The Morrison & Foerster Technology Transactions group continues its discussion around contractual nonperformance during the COVID-19 pandemic, covering considerations including anticipatory repudiation, common law doctrines and legal considerations abroad.
A party’s anticipatory repudiation (also called anticipatory breach) might also serve to discharge the other party’s contractual obligations under a commercial contract. In the U.S., particularly in the context of the sale of goods, this right arises under the Uniform Commercial Code (UCC), which has been adopted in some form in all states within the U.S. (see UCC § 2-609 et seq.). This occurs when one party makes a statement or engages in an action that indicates to the counterparty that it will not or may not fulfill its contractual obligations by the time performance is due. Here, the value of the contract to the other party is impaired because the repudiating party either demonstrates that it will not perform as required under the agreement or renders its performance not reasonably possible under the circumstances.
Under the doctrine of anticipatory repudiation, if a reasonable person would find that the repudiating party will not or cannot fulfill its obligations, then the aggrieved party may avail itself of any of the remedies for breach of contract offered and is entitled to suspend any performance for which it has not already received the bargained-for return, as is commercially reasonable (contrast this with the doctrine of impossibility, as discussed below). Examples of statements or actions that constitute anticipatory repudiation include: a buyer’s unequivocal statement that it will not pay for pre-ordered goods; a seller’s statement that it will no longer produce the goods that the buyer has pre-ordered; and a seller’s closing of the production facility where the goods pre-ordered by the buyer are made.
While anticipatory repudiation is a theory of excused performance in the context of the sale of goods under the UCC, some states, including New York, have recognized theories or arguments analogous to anticipatory repudiation of certain services contracts, including contracts for personal services. Other jurisdictions provide comparable rights to the other party to discharge its contractual obligations in such a case. For example, under German statutory law (§ 323 (IV) German Civil Code), the customer may withdraw from a contract if it is obvious that the vendor will not perform its contractual obligations in due time (meaning that the objective circumstances indicate that a delayed or nonperformance is very likely to occur). The examples for statements and actions set out above would trigger such a withdrawal right. Under the PRC law (§ 94(2) PRC Contract Law), a party may rescind a contract if the other party indicates expressly or by conduct, before the expiration of the performance period, that it will not perform its principal obligations under the contract.
Other Common Law Doctrines
In addition to the above contractual rights and remedies and the doctrine of anticipatory repudiation or breach, most jurisdictions also have adopted, either under the common law or by statute, certain doctrines that excuse performance. In the U.S. and U.K., there are three main common law doctrines or theories of excused performance: impossibility of performance, commercial impracticability and frustration of purpose. Under any of these theories of excused performance, however, the language of the contract and force majeure provision will be reviewed for the parties’ indications of risk allocation. Note that states may use these doctrines and terms interchangeably or together, without functional distinction.
In the U.S., the doctrine of impossibility excuses a party’s performance only when the destruction of the subject matter of the contract or the means of performance renders performance objectively impossible and the impossibility of performance was the result of an unanticipated event that could not have been foreseen or prevented. A key consideration is whether the event was foreseeable; most courts have held that failure to address a foreseeable risk in the contract deprives a party of using impossibility as a defense. The impossibility doctrine applies only under circumstances typically defined and covered as force majeure events, rather than mere economic or financial difficulties.
Also in the U.S., commercial impracticability (often viewed as a subset of the doctrine of impossibility of performance) discharges a party’s duty to perform under the contract where, after the contract is made, the party’s performance is made impracticable without its fault by the occurrence of an event, the non-occurrence of which was a basic assumption of the contract and the language or the circumstances do not indicate the contrary (see Restatement (Second) of Contracts § 261 (1981)). Qualifying events under the impracticability doctrine include acts of God or third parties making performance impracticable, even if not actually impossible, due to “extreme and unreasonable difficulty or expense” (including a severe shortage of raw materials or supplies due to war, embargo or “unforeseen shutdown of major sources of supply”). However, in the U.S., performance is deemed impracticable only if the “extreme and unreasonable difficulty or expense” caused by the event cannot be overcome by the nonperforming party’s reasonable efforts.
In addition, another consideration in the U.S. to consider is that contracts governing the sale of tangible goods are subject to the UCC (as adopted in the relevant state) unless application is excluded by contract. For technology companies that sell hardware, medical devices, semiconductor products or other tangible goods, timely delivery or nondelivery could, therefore, be excused under the UCC when performance has become impracticable either (a) due to something occurring, the nonoccurrence of which was a basic assumption of the contract or (b) as a result of compliance in good faith with any applicable foreign or domestic governmental regulation or order (see UCC § 2-615(a)).
Frustration of purpose is difficult to prove and rarely used in the U.S., although it may be considered as a potential defense in addition to impossibility and impracticability. Frustration of purpose applies when a party’s purpose for entering into the contract is destroyed or obviated due to a supervening event and performance is deemed excusable for this reason even if performance is still possible. In other words, the party is capable of performance, but its original purpose for doing so no longer applies (see 14 Corbin on Contracts § 77.1 (2019)).
In the U.K., while the doctrine of frustration is the main relevant common law principle for excused performance, the doctrine only applies in certain limited circumstances where performance has become impossible; it is not sufficient if performance has merely become more difficult or expensive than originally anticipated. And the doctrine of frustration only offers limited remedies: termination (plus recovery of monies paid under the contract before it was ended, subject to an allowance, at the court’s discretion, for expenses incurred by the other party) and excuse from further performance.
To qualify, an event must: be unforeseen, not exist at the time of contract, have occurred without fault of either party or either make contract performance impossible or destroy the fundamental purpose of the contract. While it is conceivable that COVID-19 could result in some valid claims for frustration in the U.K. (for example, where the contract requires performance in a country or region that is subject to a government-imposed lockdown), frustration ought to be seen as a fallback or secondary option — and most parties to an English law-governed commercial contract will need to work out the extent to which they are protected by an express force majeure clause. The limitations of contract frustration as a remedy are the reason why force majeure clauses are included in contracts to provide a clearer contractual remedy.
German Statutory Law
Under German statutory law, similar doctrines may excuse a party’s performance when impacted by the COVID-19 pandemic. Under § 275 para.1 German Civil Code, the vendor would be excused of performance if the performance is impossible for the vendor in the sense that the obstacle to the performance is insurmountable for the vendor (for example, when the local government agency ordered the shutdown of its production site and there is no other way to deliver the agreed goods (e.g., by producing them at another production site or by buying them from a third party) and there is no indication that such shutdown will end by a date reasonably acceptable to the customer).
In addition, similar to the U.S.’s impracticability doctrine, the vendor may be excused of performance if the performance of the obligation would require efforts and costs that are grossly disproportionate to the customer’s interest in the performance (§ 275 para.2 German Civil Code). German courts interpret this provision narrowly and apply it only rarely. There is no fixed percentage to determine such disproportionality. All circumstances of the individual case are considered, including the interests and situation of the customer; mere (significant) cost increases for buying the required raw material or components do not suffice. As a result of excused performance of the vendor, the customer is excused from paying the agreed fees and has the right to withdraw from the contract (§ 326 para.1 and 5 German Civil Code). If the failure to perform is the vendor’s fault (because it could have prevented or overcome the obstacle to its performance by applying the care and making the additional efforts that could have be expected under the given circumstances, including spending reasonable extra costs and looking for other solutions), the customer can claim compensation for the damages suffered from the vendor’s failure to perform (§ 280 German Civil Code).
Like the U.S. and U.K., only in exceptional cases do German courts permit an adjustment or termination of a contract for its frustration under § 313 German Civil Code. To qualify, circumstances on which the parties mutually (explicitly or implied) based the contract must unforeseeably and materially change so that the parties would not have concluded the contract with the given terms and conditions had they been aware of this change occurring. It is further required both that this change must not be the fault of either party and that the risk realized with the change is not allocated to either party under the contract or law.
We believe that the COVID-19 pandemic could result in valid claims for an adjustment or even termination of contract by some customers for frustration of contract (e.g., by retailers of seasonal goods (such as fashion) whose businesses are shut down during the relevant season or by customers whose relevant sales market is subject to a complete shutdown, leaving no sales option at all). On the other side, this doctrine may grant the vendor a right to an adjustment of the contract in the form of an increase of the purchase price or even a termination right if its costs for acquiring components/the goods from third parties not only increased significantly, but that the increase results in a gross imbalance of costs and price (an example is an increase of production costs by 15 times as result of war with no corresponding increase of the purchase price).
The PRC Law
Under the PRC law, there are two main doctrines of excused performance: force majeure doctrine and changed circumstance doctrine. Under the force majeure doctrine, if a party is unable to perform its contractual obligations because of a force majeure event, that party generally will be partially or fully exempted from contractual liability in proportion to the circumstances of the force majeure. The PRC Contract Law also allows either the defaulting or the innocent party to rescind the commercial contract if the force majeure event renders the purpose of the contract unachievable. As mentioned above, a party to a contract may invoke the force majeure doctrine to excuse itself from performance even if the contract does not contain a force majeure clause or if the agreed force majeure clause does not cover a certain event (e.g., COVID-19), provided that the invoking party can prove that the event which it is suffering from is unforeseeable, unavoidable and insurmountable and also that the circumstances of such event render the party unable to properly perform the contract. In addition, the party seeking to invoke force majeure also needs to (a) promptly notify the other party of its inability to perform and (b) furnish evidence proving the force majeure. Currently, courts of different cities in China have issued guidances on trial of cases in relation to commercial contracts affected by COVID-19 (Trial Guidances). Though the Trial Guidances of different cities are not entirely consistent, most of them recognize that the COVID-19 outbreak may constitute a force majeure event under the circumstances.
“Changed circumstance” is another doctrine under the PRC law that a party to a contract may invoke to excuse itself from the performance of the contract. Chinese practitioners generally trace the changed circumstance doctrine to an interpretation of the PRC Contract Law issued by the Supreme People’s Court (“SPC”) in 2009. Under that interpretation, a contractual party impacted by “changed circumstance” can petition a People’s Court to modify or rescind a contract. The interpretation permits application of the doctrine where, after a contract is concluded, there is a material and objective change of circumstance that: (a) was unforeseeable at the time of contracting, (b) was not caused by force majeure and (c) is not a commercial risk assumed by the parties.
A qualifying “changed circumstance” must either render the performance of the contract obviously unfair to the party invoking the doctrine or render the contract’s purpose unachievable. Notably, the changed circumstance doctrine does not require a party to be completely unable to perform; it applies where an event makes it obviously “unfair” for a party to perform. The principle of fairness is the touchstone of the doctrine, and courts apply the doctrine with the principle of fairness firmly in mind, considering the facts of each individual case. Currently, according to Trial Guidances, “changed circumstance” is also a commonly recognized doctrine that should be applied in trial of cases in connection with COVID-19 outbreak if the courts view that the outbreak does not qualify as a force majeure event in the circumstances of a particular contract. However, in judicial practice, invoking the changed circumstance doctrine is procedurally more cumbersome than invoking force majeure, because it requires a court petition to modify or rescind the contract at issue. The SPC also has instructed lower courts to apply this doctrine cautiously.
In addition to these doctrines of excused performance, parties should also consider whether there are other relevant force majeure principles or relevant statutes that may apply to a particular contract, depending on the subject matter and jurisdiction. As an example, in California, performance is excused when it is “prevented or delayed by an irresistible, superhuman cause or by the act of public enemies of this state or of the United States” (Cal. Civ. Code § 1511(2)). California courts have interpreted the term “superhuman cause” to mean a situation that is highly unusual and could not have been anticipated by ordinary prudence. For example, California courts have held that force majeure is “not necessarily limited to the equivalent of an act of God,” but rather “the test is whether under the particular circumstances there was such an insuperable interference occurring without the party’s intervention as could not have been prevented by the exercise of prudence, diligence and care.” California courts have interpreted the statute and the language “superhuman cause” to apply across both goods (e.g., concerning the shipment of goods) and services (e.g., consulting agreement), and even if the parties have entered into a contract that defines rights and remedies under a force majeure clause more specifically.
All manner of companies are struggling to respond to the global challenges of the COVID-19 pandemic. While the pandemic certainly presents some unusually difficult problems both for buyers and suppliers of technology products and services, organizations do have tools at their disposal. By strategically prioritizing the most consequential relationships with customers and suppliers and identifying contractual and noncontractual bases for adjusting performance expectations, companies both manage and mitigate risk.
Morrison & Foerster associates Richard Jerman and Jackie Li, and senior legal consultant Angela Shen also contributed to the writing this article.