COVID-19 AND CONTRACTS: ARE YOU READING THEM MORE CAREFULLY NOW?

30
Mar 2022

The toll that the COVID-19 pandemic has taken on businesses, global and local markets, international trade, as well as almost any service industry has been far-reaching.

During the pandemic, companies faced difficulties in complying with their contractual obligations.  many of them were wondering can they be excused from those obligations due to COVID-19? Who should bear the responsibility for the failure to perform caused by COVID-19?

Having in mind the political situation that the entire world is facing right now, there are certainly some parallels that could be drawn with COVID-19 impact on doing business and fulfilling contractual obligations toward business partners

Domino Effect

Let’s start with an example. During the pandemic, some traders have been facing a ban on the export of their products, while others have faced a challenge imposed by a complete lockdown of certain countries in their transport chain.

In that sense, they were in default of the nonperformance of contractual obligations towards their cross-border buyers.

Consequently, export-oriented businesses faced a loss of profit and were unable to fulfill their duties towards employees or other contractual parties (for example, their suppliers). Such a situation has caused many companies, especially SMEs, to go bankrupt.

For more information on the changes COVID-19 caused in the area of labor and employment please see COVID-19 And the Employers: Didn’t Like Work From Home? Better Start.

COVID-19 Effect on Commercial Contracts

Taking into account everything previously described, delay or cancellation under many contracts was inevitable.

Under normal circumstances, the rule is clear: in the event of non-performance, the non-breaching party may request the performance, or, in case of a material breach of contractual obligations, unilaterally terminate the contract. In each case, the non-breaching party is entitled to claim damages due to the other party’s failure to perform or due to the delay in performance.

However, the Covid-19 pandemic and the related measures (such as the national export bans) may cause extraordinary circumstances which may justify the non-performance. This means the exceptions to the rule may apply.

So, what are exceptions the parties may consider?

Essentially, two legal institutes may be considered:

  • Force Majeure
  • Hardship (usually also called “Rebus Sic Stantibus” or “Change of Circumstance”).

So, where should the parties look for the answer to the question should Covid-19 or political sanctions be considered a legitimate reason for non-performance due to force majeure or change of circumstance?

The first point should be the contract. Read the contract carefully, and if the contract does not regulate such a situation, the answer may be found in the applicable law.

This analysis focuses primarily on the position under Serbian law.

What is Force Majeure?

A force majeure event represents the occurrence of an event that is outside the reasonable control of a party and prevents that party from performing its obligations under a contract. The essence of this concept is that such an event could not have been predicted at the time of the conclusion of the agreement and could not have been prevented by the non-performing party.

The non-performing party may be able to claim relief for a force majeure event.

Although not mandatory, the force majeure clause is most commonly one of the express terms of the contract. Unfortunately, it is also common that parties do not pay much attention to this clause and its wording in their contracts.

The parties may specifically state the events that would represent force majeure, which would make it easier to recognize its occurrence. Usually, the force majeure clause will contain the general definition (catch-all provision) and then a non-exhaustive list of examples. Therefore, by looking through your contract, you can search for terms such as an act of God, an act of nature, natural disasters, war, epidemic, pandemic, diseases, etc.

It is very important to bear in mind that the event must represent an unpredictable risk. However, if you are doing business in an area in which the profit is highly dependable on regular natural or climate conditions, this unpredictable, but reasonably expected event should not be confused with force majeure.

Hence, each force majeure provision must necessarily be considered on its precise terms and in its specific context of the contractual obligations.

What if the Contract is Silent on the Matter?

When there is a lack of consent, force majeure can also be determined by the court, which then decides whether the certain event could be considered Force Majeure (for instance, the introduction of a certain restriction due to the burst of the COVID-19 pandemic) was the direct cause for nonperformance. In such cases, the court will decide based on the applicable law to the contract. The conclusion would require a thorough analysis of the circumstances in each particular case.

However, one should bear in mind that a contracting party is always expected to mitigate, put reasonable effort to perform its obligation, and act in good faith and good professional practice.

To be qualified as a force majeure, an event has  to satisfy the following criteria cumulatively, which we will analyze in the COVID-19 example:

  • The event must be beyond the reasonable control of the non-performing party. It is important to note that, for example, COVID-19 itself is not the event, but one of the consequences of the pandemic would probably be (for example, the export ban).
  • The non-performing party’s ability to perform its obligations under the contract must have been prevented, impeded, or hindered by the event. In this case, the non-performing party would have to prove the cause-effect relationship between the COVID-19 pandemic and its hindrance to performance.

However, it is important to note that an economic downturn due to which the non-performing party became insolvent, usually will not satisfy this criterion, unless the contract itself says so in express terms. On the other hand, a state measure according to which a company’s activity must stop, and the workplace has to be evacuated could satisfy the criterion.

  1. The affected party must have taken all reasonable steps to avoid or mitigate the event or its consequences. What constitutes such a measure depends on the nature of the contract and specific circumstances. For example, in some industries (for example, in the IT industry) the employer may organize work from home, which would provide (at least) a close level of effectiveness as in ordinary circumstances.
  2. The non-performing party will have noticed the other party of the force majeure event in accordance with the instructions stipulated in the contract or the applicable law.

What if the Consequences of COVID-19 or the Current Political Climate Constitute Force Majeure?

The effect of force majeure, again, depends on a contract. Typically, there will be a contractual term that stipulates an extension of time to perform those obligations or suspension of contractual performance for the duration of the force majeure event. Most commonly, if the force majeure event extends over a longer period, the agreement entitles the parties to terminate the contract.

Is there a Case for the Change of Circumstance Clause?

Depending on the effect that certain event has on the performance under the contract, it can cause difficulty in fulfilling obligations, but not the entire inability to perform obligations. In such a case, one may consider the application of the change of circumstance clause (rebus sic stantibus).

The concept of changed circumstances means that the parties may:

  • Modify their agreement and their obligations

or

  • Mutually decide to terminate the agreement,

provided the following criteria are met:

  • The circumstances have substantially changed in comparison to the circumstances from the effective date of the agreement,2. The change in question makes it difficult for the party to fulfill its obligations or the purpose of the contract cannot be fulfilled,
  • It is obvious that the contract no longer corresponds to the expectations of the contracting parties,
  • It would be, according to the general opinion, unfair to maintain it in force in its present form,
  • The party in difficulty was not obliged or was not able to take into account the change of circumstances on the effective date or the party could not have avoided or overcome the difficulties,

It should not be forgotten that a party that is facing a change of circumstances must notify the other party of such a change of circumstances before the contractual obligation is due. The same applies to the request for termination of the agreement.

It is very interesting to note that criterion 2 corresponds with the concept of “Doctrine of Frustration” under the English law, although this doctrine is highly uncommon in the legal systems that belong to the civil law legal tradition, such as the Serbian legal system. In practice, this criterion has proved to be one of the most difficult ones to meet.

If the parties may not agree on the modification or termination of the contract, the party which is faced with difficulty performing and finds itself in an unfair position may seek the termination of the contract through the court.

Like in the case of force majeure, the burden of proof lies with the party claiming the change of circumstances.

However, even if all the criteria are met there may be a clear obstacle in the contract. Namely, under Serbian law, the parties have the possibility of a prior waiver of the right to terminate the contract due to changed circumstances, unless it is contrary to the principle of conscientiousness and honesty. So, before you intend to claim the change of circumstance, read through the contract carefully again, in order to determine whether you actually do have this possibility.

After the COVID-19 pandemic, we can conclude with certainty that provisions like Force Majeure, although they do not affect the commercial terms of your business relationship, should be read more carefully – just in case.

The effect of force majeure will, again, depend on a contract. Typically, there will be a contractual term that stipulates an extension of time to perform those obligations or suspension of contractual performance for the duration of the force majeure event. Most commonly, if the force majeure event extends over a longer period, some provisions may entitle the parties to terminate the contract.

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