COVID-19: assessing your litigation risk
This article was authored by Rod Vaughan and was first published in LawNews, Issue 8, 27 March 2020.
The devastating health, social and economic impacts of COVID-19 are sowing the seeds of widespread litigation as businesses scramble to review contractual obligations, balance sheets, crisis management plans, and director and employee obligations.
When the dust settles, businesses, boards, individuals and even governments are likely to face a raft of lawsuits and/or prosecutions. As the effects of the virus begin to bite, how can companies and other organisations best protect themselves?
To gauge the litigation risk in this country, LawNews approached three of New Zealand’s largest law firms for an assessment of the likely legal landscape that lies ahead.
High on their action lists is to closely review the wording of force majeure (the so-called ‘Act of God’) clauses. Business continuity plans should be continually reviewed and updated and, above all, directors and executives should never lie – to employees, customers, suppliers, financiers or the government.
Contractual disputes about the applicability of force majeure clauses
“While the effects of COVID-19 are outside any contracting party’s control, whether or not a non-performing party can rely on a force majeure clause will depend on: its wording; the connection between COVID-19’s effects and the non-performance; whether there has been compliance with notice provisions before declaring force majeure; and the steps the non-performing party takes to mitigate or avoid non-performance,” the three said in a statement.
“As a force majeure clause may lead to termination rights, it seems inevitable that there will be disputes about the scope of such clauses, particularly between entities involved in supply chains.
“Where a contract lacks a force majeure clause or the event falls short of constituting force majeure, non-performing parties will also be assessing whether it is possible to assert that performance was impossible because the contract was frustrated.”
Potential claims against directors
“COVID-19 is plainly a headline issue for most, if not all, directors. “However, as with potential climate change claims, directors who fail to consider and respond to COVID-19 risks, causing harm to the company, could face claims that they breached reporting obligations and duties of care.
“Boards must therefore constantly assess the effect of COVID-19 on their business, rather than generally in the market.”
“The majority of business interruption insurance policies are likely to require physical damage to property, which may not have occurred, and contain exclusions relating to losses caused by infectious diseases.
“However, insureds will be reviewing their policies to assess whether they provide cover for loss arising from disruption caused by COVID-19, including in coverage extensions.
“For example, it may be possible to argue that COVID-19 contamination constitutes physical loss, but this will depend on the policy terms and exclusions.
“Some insureds will also be looking to other types of policies, such as event cancellation insurance, which may not exclude communicable/infectious disease-related losses.”
Disputes where a party avoids performance or terminates an agreement on the basis of a “material adverse change” (MAC)
“An MAC clause in a commercial agreement typically allows a party to avoid performance or to terminate an agreement.
“They can include different triggers, thresholds and exclusions and will need to be considered on a case-by-case basis.
“In the context of COVID-19, disputes may well arise in relation to the scope of the MAC clause and the timing of the specific trigger event.”
Practical steps entities can take to manage litigation risk
- Continually revise crisis management and business continuity plans. Test them.
- Proactively manage supply arrangements on an ongoing basis. Engage with suppliers on their ability to meet delivery commitments and their supply forecasts. Where necessary, consider alternatives.
- Review contractual obligations to customers and financial arrangements to assess potential issues and mitigation strategies early. This includes identifying notice requirements.
- Monitor disclosure obligations regularly. Constantly review the business’ financial position and consider whether statements need to be corrected, clarified or supplemented.
Directors must be honest and forthright. Once trust is lost, support for distressed businesses evaporates.
The application of force majeure clauses is also seen as a pivotal issue by David Friar and Simone Cooper of Bell Gully.
Friar and Cooper say the wording of the particular clause at issue will be critical in assessing whether it applies.
“The courts have said a party seeking to rely on such a clause faces a comparatively high hurdle.”
There are typically four key considerations in assessing whether a force majeure clause applies.
- Specified event: A force majeure clause often lists specific events that must occur for the clause to apply. Commonly specified events include natural disasters, wars and strikes. COVID-19 may be covered if the specified events include “disease” or similar. It arguably could be covered if one of the named events is an “Act of God”. In addition, COVID-19 could lead to travel or import/export restrictions that may qualify as “Acts of State” or “governmental restrictions”. Some clauses go further than a list of specific events, and generally apply to all events that “could not have been reasonably prevented by the affected party”. As a result, it is essential to closely review the relevant wording.
- Prevented performance: If there is a qualifying event, the clause will often require that event to have “prevented” performance by the affected party. This is a high standard. The courts have ruled that it is not enough for the event to have made performance more difficult or expensive. Instead, performance must be legally or physically impossible. Some force majeure clauses may have a different standard. For example, a clause may require the event to have “hindered”, “delayed” or “adversely affected” a party. These set a lower standard than “preventing” performance. This is an important distinction when considering the impact of business or travel restrictions that are officially recommended, but not legally required. Following self-quarantine and travel restrictions may be prudent and responsible, but that may not be enough to engage force majeure protections.
- Party’s control: Typically, the clause will require the failure to perform to be due to circumstances beyond the party’s control. If the clause is silent, the courts may read in this requirement.
- Mitigation: Finally, there must be nothing the party could reasonably have done to avoid or mitigate the event or its consequence.
Friar and Cooper say if the contract does not contain a force majeure clause, the common law doctrine of frustration may apply.
“It releases the parties from their contract where, by no fault of either party, an intervening event makes performance impossible or radically different than what the parties agreed.”
Examples of frustration include circumstances where:
- a change of law or government directive makes performance illegal;
- the subject matter of the contract is unavailable – for example, the person providing the services is permanently indisposed; and
- the purpose of the contract no longer exists – for example, the contract relates to an event that has been cancelled.
Friar and Cooper recommend that when reviewing a contract to assess the potential impact of COVID-19, consideration should also be given to a range of other clauses that may potentially be relevant.
Chapman Tripp has published on its website a series of articles on the legal implications of COVID-19. In one of them, Leading a company through a crisis – what will it take? the firm spells out some of the factors boards will need to consider.
“Even if New Zealand manages to contain COVID-19 as a health threat, it will be at huge economic cost. That trade-off is already obvious and is inescapable.
“We now know what the government and the Reserve Bank will do to try to nurse the economy through the crisis. But much will also depend on the foresight and leadership exerted through corporate boardrooms. “Most companies will seek to endure – to continue operations with a tight control on costs until economic activity returns to normal. This will mean entering discussions with their lenders to ensure they have working capital facilities available.
“But will responsible lenders and responsible boards allow a company to continually increase debt levels while incurring substantial losses? Will the banks themselves have sufficient liquidity?
“And even if they do, will the law allow directors to incur debt that the company may not be able to repay? At what point will increased borrowing become reckless trading (by directors) or reckless lending (by banks)?” So, what should directors do?
Forecast and monitor
“Because no one knows how long the epidemic will last, businesses need forecasts that look out three months, six months, nine months and a year. Prepare a low case, medium case and high case forecast for each time period and prepare a business plan based on each forecast.
“The board should carefully monitor the trading performance against each forecast. This will allow a board to determine if, and when, a company will run out of money in each scenario and how significantly operating cost reductions will affect that liquidity analysis.”
Subsidiaries and joint ventures matter too
“Typically, boards think on a consolidated basis and groups of companies operate on a cash pooling basis. But in times of distress, and in determining whether directors have complied with their directors’ duties, the law views company groups on an entity-by-entity basis.”
Directors will need to think about:
- whether a subsidiary should pay money to a parent to be used in another part of a group if it is at risk of not having sufficient cash available to meet its own liabilities; and
- whether the board wishes to continue to fund speculative subsidiaries or joint ventures.
Consider the spectrum
While the endurance approach may be the preferred plan, the company should work through the spectrum of options and carefully consider each of them.
This will include:
- whether shareholder support will be available;
- whether operational cost reductions can be implemented;
- whether government or industry support may be available; and
- whether your key stakeholders can provide any other form of assistance or relief.
Who are you reliant on?
“The board should consider whether the company is dependent on any key supplier, customer, joint venture partner or business partner and whether there are alternative options available should that supplier, customer, joint venture or business partner fail.
“The board should ensure the company engages with those key parties so it can understand and respond to any risk of failure.”
Analyse the balance sheet
“Operating cost reductions can be traumatic, time-consuming and slow to impact on cash flow (redundancy processes/winding down unprofitable operations). The reductions may also mean the business is poorly positioned to take advantage of the inevitable economic improvement.
“Restructuring financial obligations may prove to be more efficient and flexible. The company should consider its financial position with lenders, landlords, financiers and Inland Revenue. Financial creditors may be prepared to amend repayment terms, defer payments, switch to interest only etc. Implementation of these sorts of steps will have an immediate positive impact on liquidity.”
Tell the truth
“Desperate people do desperate things. Very often, directors and executives convicted in criminal prosecutions were acting to cover up something or to convey a false reality.
“Directors need to be honest and forthright with employees, customers, suppliers, financiers and the government. Once trust is lost, support for a distressed business evaporates.”
Restructure vs liquidation
“Some companies will lose too much revenue and have too much debt to survive. For the directors of those companies, the business might be saved in a new capital structure and/or a new corporate entity.
“There are several restructuring tools that can be used: debt can be forgiven, rescheduled or converted into equity. Sophisticated financial creditors understand that by giving a business the benefit of time they are likely to get a much better return than from immediate liquidation. Voluntary administration will provide a particularly useful tool for companies to obtain relief from their creditors while they restructure their balance sheets within a mandated timeframe.”