COVID-19 directly threatens the business model of relying on large service delivery centers for critical services, especially centers in offshore locations operated by third-party suppliers. Because of the perceived risk of transmission in large facilities with substantial numbers of people in close proximity and recirculated air, numerous governments, companies and/or workers have decided that the continued operation of certain facilities is just too risky. And, even where a “work from home” option is available contractually, working from home often requires infrastructure that is not currently in place and/or creates new risks. Thus, customers may suffer significant interruptions in service.
This Legal Update describes legal rights of customers associated with the risk of such interruptions and offers general guidance on steps to take. Each contract and situation is of course different, and this is not legal advice as to any specific contract.
Top-of-mind for lawyers is the concept of force majeure, which translates from French roughly as “a major force” and is used in contract law as a force so great as to overwhelm the contract obligation and excuse defaults. Commercial contracts often include force majeure clauses, which are often under-negotiated because of the assumption that these events are rare, that contracting for a force greater than contracting is futile, and the sense that there must be some magic to any words where the parties shift from English to French.
Even in the absence of force majeure provisions, a party to a contract whose performance is rendered impractical or impossible as a result of either COVID-19, or the governmental response, may seek to excuse its performance under the doctrines of impracticability of performance or frustration of purpose. To succeed on an impracticability defense, however, the party must typically demonstrate that its performance was made impracticable due to a supervening event, the occurrence or non-occurrence of which was a basic assumption of the contract. (See, Restatement (2d) of Contracts § 261). Many courts will also require the supervening event to be unforeseeable. While this principle has traditionally been applied based on the death of a party or destruction of a thing, a supervening prohibition of law (such as a quarantine or travel restrictions) may be a sufficient basis to support such a defense. (Id. § 264), Similarly, for a party to be discharged from its obligations under the frustration of purpose doctrine, the frustration must go to the very purpose of the contract, and it must be substantial (e.g., not just that the transaction would result in a loss). (Id. § 265). Where a contract calls for performance by a specific person and that person becomes ill due to COVID-19, performance may be excused. But the same may not be true where performance merely becomes unprofitable due to economic or political turmoil caused by the virus. Further, where the supervening event is temporary, courts will typically find that the supervening event merely temporarily excuses timely performance. It may not be sufficient to discharge the obligation altogether.
Legal rights in this area differ by jurisdiction and contract type. See, for example, our Legal Update regarding UK construction law titled Coronavirus COVID-19: Construction, frustration, force majeure - What does contract law say? as well as our Legal Update titled Operation of Force Majeure in an Epidemic from lawyers in our Hong Kong office.
Key Questions in Reviewing Force Majeure Clauses
Actual force majeure clauses vary substantially, so read each clause very carefully. Key questions include:
- Is a pandemic a force majeure event? Some contracts indicate that performance is excused by any occurrence outside of the performing party’s control. However, customer-favorable contracts often limit the term to cataclysmic events such as fire, flood, war, insurrection, earthquake, and severe weather. Government action is often included, but a company closing a facility for the good of its workforce on its own volition would arguably be in the party’s control and not a force majeure event.
- Is the supplier required under the clause to give the customer notice of the service interruption and regular updates regarding the restoration of service?
- Under the force majeure clause, is the supplier required to use at least commercially reasonable efforts to implement a workaround and/or restore service as quickly as possible? In practice, what does that mean? Which party is financially responsible for the efforts required to do so? Is there any limit on the effort or expense that the supplier must incur? Even if the contract is silent on this point, we recommend that customers press for reasonable efforts to implement a workaround and/or restore service.
- Does the affected party have specific business continuity/disaster recovery (“BC/DR”) plans and associated obligations? Customers prefer, among other things, that suppliers agree to conform to a plan that is part of the contract and tested regularly.
- If there is a BC/DR plan, it is important that a disaster be declared and that the plan be implemented. Be aware, however, that the plan may not address this specific situation. The usual focus of a BC/DR plan is on the unavailability of all or part of a facility, not on the inability of the workforce to enter the facility due to the risk of infection. So, having a backup site with backup seats may not help.
- What priority does the customer have in a force majeure event affecting a supplier? If a disaster occurs, a customer wants priority over, or at least equal status with, the supplier’s other customers for some or all of its functions. The supplier, on the other hand, wants to preserve its flexibility in allocating scarce resources. In our experience, this is a situation in which demanding the supplier’s attention and being the “squeaky wheel” is important.
- Is the customer required under the contract to continue paying for services that are not delivered? This may depend on which party is affected, for example, if the supplier is capable of performing but the customer is no longer able to receive or use the services in question.
- Does the contract give the customer the right to terminate the contract if the supplier is unable to restore service within a reasonable time? While a declaration of force majeure typically relieves both parties of their contractual obligations, parties can agree that the force majeure merely excuses performance for a period of time. A party that is impacted by a force majeure event and is unsure of its rights may seek assurances from the supplier as to the expected duration of non-performance. Absent adequate assurances that the supplier can restore service within a reasonable period of time, the customer would typically be within its right to seek alternative supply. But, unless spelled out in the contract, what is considered a reasonable period of time will depend on the circumstances. And, if the customer opts to contract with an alternative supplier, how long is it permitted to do so and at whose expense?
Note, even where the contract contains a force majeure clause, parties should consider the law of the applicable jurisdiction to determine the circumstances in which such a provision will excuse performance. Force majeure provisions are typically narrowly construed, and most courts place the burden on the party asserting the force majeure defense to demonstrate the existence of the force majeure. Many courts, including those in New York and Pennsylvania, will require the force majeure event to be unforeseeable and outside of the party’s control, and will typically not excuse performance due to economic hardship or changing economic conditions. If notice or other conditions apply to the exercise of force majeure provisions, most courts will reject the defense if those conditions have not occurred. Further, some courts will require the nonperforming party to demonstrate its efforts to perform its duties despite the occurrence of the event.
Other Critical Contract Clauses to Review
The force majeure clause, while an obvious target for your analysis, is only a starting point. Other critical clauses include the following:
- Efforts Obligations. Contracting parties may have an argument, based on COVID-19, that any clauses limited by language such as “use reasonable efforts to” or “to the extent available” are not binding because COVID-19 has made the effort unreasonable or the service unavailable.
- Shifting Standards. Obligations to perform to “industry standards” or the supplier’s own standards arguably decline if a pandemic is reducing performance across the industry or company.
- Restrictions on Alternative Delivery. Contracts may require that all work be done from specific facilities. If the facility is closed, perhaps by government action, performance is prohibited. Further, moving the work from one country to another may raise new data privacy, data security, tax, employment or intellectual property concerns.
- Governance Provisions. Various clauses designed to support the “relational contract,” such as agreements to have designated people speaking regularly, may be a good avenue to obtain information and remain “top of mind” at the other party.
- Termination Rights. Parties may have rights to terminate if performance is illegal, impossible, unreasonable, or otherwise constrained.
Practical Steps Now
You have limited resources and your suppliers have limited resources. The situation may be changing fast. Consider the following questions from a contract standpoint:
- Where is the risk? Comparing a critical supplier facilities list to a COVID-19 heat map might show you where to focus first.
- Are the governance teams communicating? Being top-of-mind at the other company may provide priority in supply, access to planning information, and other benefits.
- What other sources of information do you have? For example, employees located near the facility may be able to provide real-time reports on local government action and conditions.
- Are there useful notice, first-priority, damages, BC/DR or other clauses in the contract? If so, consider sending firm, well-crafted correspondence reminding the counterparty of those clauses.
- Can you bargain now for first priority on available resources? Or set up new contractual relationships in geographically distinct locations?
- Would it help to make your damages more foreseeable? If so, send a letter expressing gratitude for current efforts and highlighting the potential harm from any service disruption.
- Are there clauses that make you harder to serve that should be reconsidered? Continuing the example of the requirement to perform all services from a primary facility or a backup facility, consider sending a waiver of that obligation applicable if neither facility is reasonably available due to COVID-19.
- What records will you need to make a damages claim in the event of a breach? Contemporaneous records of actions such as overtime authorized will be vital in claiming damages post-pandemic.
- What guidance can you provide to your governance teams to best position you to make a claim? For example, the governance teams should be given polite responses that preserve rights, more “thank you for doing what you can to avoid further damage here” than “we understand your challenges and would not expect you to deliver in such trying times.” Well-written, firm correspondence now could make all the difference in financial settlements down the road.
We remain hopeful that the enormous effort of the global community stops COVID-19 before it causes substantial damages. However, we also recognize that this outbreak may be remembered as a milestone moment that caused companies to reconsider their global sourcing strategies. While we don’t expect companies to abandon the sourcing of products and services from lower cost sources, we do expect them to focus more on the associated risks and how to mitigate them, including redundant sources of supply, detailed disaster recovery planning, pre-defined business continuity measures, and alternative sourcing options.
Regulators have long advised a focus on the risk service disruption issues associated with third-party sourcing. For example, in OCC Bulletin 2013-29, the United States Office of the Comptroller of the Currency required banks to consider the following:
Ensure that the contract requires the third party to provide the bank with operating procedures to be carried out in the event business resumption and disaster recovery plans are implemented. Include specific time frames for business resumption and recovery that meet the bank's requirements, and when appropriate, regulatory requirements. Stipulate whether and how often the bank and the third party will jointly practice business resumption and disaster recovery plans.
We believe that COVID-19 will shine a bright light on the risk of a pandemic, whether it leads to substantial harm or not. Companies likely will face new regulations, and supplier risk management may become more of a requirement and disclosure item than it is today. Public companies, for example, are likely to be required to disclose the risk and what they are doing to mitigate it. Readiness will likely rise in importance as a due diligence item for acquirers, financing sources, and customers. The actual risk might not have changed, but the experience that we are all having will heighten the perceived risk.
Your company may create a task force on improving resiliency, and legal participation can provide great value. As noted above, the applicable clauses vary widely. A concerted effort to have the right clauses in the right contracts may be decisive in how your company handles the next big crisis or the next due diligence effort from a counterparty considering a deal.