Supply Chain Coronavirus Impacts: Force Majeure and Beyond

How vulnerable is your supply chain?
The enterprise should first visualize the entire supply chain in which it participates. Your primary concern may be your immediate suppliers and service providers, and your immediate distributors and customers; those will be your direct sources and targets of communications. But the critical problem during such a global contingency may be more remote, like an essential precursor far upstream from your supplier, or far downstream with the ultimate purchaser of a finished item into which your customer incorporates your product or service. 

All contributions should be considered. Your key inputs may be raw materials, components, consumables and catalysts, or they could be vital spare or replacement parts. Even if the goods are available, the means of transportation to get them where they are needed may be impacted. Manufacturers, transporters and service providers may not be able to do their part in the process if employee health, safety or travel restrictions prevent their essential personnel from showing up for work.

The enterprise can then assess the present and potential vulnerability of the links in the chain to the virus and the responses. Elevated risk may be present with sole or limited supply sources, and with imports from high-risk regions. Inputs may be vulnerable where an enterprise is used to a frequent turnover of supplies, keeping minimal stock available, and import of those supplies now looks likely to be disrupted. Not many countries are likely to impose restrictions on movement as China has done, but it is not far-fetched to think that ports elsewhere may refuse to accept vessel arrivals or departures. Even when factories and ports in China and elsewhere come back online, they may take time to ramp back up because of curfews and reduced workforces.

Are changes in procurement and distribution strategy in order?
“Just in time” lean inventory practices have enhanced profitability, and perhaps reduced the duration of recent recessions. The outbreak suggests that modifications to those strategies may be in order.

Each enterprise should consider whether alternative sources of inputs or stockpiling are practical. Diversification of procurement across regions and suppliers may be worthwhile even if it adds cost and complexity. Business continuity plans can be put in place for particularly vulnerable sources.

Direct and candid communications with suppliers and customers may allow you to make alternative arrangements for products or outputs, and are better for long-term relationships than exclusively relying on or enforcing contractual rights. If your sources may not be able to perform, whether or not such a failure may be excused, it pays to explore relief with your own purchasers.

What are your contractual defences and exposures?
If there will likely be a shortfall of input or lack of offtake, it is worth reviewing your contracts to see what defences and remedies you may have. Identifying the applicable law is important, as English and U.S. legal principles differ from those in civil law jurisdictions.

In interpreting the parties’ obligations during occurrence of a contingency, courts and arbitrators will look first to the bargain that the parties made in fact, and then to the background doctrines that might excuse performance. For example, in the United States, the doctrine of impracticability applies to the “occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made” (Restatement of Contracts (Second) § 261; Uniform Commercial Code § 2-615 for sales of goods).

Evidence of which party assumed the risk of the occurrence will therefore be relevant, and in some cases parol evidence is admissible to assist in the interpretation of written contracts. U.S. law is rather restrictive on implied excuses for non-performance and English law even more so, however, so attention should initially be paid to the negotiated defences and remedies that are present in your contracts.

Specific clauses
If present, clauses providing for price escalators, options for reduced supply or purchase commitments, and general “hardship” circumstances would be the primary line of defence. Courts and arbitrators will look foremost to indications that one party or the other was allocated responsibility or flexibility for changed conditions.

Force majeure
A force majeure clause typically provides that a party is not in breach of its obligations, other than the payment of money, if performance of those obligations is prevented or delayed by the occurrence of a defined contingency. (Some clauses also provide relief if performance is “made significantly more expensive” as a result of the contingency. Others may be even broader, applying to cases where performance would create a hardship or would be “inadvisable.”)

The contract may provide an exclusive list of events or occurrences that qualify for relief from performance, or it may provide illustrations of any event that is outside the party’s reasonable control. Those event lists should be carefully read to determine if epidemics, quarantines, curfews and government recommendations are expressly referenced, and whether such occurrences in the relevant locations and time periods might qualify for other included terms.

One event commonly included in force majeure clauses and likely to be relied on with respect to coronavirus is the “government order.” As the coronavirus response evolves, what are now “advisories” and “warnings” may turn into government mandates that would strengthen the case for force majeure. The obligor’s duties as an employer to provide a safe workplace and related health and safety protections for employees may be cited.

Several force majeure analyses during the outbreak have referred to the designation by the UK government of coronavirus as a "notifiable disease", a formal classification required by many insurance policies. The UK National Health Service declared COVID-19 a level 4 incident, its highest level of emergency. These and similar government actions that have a mandatory character even under separate legal or regulatory regimes may be given weight for commercial contracts.

The clause may impose duties to provide prompt notice after the point when the party learned of the contingency. In the case of an evolving outbreak, that point may be obscure, so early notice may be in order. There are expressly or implicitly duties to mitigate the impact and to resume performance (with or without a duty to make up lost quantities). And sometimes the other party ultimately has a termination right for extended force majeure.

Many jurisdictions construe force majeure clauses strictly and require the party hoping to rely on the clause to demonstrate that it is entitled to relief. See our recent client alert by James Campbell and April Lord for a detailed application of English law principles to coronavirus.

In the United States, an unforeseeability requirement is not typically read into a clause that does not expressly require it; this is a core advantage of an express force majeure clause over the background rules for impracticability. Nonetheless, there have been so many actual and threatened interruptions in 21st century supply, particularly from China—from SARS and H1N1 to trade disputes and sanctions—that U.S. courts and arbitrators will be attentive to whether there is any reason to think the parties allocated the risk in one direction or the other.

Impossibility, and frustration of purpose
Many of the current disturbances in the supply chain may not be instances where performance of obligations is prevented. It would be possible for an LNG purchaser to take delivery; the complaint is that there is a substantially diminished demand for natural gas in the aftermarket. Absent further clarity in the clause itself, a force majeure declaration without a prevention of performance may be of limited effect.

The doctrine of frustration in U.S. law may apply where performance is physically possible but the “principal” economic purpose of the transaction is substantially frustrated (Restatement of Contracts (Second) § 265). But in general, “the frustration must be so severe that it is not fairly to be regarded as within the risks that [the obligor] assumed under the contract” (comment a). 

In English law, the doctrine may allow a contract to be discharged where an event arising after the entry into the contract renders it impossible to perform, or makes the obligation to perform radically different than that which was envisaged, through no fault of either of the parties. This doctrine might apply where the goods to be supplied were contemplated by both parties to come from a particular country or region, but there are no longer any goods of that type available from that location.

Anticipatory breach, and demand of adequate assurance
In general, being able to take action against a counterparty requires actual non-performance, unless the conditions for “anticipatory breach” are established. In the United States, a party to an instalment or long-term contract for sale of goods may demand adequate assurance of due performance if it has “reasonable grounds for insecurity” whether its counterparty will perform. If the assurance is not provided, the party may be entitled to terminate the remainder of the contract and secure supplies from other sources (Uniform Commercial Code, § 2-609). Under English law, where a party indicates by its words or conduct that it definitively will not perform its obligations under or in accordance with a contract, the other party may accept the breach and choose to no longer be bound.

What steps should be taken to utilise contractual solutions?
After sizing up the supply chain vulnerabilities and the contract defences and exposures, a party in a stressed supply chain can be expected to manage the following tasks:

• Draft or respond to declarations of force majeure, notices of default, and demands for adequate assurance of due performance.
• If you declare force majeure or give notice of default, consider what evidence will best support your position. It could well be that additional ammunition for a force majeure declaration (e.g., government mandates) will develop after the notice is issued. Conversely, the resumption of manufacture or shipment may end the force majeure condition or bolster a claim for breach.
• Maintain records of any communication with your counterparty, whether for force majeure, breach or adequate assurance.
• Develop or respond to policies of allocation of shortfalls. The constrained seller, whether under force majeure or in conditions of potential breach, is afforded deference in its allocation method, so long as it is consistent, “fair and reasonable” (Cliffstar Corp. v. Riverbend Products Inc., 750 F.Supp. 81 (W.D.N.Y. 1990)). Disputes have arisen over how a seller allocates to its own needs or those of its affiliates along with outsiders, and over the treatment of customers that are long-time purchasers (versus recent arrivals) or committed-quantity purchasers (versus spot buyers).
• If you have considered inputs and outputs and there are reasons to believe that these will be affected, consider what impact this may have on your liquidity. Companies with constrained cashflow may be susceptible to unreasonable counterparty demands.
• Consider the impact on marketing and sales activities. France and Switzerland have banned public indoor events with more than 5,000 and 1,000 people respectively, and other countries may follow suit if infection becomes more widespread. Flights have been cancelled to save costs, and moving round the world may become harder while the spread of COVID-19 continues. If your business is reliant on conferences or mass selling events, it is worth considering other approaches and contingency plans if events must be cancelled.
• Monitor electronic communications and shared supplier and customer information systems for cybersecurity protection.
• Review a comprehensive checklist of insurance policies that may be responsive if your company faces interruption to its business.  

Communications are key.
Above all, an enterprise should communicate accurately, consistently and frequently with customers, distributors, and suppliers—and with employees, lenders, and investors.

In general, a party to a commercial transaction does not need to speculate, predict or guarantee the future. However, its comments should be in line with what is known at any given time, and open dialogue may help to avoid or mitigate the supply chain risks that are identified. The outbreak and the responses are evolving so rapidly that most communications should be expressly based on the state of knowledge on the day and at the hour they are issued.