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Law360 (June 11, 2020, 6:12 PM EDT) --
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| Jennifer Tsai |
Unfortunately, however, there is no universal or one-size-fits-all solution to this since the provision (or provisions) a party would rely on in order to terminate a contract, or exempt itself from performance without breaching the contract, is dependent on the language in the contract itself.
So, what now? There are approaches that businesses can take to understand the risks tied to their contractual obligations, as well as some strategies that can be implemented to future-proof new contracts to an extent where the risks associated with unforeseen circumstances, such as pandemics, will cause fewer losses if amendment and renegotiation are not viable options.
Identify and Understand the Provisions That May Provide Relief From Contractual Obligations
It has been established that businesses should be reviewing relevant contracts to assess risks caused by the impact of COVID-19. Understanding what its contracts say about provisions such as force majeure and termination allows a company to be more informed in dealing with contract counterparties.
It also helps a company to be more prepared when it comes to anticipating how contract counterparties may react if unexpected circumstances (e.g., pandemics) occur, putting the company in a position to be agile and ready with a response. Having a deep understanding of its contracts also helps a company figure out which contracts to focus on, and which contracts may require a more "high-touch" approach.
It can be very valuable to understand the aggregate level of risk to be found in the termination provisions in a company's body of contracts. It is useful to review large sets of contracts in order to see patterns and outliers in order to more effectively target specific contracts for further analysis and possible termination or renegotiation.
Once that big-picture review is complete, it's time to look more closely at three separate types of provisions that could be invoked (by either party) in the contracts deemed to present the most risk:
1. Force Majeure
Force majeure provisions in contracts establish the circumstances under which a party's obligations under the contract may be suspended, or otherwise altered, due to events deemed to be out of the affected party's control. Examples include natural disasters, acts of terrorism or war, acts of God, labor disruptions, or, as seen this year, pandemics.
This is an essential provision because the occurrence of a force majeure event can result in any number of effects, such as a party's exemption from performing its contractual obligations (important to the nonaffected party), potential notification requirements (important to the affected party), or even the possibility of terminating the contract altogether (important to all parties).
It is important to ensure future contracts include force majeure provisions that cover outbreaks/pandemics, and that clearly state the effects of force majeure. In fact, we found that 72% of commercial contracts filed on the U.S. Securities and Exchange Commission's Electronic Data Gathering, Analysis, and Retrieval, or EDGAR, database between 2018-2020 (which involved at least one Chinese entity) included force majeure provisions.
But, only 14% of commercial contracts with force majeure provisions explicitly state that public health events — such as flu, epidemic, serious illness, plagues, disease, emergency or outbreaks — would constitute a force majeure situation. When force majeure or health-related events are not addressed, it leads to confusion and potential litigation if the parties cannot reach agreement on how they will deal with COVID-19-related impacts.[1]
2. Termination for Convenience
Termination provisions set forth the circumstances under which contracts may be terminated before the end of the prescribed term of the contract, including the procedures to follow in order to terminate the agreement, and the effects of termination, such as payments and other rights and obligations of the parties. One type of termination clause is known as termination for convenience.
Termination for convenience clauses provide that one (or any) of the parties may terminate a contract before the end of the stipulated term with or without cause — that is, for any reason or no reason.[2] This provision can be useful when long-term contracts may have become burdensome such that they no longer work to a company's benefit. So, having the option to terminate such contracts without triggering a breach of contract may be an option for companies seeking to preserve liquidity.
In the travel, hospitality and entertainment industries, we found that 46% of the commercial contracts filed on EDGAR by companies in those industries between 2014-2020 included termination for convenience provisions. This includes both termination for convenience as well as nonrenewal options.
Of course, terminating a contract may not be the ideal solution or first choice. But when facing surmounting challenges as companies in the travel, hospitality and entertainment industries are, it does present a viable option when it is not possible to get a pause on contracts, or if renegotiation and amendment are not possible.[3]
Companies should consider including termination for convenience clauses in future contracts to provide additional flexibility to quickly reduce spending during future unforeseen circumstances. The availability of the provision may enable businesses to remain agile and mitigate risk exposure during unanticipated events.
On the other hand, companies that are highly dependent on key customers, especially those in the travel, entertainment and hospitality industries, should be wary of termination for convenience clauses so they can count on stability in their contracts when unforeseen circumstances occur.
3. Termination by Efficient Breach
If other contractual avoidance avenues are not available, companies may also consider efficient breach[4] as a strategy to reduce spend. Under this theory, a party might intentionally breach a contract, if paying damages for breaching the contract is more cost-effective than bearing the losses associated with continued performance under the contract.
As with termination for convenience, this is an approach that may be used when a contract has become burdensome to a company. In order to determine whether efficient breach might be a plausible solution, it is critical to understand what payments or other obligations become due upon termination or default of the contract. By comparing those obligations to the cost of continued performance of the contract, a company can then perform a cost-benefit analysis and make an informed decision on whether to move forward with efficient breach.
On the same set of commercial contracts as for termination for convenience, we found that 85% included language addressing the effects and consequences of terminating an agreement. As with termination for convenience, efficient breach may not be a company's first choice, but depending on the circumstances, it may be "the only sensible and fiduciarily responsible decision that can be made."[5]
The effects of termination or default should be clearly stated in each contract, so there is no ambiguity if one of the parties later seeks to terminate the contract. Even when such language is included, litigation is a real risk. Without language to delineate what the rights and obligations of each party are in the event of termination or default, litigation — costly for all parties involved — becomes even more difficult to avoid. Accordingly, defining the effects of termination or default is yet another essential contract provision to keep track of during contract negotiations.
Risk Management Allows Businesses to Be Agile in Times of Crises
Undoubtedly, parties should investigate all contracts to fully understand the scope of their obligations and potential exposure during the pandemic, and to mitigate future risks associated with unforeseen events or circumstances. As we have seen in recent months, force majeure and termination-related provisions have come into play as a result of a pandemic that has impacted many on multiple fronts.
Developing a thorough understanding of these provisions affords companies the opportunity to be agile and make informed decisions quickly by knowing what rights they or their counterparties may exercise in order to reduce spend and minimize risk exposure during challenging times. Additionally, reviewing and ensuring that future contracts include language to address what was previously considered "just boilerplate" is more critical than ever before.
Jennifer Tsai is a legal knowledge analyst at Kira Systems.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] https://kirasystems.com/forms/guides-studies/force-majeure-coronavirus/
[2] Examples include the following:
"Any party may terminate this Agreement at any time for any reason by giving at least thirty (30) days' written notice."
"This Agreement may be terminated by either party for any reason or no reason, whether or not extended beyond the initial term, by giving the other party written notice ninety (90) days in advance."
"Licensee may terminate its license to use any of the Licensed Trademarks at any time, upon thirty (30) days' prior written notice of such termination to Licensor."
[3] https://kirasystems.com/forms/guides-studies/termination-convenience-travel-hospitality-entertainment-contracts/
[4] https://www.law.cornell.edu/wex/efficient_breach
[5] https://privateequity.weil.com/covid19-updates/impossibility-impracticability-frustration-force-majecure/
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