With the rapid global spread of the new coronavirus disease Covid-19, uncertainty prevails in the business world. In recent weeks, governments and companies alike have implemented a host of different measures to slow the outbreak’s spread and manage the unprecedented economic consequences.
As government and management-mandated shutdowns increase, and fewer and fewer employees are able to come to work, your company may face a wide range of supply chain challenges. Your own production and ability to supply customers may be affected, or you may be unable to produce your goods because your suppliers have discontinued shipments.
Contracts in numerous different global supply chains are already being affected by an increasing number of force majeure notices, and there will undoubtedly be many disputes over who must bear the losses caused by Covid-19-related supply problems.
This Q&A addresses some common questions facing companies as they seek to manage the legal challenges associated with the Covid-19 outbreak.
1. What steps should a company take if it cannot supply its customers?
Whatever the specific impact of Covid-19 on your business – whether Covid-19 affects your own production (such that you need to declare force majeure) or shipments from your suppliers (such that you receive a declaration of force majeure) – the following steps will help you to manage the situation.
• Identify and document the exact cause of the supply problem. It is critically important that you understand why you cannot supply – whether due to government-ordered shutdowns or quarantines, staff illness, or something else – and that you document and collect the evidence of those reasons.
If you receive a force majeure declaration from your supplier, ask for details about how exactly the supplier is affected by Covid-19 (and document those details) before responding or otherwise taking a formal position on that declaration. Do not accept a force majeure declaration that is vague or lacks specificity.
• Analyse whether the specific supply problem you face constitutes force majeure. Since the terms and governing law of every contract differ and do not necessarily provide a force majeure defense for unforeseeable events outside of the parties’ control, careful legal analysis of your specific situation is indispensable. The availability, scope, and requirements of a force majeure defence will depend on the exact nature of the supply problems, the specific terms of your contract, and the governing law. If your supplier has issued a force majeure notice, such that you cannot supply your own customers as a result, you should assess the risk allocation under each contract separately.
• Issue the required notices of a force majeure event. If your contract or governing law require you to provide prompt notice of a force majeure event (which is typical), you may need to issue a force majeure notice before you have fully analysed the situation. When declaring force majeure, you should therefore use appropriate, broad language that covers different scenarios, and thus protects your legal position.
If you receive a force majeure notice from a supplier and then must declare force majeure to your own customers, carefully draft your notice to avoid affirmatively accepting your supplier’s force majeure defence. For example, you could reference the fact that your supplier declared force majeure and state that the lack of supply is outside of your control. This avoids prejudicing your company’s own position in a potential future dispute with your supplier. If and when you have sufficient information about the event in question to establish that your supplier’s force majeure defence is invalid, you should formally object to their declaration of force majeure. You should also inform your supplier about the damages you are incurring because of their supply failure.
• Make and document your efforts to overcome the supply problems. Many contracts and governing laws exclude a force majeure defence if it is possible to overcome the consequences of the force majeure event. Also, if you receive a force majeure declaration that you consider to be invalid, you must still attempt to mitigate your damages, for example, by making efforts to procure replacement goods. You should determine the level of efforts required under your contract and governing law (e.g., “reasonable efforts” or something else?), and create a paper trail of all such efforts. Creation of a paper trail is even more important when your mitigation efforts are unsuccessful, or you know that supply alternatives are unavailable.
• Carefully manage the allocation of existing supplies. If your reduced production output allows you to supply only a portion of your customers, review your contract and the governing law for any restrictions or guidance about how to allocate supplies. For example, they might provide for a pro rata allocation between customers or mandate that you use reasonable business judgment. You should identify objective criteria (other than your company’s profitability) that would justify a priority allocation.
If you receive a force majeure declaration, first determine how your supplier is allocating remaining stock and available product quantities and then, if you consider this allocation to be inappropriate, consider whether a request for interim relief may be available.
2. Does the Covid-19 outbreak constitute force majeure and excuse non-performance of commercial contracts? For cross-border transactions involving a particular country severely impacted by Covid-19, how long can a party seek to avoid performance as a result of Covid-19?
The essential question is how the Covid-19 outbreak specifically impedes a party’s ability to perform under a commercial contract, whether that impediment can be overcome and, if not, whether that impediment entitles you (or the other party) to invoke force majeure. In short, who bears the risk under the contract and applicable law?
The answer depends on the particular circumstances and the exact Covid-19 supply-related problem facing your company, and lies first and foremost in your contract and the governing law.
Contracts often contain a force majeure clause that provides some form of relief from performance obligations where there is a defined change in circumstances outside of a party’s control. In addition to specifically listing certain force majeure events, these clauses typically include more general language covering other circumstances falling outside of the listed events. A court or tribunal will interpret a force majeure clause in accordance with ordinary contract interpretation principles under the governing law. Generally speaking, a clause that contains specific words like “epidemics”, “pandemics”, “diseases”, “public health risks”, or refers to “matters beyond the party’s control”, will probably cover Covid-19-related impediments if performance has thereby become physically or legally impossible. When a force majeure event occurs, the clause might suspend certain performance obligations, excuse non-performance, or in some cases allow the parties to adjust or even terminate the contract.
However, not every supply contract contains a force majeure clause, and in those cases it is unlikely that courts or tribunals will imply one into your contract. That said, depending on what law governs your contract, various legal doctrines with similar effect may be available to you. For example, under English and US law, the doctrines of impossibility and frustration may be available, with the result that you may be able to terminate the contract if you meet the relevant high bar. In some civil law jurisdictions (e.g. France), force majeure is codified, and allows for both contract adjustments and termination. Other jurisdictions, such as Switzerland or Germany, recognize the concepts of impossibility to perform, which exempts you from performance, and substantial change of circumstances, which allows you – subject to strict requirements – to amend the contract terms or, as a last resort, even terminate the contract.
The requirements for a contract party to benefit from a force majeure clause or related legal doctrine will depend on the applicable law, but typically require the following:
• The impediment was beyond the reasonable control of the party who seeks to invoke force majeure. A force majeure clause effectively allocates risk between parties, with the spheres of risk varying from contract to contract, and depending on the particular language of the force majeure clause. For example, your contract may allocate the risk of government action to the party located in that country, which becomes relevant as companies are faced with government-mandated shutdowns in response to Covid-19. In some cases, even if your supplier is affected, it may nevertheless fall within your own supply risk depending on the contract.
• The impediment was not reasonably foreseeable when the contract was signed. Not all force majeure clauses require the absence of foreseeability, and whether this would be a strict requirement depends on the governing law. For example, this is not a strict requirement under English law, but it is under German law.
• The impediment cannot be avoided or overcome. The party seeking to rely on a force majeure defence bears the burden of proof, making it indispensable that you document your efforts to avoid or overcome the specific consequences of Covid-19 on your supply. Under many contracts and governing laws, a force majeure defence will not allow you to avoid significantly higher costs of supplying alternative goods, unless you are entitled to invoke hardship as an exception (which is subject to strict requirements). For example, under English law, a party must prove that there were no reasonable steps it could have taken to avoid the force majeure event or its effects. Again, if you receive a force majeure declaration that you consider invalid, you are nonetheless required to mitigate your damages, by taking efforts to procure replacement goods.
• The impediment cannot be due to the claiming party’s negligence or fault.
The failure to perform must be a result of the impediment, and nothing else.
• Prompt notice of a force majeure event. Certain civil law systems require prompt notice of a force majeure event, failing which the defence is barred. While most common law systems do not have such a requirement, it might be required under your contract.
In terms of consequences, before assuming that Covid-19 automatically excuses non-performance altogether, you should carefully assess whether your contract and the governing law only excuse temporary non-performance or also entitle you to modify the contract terms or terminate the contract. Generally speaking, the force majeure defence is only temporary, and a party needs to resume performance as soon as it can overcome the specific Covid-19-related impediment, for example by resuming its production or by procuring alternative goods (if alternative goods are allowed under the contract).
3. When should a force majeure notice be issued and what steps should be taken in response to a force majeure notice? How does Covid-19 affect “time of the essence” clauses in contracts?
As described above, contracts and governing laws often require companies to give prompt notice of a force majeure event, failing which this defence will be barred. While most common law systems do not have such a requirement, certain civil law systems (e.g. France) do require notice, and you should therefore carefully review your contract and governing law to determine what is required in your particular circumstances. If you receive a force majeure declaration from a supplier, you may also be obligated to promptly issue a force majeure declaration to your own customers. The steps to take in relation to such force majeure notices are described in the answer to Question 1 above.
If a Covid-19-related impediment entitles a party to suspend performance under a force majeure clause or related legal theories under the governing law, this will typically be the case regardless of whether there is a “time of the essence” clause in the contract.
4. Who is responsible for losses when a supplier cannot supply a customer due to the Covid-19 outbreak?
A supplier who is unable to supply as a result of a Covid-19-related impediment will typically be liable for damages under the contract unless it is able to invoke a force majeure clause in the contract or a related legal doctrine under the law governing the contract. The typical requirements for invoking such defences are discussed in the answer to Question 2 above.
5. In the event of a disagreement about responsibility for loss, what is the most efficient way to resolve the disagreement?
As always, amicable settlement is the most efficient way to resolve any disagreements about responsibility for losses stemming from the Covid-19 outbreak. It is typically both faster and cheaper than arbitration or litigation, and is particularly well-suited for parties with common business interests who wish to preserve their business relationship. Amicable settlement can be achieved through structured negotiations, such as escalating the matter to designated members of senior management. It can also be achieved through mediation, an informal and non-binding procedure whereby a neutral mediator assists the parties in reaching a settlement.
If you are unable to reach an amicable settlement, the question of whether the dispute will be resolved by a state court or a private arbitral tribunal will depend on the dispute resolution clause in your contract.
If you are already thinking about how to update your dispute resolution clauses for the future, you should consider the benefits of choosing arbitration over litigation for international contracts, including: the neutrality of the arbitral process, the near-global enforceability of arbitral awards, the ability to select your decision-maker, the confidentiality of the arbitral proceedings, and the efficiencies of time and cost.
6. What steps should a company take if threatened with litigation over a supply chain disruption?
With the many lawsuits that will undoubtedly arise over who must bear the losses caused by Covid-19-related supply problems, your ability to proactively manage disputes will increase the likelihood that you are able to resolve those disputes both efficiently and successfully.
One step that goes a long way to avoiding or resolving contract disputes is to interact with your suppliers and customers constructively, and in the spirit of cooperation. At the same time, however, you must take all necessary steps to protect your company’s legal and evidentiary position – in the event that amicable resolution fails and the dispute escalates. For example:
• Collect all necessary evidence, and maintain it in a well-organised document management system;
• Create a paper trail that documents your reasonable conduct, and the deficiencies in your contract partner’s conduct;
• Avoid exaggerating or inflating your claims, which risks damaging your credibility and ultimately weakening your case;
• Check your insurance policies to determine whether Covid-19-related supply risks are covered, and make certain that you issue any of the required notices under those policies;
• Control all communications with the counterparty;
• Identify and interview individuals with knowledge of the events before their memory fades, and have outside counsel record their evidence in writing to avoid having to disclose those records later;
• Keep track of statutes of limitations that may bar your claims;
• Ensure the confidentiality of your negotiations, including through non-disclosure agreements.
You might also engage outside counsel to conduct an early case assessment (ECA), i.e. a factual and legal analysis of the dispute at the outset that leads to a strategic assessment of your options. An ECA is a valuable tool to help your company make informed decisions about whether to settle a dispute or pursue a lawsuit, ultimately increasing your chances of success. This type of analysis will enable you to develop a strategy that is consistent with your business goals and to put yourself in the best position to prevail if a settlement cannot be reached. An ECA will help you to identify weaknesses in your position that can be addressed and ensure that you secure critical evidence. An ECA becomes particularly useful when combined with a risk-based claim calculator, which provides a structured framework for estimating a reasonable settlement amount and for comparing chances of success with litigation cost.
Once again, you should carefully review the terms of your contract to see what is required both in terms of effective escalation of the dispute, and what court or tribunal would decide any legal proceedings. If your supplier has issued a force majeure declaration with the result that you cannot supply a major customer, check whether the dispute resolution clauses in the different contracts allow the disputes to be heard in one proceeding to avoid conflicting decisions.
7. How can companies become more “virus-fit” for the future?
Covid-19 is not the first, and is unlikely to be the last, global health crisis with such serious implications for the global supply chain. Accordingly, now is the time for companies to implement measures to reduce the impact of such health-related problems in the future.
• Put in place a back-up plan. It is not surprising that the companies facing the most significant challenges are those with a single-source supply. A strong supply chain requires diversification, ideally across different suppliers, different supply sites, and different geographies. This diversification will help minimise supply chain disruptions that risk increasing in the future due to global pandemics, climate change, or other global phenomena.
• Update your force majeure clauses. You should update your template force majeure clause for future contracts or renegotiated contracts to make certain it covers common problems in the event of a global pandemic, extreme weather events, or similar disruptive phenomena. You should also address the allocation of reduced supplies, and the specific consequences of force majeure.
• Update your dispute resolution clauses. Your dispute resolution clause determines whether you can effectively enforce your rights. The selection of a neutral and effective forum, whose decisions can be enforced, is critically important. For example, national courts may not give even-handed treatment to foreign parties pursuing a claim for damages against a national company. It is also important to ensure that the dispute resolution clauses across contracts within your supply chain are compatible. For example, they should allow you to consolidate related supply disputes under multiple contracts in a single legal proceeding, thus avoiding inconsistent or conflicting decisions.
• Review your insurance coverage. You should review your insurance policies to see whether your exposure to pandemic-related supply risks are covered, and consider adding appropriate coverage.
☛ David Roney, Dorothee Schramm and Katie von der Weid are lawyers at law firm Sidley Austin.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content of this article is personal to the authors and does not reflect the views of the firm.