By: Lori S. Smith
A little over a year ago, I wrote a blog post about the danger of relying on precedent. Now, more than ever, clients and their advisors need to revisit contract forms on which they may have been relying for years. While many of us have lived through times that required certain adjustments in how we viewed contractual obligations — recessions, wars, oil embargoes, natural disasters, 9/11 — none of these events had the widespread and long-lasting impact that the current COVID-19 pandemic is having. None of these events shut down the U.S. economy and impacted global supply chains across every industry in the manner we are now experiencing.
With this in mind, there is a need to figure out what the “new normal” will look like for contract negotiations in a post-pandemic world. Business professionals need to now anticipate more widespread disruption than we could have ever before imagined. It isn’t just force majeure clauses or material adverse effect provisions, as these will likely add pandemics and government shutdowns to their ever-growing list of contemplated risks, if they were not already expressly covered. And it is not clear, at least in the near-term, whether a resurgence or mutation of COVID-19 or the emergence of another virus can truly be seen as unforeseeable in a post-COVID world. The issues are much more fundamental to the approach that parties may take in negotiating contracts. Commercial contracts between purchasers, vendors, distributors, licensors and licensees will need to evaluate allocation of risk from both sides and come to a new happy medium that all can live with in an ever-evolving world. While parties should review their standard contracts in their entirety, some key provisions to think about include:
1. Length of the contract and exclusivity. Depending on which side you are on, you may want to reconsider a long-term arrangement that ties your company to a particular vendor or distributor. Supply chain disruption can have a seriously detrimental impact on your business. Are requirements contracts where a particular supplier is required to make available all of your needs for a certain good or service really the best arrangement for your business? What about take or pay arrangements where you are obligated to which are common in certain industries pay a minimum amount or a penalty to a supplier whether or not you actually purchase the contemplated volume of goods? Do you really want to be tied up in an exclusive arrangement, or do you need flexibility to maintain secondary or tertiary sources of supply? Do you want to provide a licensee with an exclusive right to your technology (even within a limited field of use or industry sector)?
2. Termination rights. Should a contract have a more flexible exit strategy? Many contracts will allow for termination at will with an adequate notice period, but often for key arrangements. Parties exclude termination for convenience as they seek more certainty and less flexibility to avoid disruption into their business. Should there be something beyond a force majeure provision that allows for addressing not just unforeseeable circumstances, but rather circumstances that make a contractual arrangement unreasonably expensive or difficult to fulfill? Some states will recognize the common law concept of impracticability as a basis for non-fulfillment of obligations but in many states, this is not the case — a contract must be impossible to fulfill in order to provide a termination right. Should there be some exit ramp that allows for paying a fee to get out of a contractual arrangement that has become impracticable? Should contracts beyond M&A agreements have fiduciary outs if a board in its reasonable business judgment determines that intervening events make the contract materially adverse to the company? Should there be more focus on negotiated liquidated damages as an exit strategy for extreme unprecedented situations such as the pandemic to avoid litigation?
3. Governing law. Most non-lawyers consider governing law boilerplate and usually choose the law of the state where their client is located or some law that all parties are familiar with — such as Delaware law. However, the choice of law can have a significant impact on contract enforceability and interpretation. For example, state law on interpretation of force majeure clauses varies. Some states, like New York, excuse performance only where it is totally impossible to perform. Other jurisdictions, such as California, will excuse performance which is impracticable such that it will require unreasonable expense to perform the contract. Delaware law tends to afford great deference to the express terms of the contract and will enforce the language as written — although sometimes going to great lengths to parse through the sentence structure and syntax of various provisions to come to a conclusion (Borealis Power Holdings Inc. v. Hunt Strategic Utility Investment, L.L.C., Del. Supr., No. 68, 2020 (May 22, 2020)). This allows for the parties to come to their own terms on allocation of risk for unforeseeable events.
4. Limitations of liability. Parties often try to limit consequential, incidental and special damages or cap liability for non-performance or breach of an agreement. This is often a highly negotiated part of a contract. This includes discussions regarding loss of profits due to interruption of normal business practices or loss of customers due to cancellation or delays. Some of the foregoing may actually be direct damages if foreseeable and not caused by special circumstances of the party. Contract language often attempts to expand the limitations beyond what would technically be consequential damages. Should we be reconsidering these limitations — and would a pandemic change the scope or interpretation of these provisions? If a pandemic or government shutdown causes the breach, should there be a different remedy? Should the parties agree to extend the time for performance by the time of shutdown and would this fully compensate for the damages caused? Sometimes this type of extension provision is already built into force majeure clauses, but the express language of how these are written will be very important.
5. Dispute resolution. In a world where virtual trials, arbitrations and mediations may become part of the mainstream, should we be reviewing these provisions with an eye to building in processes and procedures that afford a more practical and cost efficient dispute resolution process? And what are the considerations in agreeing to provisions like jury trial waivers?
6. Whereas clauses, recitals and the assumptions upon which a contract is formed. Parties often include detailed introductory recitals and whereas clauses which are not necessarily part of the actual agreement between the parties. These lay out the “history” of why the parties are entering into the agreement. However, should we be including more detailed assumptions and “purpose” clauses within the body of the contract? Would this allow for an exit strategy without damages and finger pointing under doctrines of frustration of purpose? Frustration of purpose is a common law doctrine which allows for non-performance if the purpose of the contract has been obviated — this goes beyond the situation of an event that simply prevents performance but rather deals with the situation where the nonoccurrence of an event is not the fault of the party seeking release from the obligation and the event was a fundamental assumption of why the parties agreed to the contract. Frustration of purpose does require that the frustration was almost total — it is not enough for a contract to have become unprofitable — but consider the situation where the purpose of a contract becomes prohibited by law. For example, the sale of a product to minors or the banning of a product determined to be hazardous would frustrate the purpose of a purchase agreement for such product.
7. Standards of performance. What does commercially reasonable efforts, reasonable efforts or best efforts mean in a situation where there is a pandemic, government order or other intervening event that alters operations in the ordinary course? And what does operation in the ordinary course mean? What does it mean to perform to the highest industry standards in a world where standards are constantly changing to adapt to unprecedented and unforeseen events? Should we be putting more detail around these types of standards? What about contracts that require time is of the essence, uptime or program availability and capacity…should these consider extraordinary circumstances?
8. Insurance and other business continuity requirements. What types of insurance coverage, if any, will be added to the list of insurance requirements in commercial contracts, and will purchasers take into account the scope of coverage in these policies? Arguments over business interruption insurance have made the headlines, especially for those with a virus exclusion, but these tend to deal with coverage of the business that is insured. But what type of coverage will businesses have, if any, for damage to their counter-party’s business caused by disruption of the supply chain or other inability to perform? Will contracting parties be looking for business continuity plans from their counter-parties? Will parties be requiring security for obligations and be more reticent to extend credit terms without some collateral or guarantees?
9. Indemnification. Obviously, parties will be revisiting the scope and limitations in indemnification provisions and standards of materiality for breaches.
The above are just some of the contract terms that parties should be reviewing in the “new normal.” As with prior game-changing events, the pandemic should lead all businesses to review their contractual arrangements with a new set of eyes. Relying on existing agreements and age-old precedent, as well as what was market before the pandemic, may not be wise as businesses and contracts, like people, will have to adapt to a new world in which we need to try to expect the unexpected. This may require a new understanding and appreciation for allocation of risk in a risky world.
For more information or if you have any questions, contact Lori S. Smith (email@example.com; 212.714.3075) or another member of the Corporate and Securities group.
As we continue to monitor the novel coronavirus (COVID-19), White and Williams lawyers are working collaboratively to stay current on developments and counsel clients through the various legal and business issues that may arise across a variety of sectors. Read all of the updates here.