COVID-19 – Commercial Contracts: Risk Allocation in Times of Uncertainty

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In addition to memorializing the economics and financial benefits gained by parties from a given contractual arrangement, commercial contracts commonly allocate known and unknown risks between business parties. While business parties may be well equipped to address the routine risks associated with engaging in daily commerce (e.g., bad weather, cyclical economic climates, changing government regulations, temporary market dislocation), they are likely to be substantially less adept at dealing with the unique risks associated with extraordinary events such as the new coronavirus (“COVID-19”) outbreak, or the fundamental disruptions the outbreak is having (and may continue to have) on local, national and global trade. As business communities begin to grapple with the human, financial and operational impacts of the COVID-19 pandemic, it is worth considering the common risk allocation tools that business parties use when entering into commercial contracts. An understanding of how these risk allocation tools work will enhance a party’s ability to assert such rights during times of uncertainty.

Below is a basic road map intended to help businesses assess and manage risks accompanying the economic and operational incongruities resulting from COVID-19. Also discussed below are notes regarding certain risk allocation tools that parties commonly deploy when entering into a commercial contract. These tools may provide businesses with methods for addressing contractual arrangements that become problematic or strained as a result of the pandemic and associated business disturbances.

COVID-19 Road Map

In the COVID-19 business environment, you may find that performance of your contractual obligations, or the obligations owed to you by your commercial counterparties, is now operationally difficult, economically disadvantageous, illegal or impossible.

If you are experiencing difficulties with your commercial agreements due to COVID-19, you should:

  • Analyze the contract to see whether it describes circumstances under which performance may be delayed, modified or excused (these may be in force majeure provisions only, or they may be scattered throughout the contract – a thorough read is a good idea).
  • Assess potential exposure to claims from your contractual counterparties (and any third parties) by reviewing the indemnification provisions and any limitations on liability expressly provided for under the contract.
  • Consider alternative methods of performance that may be permitted under the contract.
  • Determine whether refunds, fee cancellations, liquidated damages or similar actions are required under the contract.
  • Examine the termination conditions and procedures in the contract if you are considering terminating the agreement or think the other party might.
  • Review the dispute resolution mechanisms set forth in the contract and consider the viability of bringing or responding to a dispute arising under your agreement.
  • If possible, open lines of communication with your counterparties and attempt to negotiate an amendment to the contract that is satisfactory to both parties; then execute the amendment in accordance with the contract’s amendment provisions.

Please note that, in limited circumstances, courts may find that a party is excused from performance of a contractual obligation due to the occurrence of extraordinary circumstances; however, parties are not generally excused from their contractual duties simply because a circumstance or event has made performance more burdensome or expensive. Advice from legal counsel may be a valuable resource during analysis of any of the above matters as they relate to the specific challenges your business may be facing in the current COVID-19 environment.

A Note on Force Majeure

Force majeure clauses seek to allocate risk between the parties when events that are either unforeseen or outside the parties’ control delay or impede a party’s ability to perform its obligations under the contract. Generally, a force majeure clause excuses performance during a time in which such performance would be illegal, impossible or impracticable. Frequently, force majeure provisions contain a list of events that constitute a “force majeure event” (e.g., fire, earthquake, natural disasters, acts of God, civil unrest, riots, war, terrorism, strikes, labor stoppages, actions or orders by governmental authorities). The law controlling the parties’ contract will often determine how broadly or narrowly a force majeure clause will be applied when it is invoked by a party.

A contractual provision that is often seen by commercial parties and legal practitioners as “boilerplate” contract language has gained significant prominence since the outbreak of COVID-19 as parties come to grips with local, national and global lockdowns that can materially impact the ability of businesses to meet their contractual obligations. BakerHostetler recently issued a client alert titled “FAQs: COVID-19 - Force Majeure and Other Defenses to Contractual Performance” that explores the efficacy and application of force majeure clauses in the COVID-19 environment.

A Note on Limitations on Liability

Commercial contracts often contain limitations on liability. Liability limitation clauses function as equalizers to ensure no one party bears unlimited risk. The goal of a liability limitation clause is to mitigate a particular party’s exposure to the extent such exposure would otherwise be inconsistent with the commercial benefits to be derived by that party under the agreement. Often referred to as liability “caps,” these contract provisions commonly put ceilings on the dollar amount for which one party can be liable under an agreement. Other liability limitation clauses list particular types of damages (e.g., indirect, punitive, special or consequential losses or damages) for which one party or both parties will not be held liable.

For example, consider the situation in which a seller of customized equipment to a buyer (dependent on the equipment for continued operations) fails to timely deliver the equipment due to COVID-19 supply-chain disruptions. If the contract does not contain a limitation on liability for consequential damages, then the seller may be subject to claims by the buyer for lost profits or revenue that far exceed the potential commercial benefit of the agreement to the seller. If the contract contains such a limitation on liability, then the seller would not be liable for the lost profits due to late or nondelivery of the equipment – and this may make all the difference.

A Note on Indemnification

Indemnification clauses in commercial contracts are regularly used by parties to shift the risk of certain penalties, fines, judgments, losses, damages, costs and expenses from the party customarily responsible for such liabilities to another party. Often, an indemnification clause is used to protect a party against third party claims relating to the commercial arrangement at issue. For example, a purchaser of software from a technology company will often require the technology company to “indemnify, defend and hold harmless” the purchaser for any claims by a third party that the software or its use infringes on the intellectual property rights of another party. The rationale here is that the technology company is in the best position to protect against infringement claims and that the purchaser should be protected from the costs, expenses and liabilities of being “dragged into” a dispute unrelated to it or its business operations.

Most relevant to the business challenges caused by COVID-19, indemnification provisions can also protect a party from liabilities associated with the other party’s breach of the contract between the parties, which may allow for recovery of damages in addition to those generally imposed under governing contract law (e.g., attorneys’ fees and related costs). To the extent that the failure of a counterparty to discharge its contractual obligations as a result of the social and financial challenges associated with COVID-19 creates losses (e.g., damages, costs, expenses and other liabilities) for the other party, such party may be able to mitigate or recover such losses under the contract’s indemnification provisions.

A Note on Termination or Amendment of a Contract

A possible solution of last resort for commercial parties dealing with contractual stress resulting from business disruptions tied to COVID-19 may be to terminate the agreement if a party either can’t meet its obligations in the current environment or is experiencing substandard performance from its commercial counterparties.

With some variation, termination rights in commercial contracts come in two forms: termination for convenience and termination for cause. Termination for convenience provisions generally provide one or both parties with the option to terminate the agreement at will (after providing advance notice to the nonterminating party). Termination for cause allows one or both parties to terminate the agreement under certain circumstances. Often the circumstances triggering this right to terminate are situations that either deny a party the full benefits of its bargain (e.g., a material breach of the agreement) or materially increase a party’s liability exposure under the arrangement (e.g., the counterparty becomes financially unsound or has sustained significant reputational harm in the marketplace). Unlike the right to terminate an agreement for convenience – under which the terminating party is not required to justify its reasons for seeking termination – when a party terminates an agreement for cause, it will be required to establish and defend (often in court) the rationale for terminating the arrangement and provide compelling evidence supporting its decision to terminate for cause. Termination for convenience or cause may, of course, not be a viable option for a party if the contract and its benefits are critical to the operations of the party’s business. In such circumstances, informal negotiation, an amendment to the contract or reliance on other risk allocation tools within the parties’ commercial contract may be the more appropriate course to ensure that the critical business relationship continues during and after these uncertain times.

Concluding Thoughts

A party’s bargained-for risk allocation rights can be used to address a strained commercial arrangement resulting from the business challenges associated with COVID-19. It is worth noting that while exercising one or more risk allocation rights may provide a business with relief during times of uncertainty, doing so may lead to costly litigation or the beginning of a formal dispute resolution process, and may even irreparably damage a commercial relationship that is important to a company’s future operations. It may therefore be prudent to engage in informal communications with key counterparties as early as possible in an effort to manage current or future issues. Furthermore, be sure to clearly understand exactly what the words in the commercial contract say. Courts and arbitrators commonly look to the exact wording of the contract when determining the rights and obligations of the parties in dispute. This (often strict) adherence to the provisions within the four corners of the contract puts a heavy burden on the parties to evaluate their rights under the agreement in question and ensure that the assertion of such rights is supported by the express language of the contract.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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