Force Majeure, Commercial Frustration and Impossibility – Defenses All NC Businesses Should Understand

June 10, 2020Alerts

By now, most North Carolina businesses have considered this question: Does the pandemic or a government stay-at-home order forgive our performance under a commercial contract? The simple, but unsatisfactory, answer is maybe.

In the short term, performance may be relieved by government orders like the one Gov. Roy Cooper recently signed including lease enforcement restrictions. These orders provide some temporary relief, emphasis on temporary. See the recent Fox alert on North Carolina’s temporary eviction restrictions. In the medium and longer term, however, parties will need to understand how long-standing contract defenses may forgive performance impacted by the pandemic.

This alert discusses several established contract doctrines — Force Majeure, Commercial Frustration and Impossibility — and how these defenses may be asserted where the pandemic has impacted contract performance. As lawsuits are filed, these defenses will be tested and the law will evolve. Courts, however, are likely to begin their analyses with these long-standing doctrines.

But first, read your contract

This directive is simple, but often overlooked until it’s too late. Parsing fine print is a chore, but bargained-for contract provisions are critical because courts cannot ignore them. If, for example, your contract has a so-called force majeure clause that specifically allocates risk in the event of a catastrophe, government-mandated work stoppage or even a virus-precipitated pandemic, the precise terms will dictate what you should do next. Conversely, if your contract is silent on these matters — as many are — the other defenses outlined in this alert almost certainly are in play. The key, of course, is to know what your contract says. 

Is there a force majeure clause?

Force majeure clauses may forgive performance if it is disrupted by an unpredictable event. Courts will enforce these clauses, but they are like snowflakes; No two are exactly alike. They typically differ in two key respects: what triggers the clause and what happens if it is triggered. Here is a basic example:

The parties’ performance under this Agreement is subject to acts of God, war, government regulation, terrorism, disaster, or any other emergency beyond the parties’ control, making it illegal or impossible to perform their obligations under this Agreement.  Either party may cancel this agreement for any one or more of such reasons upon written notice to the other. 

Using the above example, is the COVID-19 pandemic an “act of God?” Maybe. Would a stay-at-home order constitute a “government regulation?” Probably. But did the triggering event — the virus or stay-at-home order — really make performance impossible, or is performance just impractical? Consider lease payments for a retail business that is permitted to operate, but has faced a sharp decline in customers and revenue. Is the virus or stay-at-home order actually making performance “impossible” or just fiscally imprudent? The answer may depend on your point of view. These are the difficult questions courts and juries will grapple with in the coming months and years. 

The best practice is to negotiate a force majeure clause on the front end, but these provisions are usually buried in the deal. Negotiated or not, parties now need to understand if their contracts have one, and if so, what it says. The Court of Appeals for the Fourth Circuit in this case recently recognized, as it enforced a contract against a foreign national who claimed he did not understand his contract, that under North Carolina law, parties have a duty to read contracts before signing them. In other words, ignorance (of what your contract says) is no excuse. And, as several pre-pandemic cases confirm, courts in North Carolina will enforce force majeure provisions. 

North Carolina Courts enforce force majeure clauses – as written.

There are relatively few North Carolina opinions involving force majeure clauses. That will change. Existing cases typically involve one of the litigants trying to squeeze their situation into a triggering event. Based on our review of the cases and consideration of settled North Carolina law, this much is clear when it comes to contracts: Words matter. Sometimes, a force majeure provision can actually make it harder for a party to wiggle out of performance. In one pre-pandemic case, a landlord sued its tenant, a law school, for breach of the lease and back rent. The law school claimed the loss of its accreditation was a force majeure event that relieved it of its rent obligations. The lease’s force majeure clause, however, included a carve-out requiring rent payments even if a triggering event — such as a loss of licensure — occurred. The North Carolina Business Court enforced the clause as written, obligating the tenant to pay rent despite its lost accreditation. 

In another pre-pandemic case that turned on contract language, a large electric utility invoked force majeure to avoid its contractual obligation to supply large quantities of gypsum — a byproduct of its coal-fired power plants. When the price of natural gas fell, the utility shifted power generation from coal to natural gas. Fewer operating coal plants meant less gypsum, making it more difficult and expensive for the utility to meet its gypsum supply obligations. The utility claimed that the drop in natural gas prices and the corresponding need to pivot away from coal was a force majeure. The North Carolina Business Court took a careful look at the contract, including its drafting history and other extrinsic evidence, and concluded that despite the changed circumstances, the utility’s obligations were not excused by any force majeure. Indeed, performance was not impossible; it was just more expensive. This, according to the court, was not a force majeure.  

Contemporaneous claims and documentation are critical

Claiming force majeure early, with documentation, is also important. In another pre-pandemic case, a court rejected a builder’s force majeure defense because it failed to claim force majeure until it was sued for failing to complete the project on time. Although the contract’s force majeure clause relieved the builder from liability for delays caused by “excessive moisture,” among other things, the builder did not claim “moisture” caused delay until years after it was declared to be in default. And the builder had no contemporaneous documentation that indicated moisture issues actually impacted performance. On this record, the court rejected the force majeure defense as untimely and unsupported. 

These examples confirm that a force majeure defense begins (and often ends) with the contract. Words matter. If a force majeure provision is in play, parties need to claim it and meticulously and contemporaneously document the impact. And parties should take great care to ensure their documentation harmonizes with the force majeure provision at issue.    

Impracticability/Commercial Frustration

“Impracticability” or commercial frustration is another defense that may relieve contract performance. Under this defense, although performance remains technically possible, some unexpected event makes it “impracticable.” Article 2 of North Carolina’s Uniform Commercial Code, which governs the sale of goods, offers significant protections to sellers who cannot deliver their goods or otherwise perform because of the pandemic. Unless the contract says otherwise, a seller’s obligation can be relieved if performance is rendered “impracticable” by one of two things:

  1. The occurrence of a contingency the contract assumed would not occur
    OR
  2. Compliance in good faith with a government regulation or order that impacts performance  N.C.Gen.Stat 25-2-615

For contracts not involving goods — typically contracts for services — the same concept applies, but is referred to as “frustration of purpose” or “commercial frustration.” When an unforeseen event not caused by the parties or specified in the contract destroys the expected value of performance, performance may be forgiven. Of course, if the contract has a force majeure provision that covers the situation, this defense may not apply. 

A party asserting commercial frustration as a defense must establish three things:

  • There was an implied term in the contract that a changed condition would excuse performance
  • The changed condition results in a failure of consideration or the expected value of the performance
    AND
  • The changed condition was not reasonably foreseeable

This defense is often asserted, but rarely successful. This is because most commercial contracts — often through force majeure clauses — allocate risk and specify remedies to account for unpredictable events. A good example is the above case in which the tenant lost its law school accreditation. The tenant argued that continued operation as a law school was an implied assumption in the contract. The North Carolina Business Court disagreed. Scrutinizing the lease, the court pointed out that the tenant was not required to operate as a law school — it could operate any number of businesses from the leased space. Thus, the court concluded, continued operation as a law school was not an implied condition, or assumption, in the contract. The defense, therefore, did not apply.

Diverted supply chains, manufacturing delays, shifting customer demands and other pandemic impacts will surely test the limits of the commercial frustration defense in the coming months. Should these disputes ever reach a jury, we expect there to be sympathy for businesses forced out of operation. Again, however, the starting point for this analysis is the contract itself. Parties need to be thoughtful about when and how they claim performance has been frustrated. And considering the likely appeal to and resonance with a jury, litigants facing this defense would be well-served to ensure their documentation is complete and leaves no doubt about how the pandemic, stay-at-home orders and other developments have affected performance.

Impossibility of Performance

In contrast to the impracticability defense in which performance is technically possible, impossibility of performance applies where the subject matter of the contract itself is destroyed, such that no one could perform. This defense is most commonly asserted (with success) where the contract calls for the purchase or sale of an item that is destroyed before the exchange. You can no longer sell a house destroyed by fire, for example; and you cannot continue to lease space demolished by a flood. Like its cousin impracticability, this defense applies only if the “impossibility” is caused by something outside the control of the party seeking to be excused from performance and only if the contract does not allocate risk associated with the disastrous event.

The following cases are examples in which parties in North Carolina Courts have successfully invoked the “impossibility” defense:

  • In a 1914 case, North Carolina’s Supreme Court confirmed an impossibility defense. The dispute involved a ship that was destroyed by an accidental fire and the contract clearly contemplated its continued existence for performance. The court ruled that performance was impossible, and the parties were relieved of their obligations. Steamboat Co. v. Transportation Co., 166 N.C. 582 (1914). 
  • In a more recent case, performance was rendered impossible when a leased tractor was destroyed, and rent had been paid in advance. The renting party was entitled to return of the pro rata share of annual rent he paid in advance. 

A mandated shutdown seems to present an easy question on impossibility, at least while the shutdown is in effect. Assuming your contract does not account for this situation, a government-mandated stoppage probably would forgive time-sensitive performance. But, as stay-at-home orders are lifted and businesses reopen, the impossibility defense becomes less and less relevant. Although new workplace environments certainly will affect performance, pre-pandemic cases make clear that increases in the cost or difficulty of performance — even if dramatic — do not render performance impossible.

We expect courts and juries will be more receptive to pandemic-related impossibility defenses. Past cases show the difficulty of establishing that performance is impossible especially where the subject of the contract hasn’t been destroyed. For example, in this case, a party tried to get out of its contract to install a septic tank when it later learned that it needed a proper contractor’s license to perform. It argued performance was impossible. The court rejected the defense for a number of reasons, including that the contract did not prohibit the contractor from hiring a licensed subcontractor to do the work. The court went on to explain the settled principle that merely miscalculating the cost of performance or a change in the degree of difficulty or expense due to causes such as increased wages, raw material prices or construction costs does not make performance impossible. This case confirms the difficulty that parties will face using impossibility as a defense to performance. 

A final, practical note on impossibility: Parties cannot simply walk away from the deal because performance is impossible. Consider a situation where one party performed some of its obligations before the pandemic and the other enjoyed the benefit of that partial performance. North Carolina law includes remedies such as unjust enrichment and quantum meruit to ensure that when performance becomes impossible, one party does not unfairly benefit at the expense of the other. The party that enjoys the benefit of the other’s partial performance has to pay for it.

Takeaways

North Carolina Courts will hold parties to the terms of their contracts, so if you are evaluating options, start there. Then, with your contract language and the above defenses in mind, carefully consider asserting your contractual rights (e.g. claiming force majeure) and document performance impacts consistent with these principles and the terms of your contract. Finally, as you look ahead, you may want to consider business interruption coverage. You can find a brief overview of business interruption claims in North Carolina here. Insurance companies will no doubt account for potential pandemics, stay-at-home orders and virus-precipitated stoppages, so businesses should investigate this. And when it comes time to contract — with customers and your insurer — do not overlook the fine print. As the current reality has shown, thoughtfully drafted force majeure clauses and similar provisions (e.g. refundability of deposits, payment for partial performance, etc.) can greatly improve your position in future disputes.