Miller Barondess Client Alert: Equitable Doctrines of Contract Performance in a Pandemic

Miller Barondess Client Alert: Equitable Doctrines of Contract Performance in a Pandemic

As of this writing, nearly a third of the world’s population is locked down in an effort to combat the spread of the COVID-19 virus.  Countless commercial arrangements have already been disrupted by the pandemic.  Businesses should examine whether equitable doctrines of contract law may excuse performance under certain contracts.

Impossibility & Impracticability

Contract law has long recognized the equitable doctrines of “impossibility” or “impracticability.”[1]  The impossibility/impracticability doctrines require (1) an unforeseeable event[2], (2) that is not caused by the non-performing party, and (3) that causes performance to become objectively or practically impossible.  Impossibility and impracticability have become somewhat synonymous in California.[3]

Miller Barondess successfully obtained a preliminary injunction preventing a lender from foreclosing on a large condominium project based on impossibility of performance due to the economic crisis of 2008.  In that case, our firm represented a real estate developer who had contracted with a lender to develop a condominium building and to sell a certain number of units at a minimum sales price.  There was no dispute that the developer breached the contract by failing to sell the required number of units.  As a result, the lender sought to foreclose on the property.

Miller Barondess filed a motion to enjoin the sale, arguing that the unprecedented credit crisis had rendered sale of the units impossible.  The arbitrator agreed, citing Federal Reserve Chairman Alan Greenspan’s testimony to Congress that “[w]e are in the midst of a once-in-a-century credit tsunami” as evidence that (1) the economic crisis and credit freeze were not foreseeable and (2) that the developer was excused from performance under the contract.

Multiple “stay-at-home” orders are currently in effect in California.  Many businesses may be able to use these equitable doctrines to argue that the pandemic has rendered performance under their contracts impossible or impracticable.  Bars, movie theaters, gyms, office buildings and most retail stores, for example, have been mandatorily shuttered, thereby making their business operations impossible.

These doctrines likely have wide applicability given the unprecedented nature of the pandemic.  Parties could point to statements from the World Health Organization Director-General that “[w]e are in unchartered territory” and that the world has “never before seen a respiratory pathogen” like COVID-19 as evidence in support of arguments to be relieved of contractual performance under the impossibility/impracticability doctrines.

Events that render performance excessively or unreasonably expensive can also trigger the impracticability defense.[4]  However, these doctrines generally cannot be invoked where circumstances have caused performance to become merely unprofitable or financially burdensome.  The Court of Appeal has held that “[f]acts which may make performance more difficult or costly than contemplated when the agreement was executed do not constitute impossibility.”[5]

In short, the impossibility and impracticability doctrines offer potentially strong defenses for parties whose business operations have been significantly impaired by the pandemic.

Temporary Commercial Impracticability

California also recognizes the doctrine of temporary commercial impracticability.[6]  This is a potentially powerful defense that applies where a temporary impracticability suspends a party’s duty to perform until performance is again possible.[7]

In practice, temporary commercial impracticability excuses performance until circumstances have changed, plus a reasonable time afterwards.[8]  Accordingly, even if businesses are experiencing temporary disruptions due to COVID-19, they may be able to assert a temporary commercial impracticability defense if circumstances appear likely to allow performance in the future.  Examples could be suspension of rent or loan payments, delivery of goods, or total suspension of business activity during California’s temporary shutdown orders.

Frustration of Purpose

Frustration of purpose is another equitable doctrine which focuses on whether the triggering event obviates the purpose of the contract.[9]  Put differently, frustration of purpose occurs where “a change in circumstances makes one party’s performance virtually worthless to the other, frustrating his purpose in making the contract.”[10]

Accordingly, under California law, courts may apply frustration of purpose where (1) a supervening event has frustrated the fundamental reason of both parties for entering the contract; (2) the event was of a nature not reasonably foreseeable to the parties; (3) the frustration is so severe as to not fairly be regarded as within the risks of the contract; and (4) the event substantially or totally destroys the value of counter-performance to the party seeking to be excused.[11]

For example, a business that contracted to rent neon signs to advertise itself at night was relieved of its obligation to pay for the signs after the federal government ordered all lights out between sunset and sunrise during World War II.  There the Court of Appeal held that the government’s wartime order had entirely “frustrated the desired object or effect to be obtained”, namely illumination and advertising of the business at night and thus the business was excused from performance.[12]

Typically, the party seeking to invoke frustration of purpose faces three hurdles.  First, courts interpret a party’s “purpose” broadly, so that the mere fact that an event has prevented a party from enjoying the expected benefits of the contract may be insufficient. [13]

Second, like force majeure and impossibility/impracticability, the purpose must be almost entirely frustrated—a transaction that  becomes merely unprofitable will be insufficient.[14] [15]

Third, the application of frustration of purpose, like the other equitable doctrines discussed above, is subject to a foreseeability requirement, i.e. whether the superseding event was reasonably foreseeable at the time of contracting.  Courts address this requirement on a case-by-case basis as it is highly fact-dependent.

As the Court of Appeal noted, “[t]he question in cases involving frustration is whether the equities of the case, considered in the light of sound public policy, require placing the risk of a disruption or complete destruction of the contract equilibrium on defendant or plaintiff under the circumstances of a given case . . .”[16]

Conclusion

In assessing whether these equitable doctrines apply, businesses should consider the following:

  • Analyze (1) whether your particular circumstances could excuse you or the other party’s obligation to perform under the foregoing doctrines; (2) whether and how notice should be or was given regarding failure to perform; and (3) what obligations remain and what obligations may be excused by the other party’s failure to perform.
  • Provide prompt notice—a party seeking excusal from performance under force majeure, impracticability, or frustration of purpose should provide timely notice to the other party of their non-performance. Notice requirements are also often specified in the contract.
  • Take all steps reasonably practicable to mitigate or reduce the disruption of COVID-19 on performance. Alternative performances should be considered in light of their relative burdens and costs.
  • Timing is key—was the contract entered into before or after declaration of the pandemic?[17] In general, contracts with force majeure clauses signed in the midst of the pandemic are less likely to be enforced.  Parties that entered contracts beginning in January 2020 have stronger arguments that the pandemic was reasonably foreseeable at the time of contracting.
  • Determine whether potential insurance coverage is available, such as business interruption insurance.

[1] The Restatement (Second) of Contracts section 261 states: “Where, after a contract is made, a party’s performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary.” See also 17A Am. Jur. 2d Contracts § 643 (defining impossibility as “not only strict impossibility but impracticability because of extreme and unreasonable difficulty, expense, injury or loss involved. . . . extreme impracticability of performance may properly be regarded as having the same effect as strict impossibility of performance,” and performance is impossible when “it can only be done at an excessive and unreasonable cost, for which the parties had not bargained.”

[2] California case law on impossibility mandates that the condition making performance impossible could not reasonably have been anticipated, foreseen or contemplated by the parties at the time of contract execution.  Ellison v. City of San Buenaventura, 48 Cal. App. 3d 952, 962 (1975).  Thus the defense will rise or fall under the analysis discussed for force majeure clauses.

[3] Kennedy v. Reece, 225 Cal. App. 2d 717, 724 (1964) (explaining the expansion of “impossibility” as a defense to include “impracticability”, emphasizing that performance does not have to be literally impossible)..

[4] Habitat Trust for Wildlife, Inc. v. City of Rancho Cucamonga, 175 Cal. App. 4th 1306, 1336 (Cal. Ct. App. 2009).

[5] Glendale Fed. Sav. & Loan Assn. v. Marina View Heights Dev. Co. 66 Cal. App. 3d 101, 154 (1977); see also Kashmiri v. Regents of Univ. of California, 156 Cal. App. 4th 809, 839 (2007) (holding that generally “economic crises do not excuse performance on a contract”).

[6] Autry v. Republic Prods., 30 Cal. 2d 144, 149 (1947).

[7] See Maudlin v. Pacific Decision Sciences Corp., 137 Cal. App. 4th 1001, 1017 (2006); G.W. Andersen Construction Co. v. Mars Sales, 164 Cal. App. 3d 326, 334 (1985).

[8] Restatement (Second) of Contracts § 269 (1981).

[9] Waegemann v. Montgomery Ward & Co., Inc., 713 F.2d 452, 454 (9th Cir. 1983); Fed Leasing Consultants, Inc. v. Mitchell Lipsett Co., 85 Cal. App. 3d Supp. 44, 47 (1978).

[10] Restatement (Second) of Contracts § 265, comment a. (1981).

[11] Peoplesoft U.S.A., Inc. v. Softeck, Inc., 227 F. Supp. 2d 1116, 1119 (N.D. Cal. 2002) (collecting cases).

[12] 20th Century Lites, Inc. v. Goodman, 64 Cal. App. 2d Supp. 938, 943-944 (1944).

[13] Dorn v. Goetz, 85 Cal. App. 2d 407 (1948).

[14] E. Allan Farnsworth & Zachary Wolfe, Farnsworth on Contracts § 9.09 (4th ed 2019).

[15] Rembrandt Enterprises, Inc. v. Dahmes Stainless, Inc., 2017 WL 3929308, at *9 (N.D. Iowa Sept. 7, 2017) (holding that determination of when the contract’s purpose was frustrated, i.e. “when the outbreak of Avian Flu occurred?” or when “[plaintiff]’s board decided not to go forward?” or when one of plaintiff’s customers “decided to reduce its dependence on [plaintiff]’s products?” or “when [plaintiff]’s financing collapsed?” presented issues of fact sufficient to deny summary judgment on frustration of purpose grounds).

[16] Dorn v. Goetz, 85 Cal. App. 2d 407, 412 (1948).

[17] The World Health Organization issued its first guidance on the novel coronavirus on January 10, 2020 and declared it a global pandemic on March 11, 2020.