of lockdowns and being unable to trade because of the shutdown of non-essential businesses.
• Did the change affect a party's earning capacity in the long-term, i.e. will it persist for a significant period (usually years, rather than just months)?
• Was there some sort of disproportionate effect on a party as compared to other companies in the same industry?
• What awareness of the change did the parties have when the contract was executed? A party seeking to enter into a new contract after the start of the COVID-19 outbreak is unlikely to be able to establish that a MAC event has occurred as it will be difficult to show that they were unaware of the circumstances of the pandemic when they entered into the contract.

UK Public Takeovers

It is common to include a MAC condition in relation to a public offer; however MAC conditions are rarely relied on in practice as they are difficult to prove.

Where a bidder has sought to rely on a MAC condition in the past, the bidder has had to show the Takeover Panel that the company making the offer has failed to meet a condition covering specific events that are material or strike at the heart of the bidder’s bid. An example of this can be seen with Pension Corporation's offer for Telent in 2007, which was subject to a condition that no changes were to be made to Telent's pension scheme, including its trustees. The Pensions Regulator intervened and appointed three new independent trustees to the pension scheme as they felt there was a conflict of interest between Pension Corporation’s interests and the interests of the beneficiaries to the pension scheme. In this particular case, although Pension Corporation could have invoked the MAC condition, they chose not to and proceeded with the takeover.

This principle can also be applied post-closing, where a Bidder’s bid is conditional on obtaining shareholder or regulatory approval and it is not subsequently obtained.

What makes a good MAC clause?

While each MAC clause will need to be considered on the individual circumstances surrounding the parties and the agreement, an effective MAC clause should:

• Clearly define the scope of the events constituting a MAC – a party seeking to rely on a MAC clause will generally seek an expansive definition of events constituting a MAC as noted above, whereas a party opposing this clause will seek to limit the scope by introducing a list of exclusions or specific threshold tests.
• Define the documents and/or tests relied on to establish a deterioration of a party’s circumstances.
• Consider defining the duration required in order to establish a MAC.
• Establish if the clause will be based on current or future events, i.e. if the event must have already caused a MAC, or whether a party can anticipate a MAC in the future as a result of the event.
• Confirm probability: Where the MAC is anticipated, whether the event or circumstance "will" or "is likely to" cause a MAC, or whether it is sufficient to show that it "may" do so.
• Confirm if reliance on a MAC clause is an objective or subjective test: A party seeking to rely on a MAC clause will prefer a subjective test as the burden of proof to show that a material adverse change has occurred is less than it is in an objective test.
• Explain the effect on the rights and obligations of the parties affected.
• Detail the consequences for the contract.

As mentioned above, wrongfully invoking a MAC clause can have legal and reputational risks for all parties concerned, and might give rise to a repudiatory breach of contract allowing the other party to terminate the contract and sue for damages to compensate it for the loss it has suffered as a result of the purported reliance on the MAC clause. For this reason, MAC provisions are generally not relied on (at least, solely) to terminate a contractual relationship.

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For more information on this alert, please contact Tim Davison, Mark Lubbock, Louisa Watt, Andrew Baker, Sabina Khan, Chandrika Puri or Lois Child.

The views expressed herein are solely the views of the authors and do not represent the views of Brown Rudnick LLP, those parties represented by the authors, or those parties represented by Brown Rudnick LLP. Specific legal advice depends on the facts of each situation and may vary from situation to situation. Information contained in this article is not intended to constitute legal advice by the authors or the lawyers at Brown Rudnick LLP, and it does not establish a lawyer-client relationship

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¹In British Electrical and Associated Industries (Cardiff) Ltd. v Patley Pressings Ltd [1953] 1 WLR 280, a clause which stated that the contract was "subject to force majeure conditions..." was held to be not effective.

²The contract will likely be considered as a whole. In Tradax Export SA v Andre & CIE SA [1976] 1 Lloyds Rep 416, CIF sellers in a chain were able to rely on a "prevention" force majeure clause when other sellers in the chain were unable to ship goods owing to a export prohibition, notwithstanding that the sellers could have actually bought the goods afloat.

³Classic Maritime Inc v Limbungan Makmur SDN BHD & Anor [2019] EWCA Civ 1102

⁴See Grupo Hotelero Urvasco SA v Carey Value Added SL & Anor [2013] EWHC 1039 (Comm) (26 April 2013), and Cukurova Finance International Limited and another v Alfa TelecomTurkey Limited [2013] UKPC2 which are the two key cases on MAC clauses.

⁵Levison v Farin [1978] 2 All ER 1149