The force of force majeure in a pandemic world
By Susana Garcia-Robles, Venture Partner, Capria Ventures – Face masks and frequent hand-washing are the new routine. But how can a company be safer in the new normal? “Good contractual hygiene,” says Joe Wallin, principal at Seattle-based Carney Badley Spellman. In particular, companies should be sure to understand – and where possible, standardise – force majeure language across all their legal contracts.
Wallin, and attorneys like him that work with venture stage companies, point to the same disturbing pattern. “I talked to someone who reviewed 200 [force majeure clauses] and he didn’t find the word ‘pandemic’ once”, he says. With legal agreements put to the test by Covid-19, founders “rushed to look at their contracts and tried to figure out whether they must continue performance of the contract,” adds Leon Yee, chairman and managing director of Singapore-based Duane Morris & Selvam LLP.
What specific protective measures should you take; whether you’re a fund manager, board member, or investor? Capria deliberated with some legal and industry experts on this topic recently.
Force majeure and Covid-19
Let’s take a moment to review force majeure. Force majeure clauses deal with situations beyond the control of any party. So in a tenancy agreement for example, force majeure would cover destruction of the leased premises by fire.
The language of force majeure varies widely by contract and parties who can “define for themselves not only what constitutes a force majeure but also what remedy and relief is available,” notes Elliot Copenhaver, commercial litigator at Seattle-based Carney Badley Spellman. “We’ve seen a lot of litigation involving existing contracts and force majeure provisions,” he adds. And parties want to know: is the pandemic sufficient to declare force majeure? Can the contract be terminated? And how are financial obligations going to be resolved and allocated?
Sometimes crucial language is not labeled force majeure. Copenhaver recently handled a case that didn’t have a force majeure clause. In this contract to hold a conference at a convention facility, termination for cause included “the inability to travel or host 100+ person conferences”. Because of recent governmental actions restricting travel and gatherings, there were legal grounds for termination. And so one party did just that.
The term “governmental action” is frequently included in the definition of force majeure. And the case above raises this question: could governmental action taken to prevent a pandemic trigger force majeure, despite no subsequent outbreak of disease or pandemic? Copenhaver suggests it does seem possible.
Yet Copenhaver warns of extrapolating too far. And when interpreting force majeure language similar to “and other such occurrences”, you need to be really careful. Courts treat this language more narrowly than a layperson might expect, he says. “So if it says ‘earthquakes, fires, acts of war and other such occurrences’, that’s not necessarily going to include pandemics,” says Copenhaver.
In some cases, even though both parties agree the event constitutes force majeure, neither can terminate or walk away. Copenhaver recently worked on a commercial lease where Covid-19 fell within force majeure, simply because force majeure was very broadly defined. But the only relief was a maximum 60-day extension to complete construction of an office building. And that can be hardship on construction companies if the pandemic hinders their ability to complete the job without substantial additional costs.
Material Adverse Change and Covid-19
Sometimes deal-breaking language appears in the Material Adverse Change (MAC) clause. Often in transactional documents, MAC clauses protect investors from unforeseen events that diminish the value of an investment after agreeing to purchase terms but prior to funding.
An important question to ask is “what is material”? The threshold of materiality typically requires that any adverse change affect earnings (or the earnings power of the company) for a significant period of time. In other words, a short term hiccup in earnings won’t trigger MAC.
Courts typically interpret MAC clauses narrowly to deter investors from walking away. But what about Covid-19? Yee says it depends on “which sector the company is in”. He points to healthcare and groceries as good examples of where MAC could be invoked in the event of a second wave of COVID-19. “But in other sectors, framing the correct terms, [and] framing the correct numbers where you can walk away is really a question of negotiation.” And he warns that it’s important to define a set percentage change in revenue, or some other measurable and transparent metric tied to valuation.
Common law or civil law?
What really gets tricky are cross-border deals. “In countries subject to civil law, all the provisions regarding force majeure are included in the code and therefore they do not need to be included when drafting agreements,” says attorney Juan Pedeflous of the Inter-American Development Bank. “But in countries subject to common law, because they don’t normally have code, force majeure needs to be included in contracts”.
In other words, a contract without a force majeure clause is treated differently depending on jurisdiction. The pandemic would not be cause for termination under common law, unless specifically included in the contract. But “the pandemic would be a case of force majeure under civil law,” says Pedeflous, unless specifically excluded by the contract.
Sounds simple – different countries, different methods. But Pedeflous points to a case that can trip up even experienced attorneys. The case relates to financing, and involves a loan agreement subject to common law and a guarantee agreement under civil law. Despite the lack of force majeure language in either agreement, a pandemic would still trigger force majeure in the guarantee agreement because “the pandemic would be a case of force majeure under civil [code],” adds Pedeflous. So if the borrower chose to default on payment, the lender would still have no way to take possession of collateral or security.
To make things foggier, common law has some arcane elements of its own, says Copenhaver. Under common law, a body of theories (referred to as the doctrine of impracticability or impossibility in certain jurisdictions) can be applied when there is no force majeure clause. “No one really knows how that law will be applied to Covid-19,” he adds. And though the threshold can be high, he warns courts could decide certain contracts are impossible and permit parties to walk away.
MAC clauses are treated differently by jurisdiction as well. Common law will uphold MAC but courts will want to see evidence of a real adverse change in business which will affect long term earnings power. In contrast, under civil law some courts may ascertain the likely understanding of the parties and find what makes good commercial sense given the context of the transaction.
So what do the experts suggest you do? If you’re a fund manager, consider buying business disruption insurance that covers pandemics, and look at the cost-efficacy of having portfolio companies do the same. It’s also a good time to review contracts with your legal advisers to uncover previously-unforeseen risks. And if you have deals on the table, be aware now is not a good time to rush decisions. Ensure your deal team takes the time to look at local and international law and evaluate risks, as case law is evolving as you read this article. This evolution means you should also implement and/or update standard policies handling both force majeure and MAC clauses as well as jurisdiction language across all of your contracts.
Investors should include contingencies tied to the impacts of COVID-19. As an investor you should weigh using clawbacks or revised conversion ratios based on changes in valuation. And look harder at tranched investments and careful use of escrow accounts. And keep in mind no founder has seen a pandemic before 2020. Strange as it may sound, their charisma and wisdom is rooted in a past era, pre-new normal. So it’s important to challenge their analysis and assumptions and be sure you’re comfortable it’s right-sized in a pandemic world.
Remember the impacts of Covid-19 are new ground for everybody. The last pandemic of this magnitude was over 100 years ago. And unlike financial crises of recent memory, it may not be a question of when the other shoe drops but how much bigger, how many more, or what parts of the economy can even move forward if no more shoes drop. Yet fund managers, investors, board members, and general partners can take steps to protect themselves and their companies from the legal upheaval of Covid-19 and be safer in the new normal.