by Brodie H. Smith. *The views expressed herein are those of the Author(s). They do not necessarily represent the views of the Orange County Lawyer magazine, the Orange County Bar Association, The Orange County Bar Association Charitable Fund, or their staffs, contributors, or advertisers. All legal and other issues must be independently researched.
This article was first published as “Beyond Force Majeure and Frustration of Purpose: How Else to Defend a Contract Claim Based on the COVID-19 Pandemic,” by Brodie H. Smith, ORANGE COUNTY LAWYER MAGAZINE, June, 2020, Vol. 62, No. 6, p.32.
A flood of contract litigation is coming. Clients and prospective clients will be calling with questions about the COVID-19 pandemic and how it affects their contractual rights.
It’s difficult to conceive of the great quantity of contracts that have been or will be breached because of the COVID-19 pandemic and its halting of economic activity. If a single corporation is a “nexus of contracts”—as some economists view it—then the nation’s economy is an enormous network of interdependent contracts. Even under normal economic circumstances, the breach of one contract can beget another breach, as in a domino effect of breaches in a supply chain. Now much of the entire economic system is halted.
Many legal blog posts and articles about COVI-19 and contracts focus on force majeure clauses and frustration of purpose. Force majeure may indeed be the first concept that comes to mind when lawyers think of the legal effects of this pandemic, but many contracts do not contain force majeure clauses. What do we do with these contracts? What if the force majeure argument doesn’t carry the day?
Impossibility and Illegality: Do stay-at-home orders render performance impossible or illegal?
Traditionally, courts in this country have closely guarded the impossibility defense, worried that, without clear limits, every contracting party looking for an excuse might claim it was “impossible” to perform. The traditional view limited the impossibility defense to three scenarios: death, destruction, and illegality.See Restatement Second, Contracts § 261.
In the first two instances, if either someone or something essential to performance either died or was destroyed, respectively—and no other person or thing can be substituted—the defaulting party could credibly claim impossibility. Here, unless an essential party died from COVID-19, these defenses aren’t likely to apply.
The third traditional type of impossibility is when an essential act required for performance has been made illegal. Most states, including California, also recognize the separate contract defense of illegality, which holds that a contract will not be enforced if its purpose is illegal or if it is found to be against public policy. Kashani v. Tsann Kuen China Enter. Co., 118 Cal. App. 4th 531, 532 (2004). The distinction then lies in the purpose of the contract: is the goal of the contact to achieve an illegal result, intentionally or not, or does the contract merely require an illegal action in order to achieve an otherwise legal goal? The former evokes the classic illegality defense; the latter, the impossibility defense based on illegality. The difference, however, is largely academic—courts often deal with them in the same breath. Id.
Consider then how these two defenses are primed for a massive surge under COVID-19, with its various stay-at-home orders. How many contracts can’t be performed unless one or more parties has the basic ability to, say, leave their home? The simple act of leaving one’s home on a non-essential errand has been rendered, arguably, “illegal” under some of the state and local stay-at-home orders.
Effect of Various Emergency Orders
The wave of emergency governmental orders issued at federal, state, and local levels beginning in March 2020 were designed to stop the spread of COVID-19. Some were more narrowly focused on particular problems arising from the pandemic: eviction moratoriums and anti-hoarding laws, for example. Others, like the stay-at-home orders, were perhaps unprecedented in their breadth.
Consider the California governor’s stay-at-home order. On March 19, Governor Newsom issued Executive Order N-33-20, widely referred to as a stay-at-home order. The question may become, does this order truly prohibit non-essential workers from leaving their homes, or is it merely an unenforceable recommendation?
The Order itself certainly reads as mandatory: “I . . . order all individuals living in the state of California to stay at home or at their personal residence . . . [except for essential tasks].” The Order also derives its authority from California Government Code section 8567, which requires that, when a state of emergency is declared, the governor’s orders “shall have the force and effect of law.” Violation of the Order is punishable as a misdemeanor and subject to fines of up to $1,000, under Government Code section 8665. The Order, then, seems truly to make it “illegal” to leave one’s home –of course with broad exceptions.
The real fight may be in the exceptions, which threaten to swallow the Order. The Order explains that the federal government has identified sixteen “critical infrastructure sectors” and that people “essential” to these sectors are excluded from the Order. It cross-references a U.S. Department of Homeland Security (DHS) web page which details these sixteen “sectors.” The problem is that these sixteen sectors were drafted with a hypothetical national emergency in mind, not necessarily a disease pandemic. Although the page has been updated in the wake of COVID-19, problems persist.
One of the identified essential sectors to be excluded from the stay-at-home order is the “Commercial Facilities Sector” which includes, incredibly, “theme and amusement parks, fairs, campgrounds, parades . . . arenas, stadiums . . . [and] shopping malls.”
On the face of the DHS web page, the sixteen essential sectors have been tailored to the current pandemic, and yet some of the sector definitions remain preposterously un-pandemic-friendly. Certainly, the governor didn’t intend to make such broad exceptions to the Order as to allow gatherings at theme parks and parades! We know, for instance, that California closed all campgrounds as of March 17—two days before the Order. Such is the unartful incorporation of “essential sectors” written before the COVID-19 pandemic and not sufficiently updated—which is perhaps forgivable under the circumstances of a pandemic that required a certain amount of haste. But the Order’s cross-referencing to a federal web page has created an interpretational quandary which might well become the center of any litigation based on illegality/impossibility contract defenses in the wake of COVID-19.
Adding still more confusion, the federal guidelines incorporated into the Order state, in their own FAQ’s, that the sector definitions are “guidance . . . [that is] not binding and is primarily a decisional support tool to assist state and local officials.” It remains to be determined what the effect is of incorporating explicitly non-binding “guidance” into a binding Order. There is no clear answer and it may be an issue for the courts to decide.
In many states, only the doctrine of impossibility was recognized at common law. In those states, if you wished to access the related doctrine of impracticability, you needed to invoke the UCC, where contracts must involve the sale of goods or services.
California took a different tact, merging the concert of impracticability into common law impossibility—it became, in essence, a sub-species of impossibility. Vernon v. Los Angeles, 45 Cal. 2d 710 (1955). In this state, the courts said that impossibility need not mean literal impossibility but could also mean “impracticability due to excessive and unreasonable expense.” Id. at 717. “Excessive and unreasonable expense” also happens to match closely with the UCC concept of impracticability. The doctrines were thus merged at common law, and impracticability ceased to be limited to UCC contracts in California.
There are many ways contract performance may have become impracticable because of the COVID-19 pandemic. Suddenly the cost of labor has increased for many essential businesses because of hazard pay—whether voluntarily paid or forced. A business that bid a contract assuming certain costs of labor may be facing substantial losses under the contract if the business performs despite increased labor costs due to hazard pay. Does that render performance impracticable? Since there is no standard rate for hazard pay, it depends whether this increased cost is deemed “excessive and unreasonable” and whether this increase would have been foreseeable at the outset of the contract (more on that below).
In some cases, the hazard pay will have been voluntary because the employer felt it was the “right thing to do.” Yet, opponents will claim that any voluntarily encountered cost disqualifies the employer from claiming impracticability. After all, a prerequisite of impracticability is that the condition rendering performance impracticable be outside the parties’ control. On the other hand, courts would have to consider whether to endorse a policy which would create a disincentive for employers to pay their employees hazard pay under circumstances which deserve it.
Labor costs aren’t the only increased costs for many businesses. Costs of many materials are increasing. Your client’s business model may depend on the purchasing of a material that is suddenly subject to cost spikes from increased demand, price gouging, or indirectly from increased labor costs to the supplier—all due to the COVID-19 pandemic. These increased costs may render your clients’ contracts, suddenly, onerous and burdensome to perform. Whether these increased costs allow a non-performing party to avail itself of the impossibility/impracticability defense is likely a matter of degree. Naturally, not all cost increases will qualify as “excessive and unreasonable.”
The impossibility and impracticability defenses assume the contract was entered into before the triggering change of circumstances, in this case, COVID-19. These defenses require, as a threshold issue, that the conditions making performance impossible or impracticable were absent at the time of contracting—or at the very least, were not known to the parties.
Many contracts, of course, have been entered into after coronavirus news reports began spreading widely in January and February, 2020—largely about outbreaks in other countries—but before stay-at-home orders in the United States. Is a party asserting the impossibility defense safe as long as the stay-at-home orders had not been issued at the time of contracting? Or will courts determine that the contracting parties could have reasonably anticipated the “impossible/impracticable” circumstances? We don’t know the answers to these questions yet because there aren’t any known cases on point. The mere consideration of this question, however, might inform how litigators use the impossibility defense. If you employ the traditional impossibility basis of illegality, your client may be better positioned to withstand challenges based on foreseeability.
Statutory Force Majeure
If the subject contract does not contain a force majeure clause, it does not mean you are completely prevented from invoking this defense—at least with contracts under California law. California, in essence, recognizes statutory force majeure. Civil Code section 1511(2) provides that contractual performance is excused where performance is prevented or delayed by an “irresistible, superhuman cause.” Case law interpreting this largely deals with weather-related events—often in the crop-destruction context—turning on whether a climactic event was foreseeable from historical precipitation levels, or unprecedented and therefore excusable. Dufour v. Henry J. Kaiser Co., 215 Cal. App. 2d 26 (1963).
Where Do We Go From Here?
Some litigators are predicting a near term slow-down in litigation as budgets shrink with the economic contraction, followed by an explosion of litigation when the economy begins to recover and the fallout of so many broken contracts hits the courts. When that occurs, we need to look beyond contractual force majeure clauses and frustration of purpose.
Brodie H. Smith is a partner at Lanza & Smith in Irvine where he practices in business litigation with a focus on civil RICO. He can be reached at (949) 221-0490. Brodie would like to thank Anthony Lanza for his editorial input.
The information in this article does not constitute legal advice, nor create an attorney-client relationship. Laws constantly change, and this information may become outdated; moreover, the information here is only a limited and general overview and may omit some aspects of law. It is provided for discussion purposes only; not to be relied upon in making real-world decisions.