Potential Traps for the Unwary: Significant Contractual Provisions That Parties Should Be Aware Of In Light Of COVID-19
March 25, 2020
In light of the wide-ranging impact that the coronavirus disease (COVID-19) may have on all businesses, business owners and managers would be wise to review their existing contracts to identify what obligations under those contracts are likely to be impacted by the COVID-19 pandemic and what protections against – or remedies for – such impact are provided in the contract, if any. Contracts that are currently being negotiated should similarly be reviewed for such protections and remedies, and added where necessary. In addition to the “material adverse event” and “force majeure” provisions discussed in our recent article here, parties should review the common contract provisions discussed below with a critical eye. While this is not intended to be an all-inclusive list of all contractual provisions and obligations that may be implicated by the pandemic, the bullet points below highlight certain contractual provisions that are frequently included within commercial contracts, and are intended to help business owners and managers steer clear of traps for the unwary.
Considerations for Existing Contracts:
- “Material Adverse Effect” and Force Majeure Provisions: Many commercial contracts include provisions permitting a party to temporarily suspend its obligations thereunder, or in some cases terminate the contract entirely, if a “material adverse event” (an “MAE”) or “force majeure” has occurred. The circumstances that constitute an MAE or force majeure event are usually (but not always) specifically enumerated the contract, and typically consist of large-scale unforeseeable events that impact the business environment but are not caused (or capable of being controlled) by either party, such as natural disasters, terrorist acts and wars. While some contracts specifically include pandemics or similar circumstances within the scope of an MAE or force majeure clause, many agreements do not. Whether or not an event such as a pandemic, or other catastrophes not specifically enumerated in a contract, constitute MAEs or force majeure events are fact sensitive determinations and depend on, among other things, the exact situation at hand, the effect on the contracting parties specifically (as opposed to their industry generally), and the precise wording of the applicable provisions. For a more detailed discussion on MAE and force majeure clauses, see our recent article on this topic here.
- Termination: Even if the situation at hand does not clearly trigger an MAE under the contract or fit within the parameters of the force majeure provision, has the pandemic given rise to other grounds under which a party may terminate or suspend its obligations under the agreement? For example, is a party permitted to terminate a supply agreement if the supplier is more than a certain number days late delivering the applicable products? Are there “time is of the essence” clauses that might alter the effectiveness of MAE or force majeure clauses?
- Cross-Default Provisions: Some contracts expressly make a party's default under a separate contract a default under the first contract as well. Even if the COVID-19 pandemic does not constitute a default under the contract being reviewed, if that or another related contract contains a cross-default provision, the reviewer must review all other contracts within the scope of the cross-default provision to make sure that a default has not occurred under that separate agreement.
- Covenants: In addition to the parties' general obligations to perform the essential business terms of the contract, many business agreements contain specific covenants by one or both parties that they must observe during the term of the agreement. These obligations can be “affirmative” covenants – i.e., an obligation to do certain things, such as maintain a specified level of insurance – or “negative” covenants – i.e., an obligation not to do certain things, such as a commitment not to wind up a party's operations. Can the parties adhere to their ongoing covenants under the agreement? What are the implications if they cannot? In particular, most credit agreements and many similar contracts require the borrower to maintain certain financial rations (e.g., debt to income ratios); business owners and managers will want to review all of the financial covenants their companies are subject to closely and consider a pro-active plan of action if they believe they will not be able to maintain those ratios due to the economic impact of the pandemic.
- Notice: Does either party have an obligation to notify the other party of certain events that may impact performance under the contract, such as a supplier's requirement to notify its customer if it cannot, or anticipates that it will not be able to, fulfill an order in full within the contracted for deadlines?
- Claw back of Payments or Discounts: If the contract is breached or terminated, does either party have a right to claw back any payments previously made, or retroactively eliminate a discount that was given based on full performance of the contract?
- Mitigation of Damages: Many contracts contain an express provision requiring a breaching party to mitigate the losses incurred by the other party by taking specific actions. Does either party have a duty to mitigate damages?
Considerations for Contracts Currently Being Negotiated:
- Representations and Warranties: Many business contracts include representations and warranties made by at least one of the parties thereto. These representations and warranties can range from very basic statements regarding the legal status of the parties and compliance with internal corporate processes for entry into the agreement, to very business- and deal-specific statements regarding a party's ability to perform under the contract or its current business operations. Parties should carefully think through potential revisions to any of the requested representations and warranties, (including any qualifications or exceptions to such representations and warranties, including any contained within a specified disclosure schedule). For example:
- Workforce Related Representations: Many contracts require a party to represent and warrant to the other that it has sufficient personnel with requisite skills to perform that party's obligations under the contract. The pandemic, and the ensuing social-distancing regulations, may limit the business' ability to deploy its workforce to the same extent it normally would.
- Sufficiency of Assets: Does the contract require that the company maintain a certain amount or type of assets or products? Does the contract require that the products on hand will be sufficient to meet the company’s need immediately following execution of the agreement? If so, has the COVID-19 pandemic affected the company’s inventory and, accordingly, its ability to make this representation?
- Representations Relating to Existing or Threatened Litigation: Has the COVID-19 pandemic exposed the business to claims from customers or other persons for non-performance under any contracts? Has or will the pandemic interrupt critical supply lines, imperiling timely delivery of any already-contracted for goods or services?
- Representations Relating to Defaults or Potential Defaults: Related, has a default been called under any of the company’s contracts or does it anticipate that a default may be triggered?
- Covenants: Are the parties’ respective covenants still reasonable in light of the changing climate and financial instability due to COVID-19?
- Insurance Requirements: Many businesses may find that the types and amounts of insurance they typically required from counterparties are insufficient to deal with the COVID-19 pandemic. Contract negotiators should carefully assess what types and levels of insurance they will require from counterparties going forward.
- Subcontractors: Can the parties subcontract out any of their duties or obligations? If so, are there limits as to what can be subcontracted and to whom?
Please reach out to your Moses & Singer attorney to help you navigate the waters in these uncertain times. Our corporate department can assist you with analyzing the foregoing provisions and the impact thereon on you and your company, and can also provide you with insight and assistance on a host of other issues that may arise during the COVID-19 pandemic.