In the current economic climate, many businesses will face the argument that contracts they rely on could not be performed because of disruptions caused by COVID-19. The party seeking to avoid the contractual obligation will either rely on a force majeure clause in the contract itself or resort to the doctrine of frustration.
This article summarizes the core information you need to understand these arguments, and offers practical advice on the steps you or your clients can take to either claim under business interruption insurance, or assess, prosecute, and de-risk a claim for damages (or possibly both).
Essentially, there are three things you need to know.
1. Although the current circumstances are unprecedented, this does not mean that a force majeure clause or the doctrine of frustration will necessarily apply.
- Force majeure
A force majeure clause excuses a contracting party from performing its contractual obligations where an unexpected supervening event, beyond the control of either party, adversely impacts performance. Under Canadian common law, force majeure clauses can only be relied on if they are explicitly included in a contract. They are interpreted narrowly, and will only apply where the language in the clause clearly captures the triggering event.
In many cases, the contract will list specific events that will be deemed to trigger the clause. For example, language evoking epidemics, pandemics, and other terms for widespread disease are the most likely to apply to disruptions created by COVID-19. Language describing government actions that prevent performance would also be relevant, while the catch-all language sometimes included in such clauses might also be sufficient. When faced with such an argument, the first step is always to determine whether the contract includes a force majeure clause that is broad enough to cover the triggering event.
Even if the COVID-19 pandemic falls within the contract’s definition of force majeure, this does not end the inquiry. These factors must also be considered:
a) There must be a causal link. The party relying on the clause must still establish a substantial causal link between the force majeure event and the party’s failure to perform its contractual obligations.
The force majeure clause itself typically sets out the degree to which the event must impact performance for the clause to be triggered. This can vary from a higher standard requiring performance to be prevented by the triggering event to a lower standard requiring only that performance be hindered or delayed.
Where the degree of impact is not specified in the agreement, the higher threshold is typically applied such that the triggering event must make it virtually impossible to perform the contractual obligation.
b) The fact that a contract has become unprofitable or uneconomical is not sufficient. A triggering event that makes performance more expensive or unprofitable will not excuse a contracting party from contractual performance. If the obligation could be fulfilled at a greater cost, then a force majeure clause will not excuse a breach.
c) All notice requirements must be met. Many force majeure provisions contain strict notice requirements. Parties opposing the use of a force majeure clause should check whether the notice requirements in the contract were satisfied.
Finally, the effect of a force majeure clause will depend on the terms of the contract. Often, a force majeure clause will only suspend or partially excuse a party’s performance of a contractual obligation for the duration of the force majeure event, but not permit the termination of the contract itself. Other force majeure clauses will allow a party to terminate the contract if the triggering event lasts beyond a set amount of time.
If the contract does not contain a force majeure clause, or if the language of the clause does not capture the disruption caused by COVID-19, the party seeking to escape its contractual obligations will likely turn to the doctrine of frustration.
- Frustration of contract
The doctrine of frustration can be used to extinguish all contractual obligations if three things are established:
a) the existence of a supervening event that occurred through no fault of any of the contracting parties, and that was neither contemplated nor foreseeable by the parties at the time of contract;
b) the absence of a contractual provision regarding the unforeseen event; and
c) performance of the contract has become something radically different from what was undertaken. For example, where: (i) the frustrating event has rendered performance impossible, (ii) performance is possible, but the purpose for which one or more parties entered into the contract has been undermined, or (iii) it is temporarily impossible to perform the contract.
Where frustration is established, contractual obligations are deemed to have been extinguished as of the date the frustrating event occurred. While force majeure clauses might permit the temporary or partial suspension of contractual obligations, the doctrine of frustration extinguishes the contract in its entirety.
The threshold for establishing frustration is higher than the threshold for establishing force majeure. Like force majeure, it is insufficient for a party to establish that it has become more onerous or expensive to perform a contract as a result of a supervening event. To establish frustration, it must be positively unjust to hold the parties bound.
While the doctrine of frustration has been historically very difficult to establish under Canadian common law, the circumstances created by COVID-19 are unprecedented. Governmental orders made under a state of emergency for all non-essential businesses to close are circumstances that have never been tested by the Canadian courts. As a result, each case will require a careful analysis of the facts, including the business realities surrounding the contractual relationship, to determine whether performance of the contractual obligation was indeed impossible or just deemed prohibitively expensive.
2. You could have a claim for damages or for coverage under business interruption insurance.
- Lawsuit for damages
If a contract is breached, the party who did not breach the agreement still has to take reasonable steps to avoid or minimize the harm that results. If the harm cannot be avoided by reasonable action, and neither a force majeure clause nor the doctrine of frustration excuses the breach, then the innocent party has a claim for damages. The damages awarded will depend on the terms of the contract itself, but are typically an estimate of the lost profits that would have been earned had the contract been performed.
In assessing the value of your claim, it is essential to have a clear understanding of your financial position with and without the breach of contract. While your actual financial position should be readily determinable, your ‘but for the breach’ financial position will require careful analysis. The ‘but for’ results represent forecasts based upon reasonable and supported assumptions. Necessary assumptions include factors such as revenue growth rates, profit margins, and the availability of input materials and labour. In the current economic context, the visibility of such variables may be a challenge and your analysis will be closely scrutinized. An experienced litigation accountant can guide you through this process and prepare a report on your behalf.
- Business interruption insurance
You may also have financial recoveries available under your business insurance policy, such as business interruption or contingent business interruption coverage (an extension of business interruption coverage for disruption of suppliers or customers).
The analysis of loss for insurance claims purposes is similar to a damages analysis for litigation, but must conform to the provisions and wording of your insurance contract (for example, extra expense vs. incremental costs). Again, an accountant experienced in such matters can guide you through this process and prepare the necessary analysis.
In many cases, the business interruption coverage will not be sufficient to compensate for the entire loss. Where the difference is substantial, a claim for damages should also be considered. Such a claim must be assessed in conjunction with your (or your client’s) obligations under the insurance policy, as well as any subrogation rights of the insurer.
Regardless of your potential avenue for recovery, we recommend documenting all activities and costs related to COVID-19 disruptions. Creating a separate general ledger account (or series of general ledger accounts) will facilitate later analysis. Keeping an account of direct costs will help you readily identify the relevant expenses. At a minimum, having a ready accounting of your costs will give an advantage in preparing timely submissions for claims, including any government support programs that become available.
3. While commencing litigation is less attractive in times of economic uncertainty, products and services exist that can reduce the financial risk implicit in starting a lawsuit.
The evolving economic climate makes the financial risk associated with litigation that much less attractive, particularly if your business is already struggling. That is why it is important to be aware of products and services that can reduce, and even eliminate, this financial risk.
- Contingency fees, after the event (ATE) insurance, and litigation funding
A variety of products and services exist to reduce or even remove certain of the financial risks inherent in a claim for damages.
Alternative fee structures can be negotiated with your lawyer, including structures where the lawyer is paid out of the proceeds of any settlement or judgment. Commonly called a contingency fee, this kind of arrangement can take a variety of forms and typically sees the lawyer receive a negotiated percentage of the damages recovered.
ATE insurance can be purchased. It is a legal expenses insurance policy that protects the plaintiff against the risk of paying the defendant’s legal costs, and may also be extended to cover the plaintiff’s own disbursements, such as expert fees, upon an unsuccessful outcome.
Litigation funding can also be sought. Litigation funding (also called litigation finance) is the term used to describe the financing of lawsuits using capital raised by litigation funds for this purpose. Such funds are typically looking to finance all or part of the legal fees and costs associated with a lawsuit.
- De-risking lawsuits
All of these services and products have the common feature of shifting the financial risk associated with a lawsuit from the plaintiff to another party: the plaintiff’s lawyer, insurer, funder, or possibly all three.
Depending on the structure that is negotiated, the plaintiff can choose to transfer the financial risk associated with the legal fees and disbursements (including expert fees) required to pursue the lawsuit, as well as the costs award the plaintiff may owe the defendant if the lawsuit is lost. All of these services and products also have the common feature that the plaintiff’s lawyer, insurer, or funder is only compensated if the lawsuit succeeds, typically out of the proceeds of any settlement or judgment. None of these services and products require the plaintiff to give up control of the lawsuit. The plaintiff will still direct the lawsuit and make the decisions when instructing counsel, including about settlement.
Law firms that specialize in commercial litigation can help you assess your particular situation and, where appropriate, engage an insurance broker to assist you in identifying the best mix of solutions to mitigate the financial risk associated with starting a lawsuit. The willingness of a lawyer, insurer, or funder to take on the financial risk described above will depend on the perceived merit of the claim as well as the likelihood of collecting on the judgment should the claim succeed. Typically, the plaintiff will not be charged for this assessment and it can be a good litmus test of the merits of a lawsuit.
The process for applying for ATE insurance and litigation funding can take time—typically anywhere from two to four weeks for ATE insurance and six to 12 weeks for litigation funding. It is therefore wise to seek the assistance of experienced counsel as soon as possible, and long before any limitation period expires.
Your business demands your undivided attention during these turbulent times. Professional advisors and experts can provide much needed support and guidance in navigating uncharted waters. You should not be shy to ask for such assistance, as professional fees incurred in connection with preparing an insurance claim may be covered by your policy, while the expert fees incurred in prosecuting a civil claim for damages are recoverable from the defendant if the claim succeeds.
Robert Brush, Commercial Litigator, Partner, Crawley MacKewn Brush LLP
Alan Mak, Forensic Accountant and Chartered Business Valuator, Partner and National Forensics Practice Leader, BDO Canada LLP
Katie Armstrong, Litigation Risk Solutions Broker, Vice-President, Litigation Funding and Insurance, Marsh & McLennan Companies
Matthew Mann, Financial Institutions and Professional Services Practice Broker, Senior Vice President, Marsh & McLennan Companies