Lessons of the Pandemic – Potential Changes of Circumstances Subject to More Precise Consideration
The impacts of the COVID-19 pandemic began to be felt in our clients’ business early last year. We received a great deal of inquiries concerning the legal ramifications of the pandemic, including about how the pandemic might affect contractual relationships and obligations.
It was already apparent at the time that questions concerning the interpretation of force majeure clauses, impediments to performance of contractual obligations in general and the adjustment of contracts would be in the spotlight. One year on, that is exactly what happened. We have assisted clients in numerous assignments dealing with the above questions, ultimately in trials and arbitrations.
In this post, I share some of my observations based on the experiences of our Dispute Resolution service over the past year. I also go over what our experiences have shown should be taken into account in the future when assessing the impacts that the COVID-19 pandemic and other external changes in circumstances may have on contractual relationships. I discuss impediments to performance and force majeure clauses as well as the adjustment of contracts in light of the pandemic.
Contracts Assumed to be Binding Even in Changed Circumstances
Finnish contract law is built on the principle of pacta sunt servanda, which translates as ‘agreements must be kept’. This principle means that the contracting parties must fulfil their contractual obligations. Ultimately, obligations can be enforced through execution based on a court judgment or arbitral award. Failing to fulfil a contractual obligation also generally leads to an obligation to compensate the damage caused to the other contracting party.
The strong main rule is that the contents of an agreement—i.e. the rights and obligations set out in the contract—are determined at the time the contract is concluded and that the contract remains binding even in changed circumstances.
Despite this main rule, the current pandemic or other changes in circumstances can, under certain exceptional conditions, affect the obligations of the contracting parties.
Contracting Parties Obligated to Seek to Fulfil Their Contractual Obligations Regardless of Impediments
If there is an impediment to the performance of a contractual obligation that the party is unable to overcome, or if the performance of the agreement would require unreasonable sacrifices, the party may be released from its contractual obligation. Legally, these kinds of situations are called force majeure or hardship.
The COVID-19 pandemic has brought up such questions, for example, in situations where quarantine orders or travel and other restrictions have disrupted supply and distribution chains.
However, it is important to keep in mind that contracting parties must seek to fulfil their obligations despite impediments. A party can only be released from a contractual obligation if the performance of the contract is impossible or would require such great efforts or resources that it would be unreasonable compared to the benefit that the other party would receive from the performance.
Furthermore, a contracting party must comply with the contract in other respects despite the impediment. In other words, the party must fulfil the contractual obligations that are not impacted by the impediment.
There also must be a causal connection between the change in contracting party's circumstances and the impediment. For example, the pandemic can only release a party from its contractual obligations if the pandemic is the specific cause of the impediment.
If the actual cause of the impediment is anything else—for example, the contracting party’s poor economic situation in general—the changed circumstance does not constitute an impediment to performance. It is foreseeable that in the future the COVID-19 pandemic may be invoked as grounds for impediments that actually have other causes.
Precise Force Majeure Clauses Reduce Interpretation Problems
Commercial contracts often include force majeure clauses that agree on impediments to performance and their implications. When a contract includes such a clause, the clause forms the point of departure for determining whether the parties to the contract can be released from their contractual obligations or liability for damages.
The terms of commercial contracts to a great degree deal with the distribution of risks between the contracting parties. This being the case, it is important to assess what risks the contract involves as well as to agree which party bears which risk.
This means that it is vital that force majeure clauses are as detailed as possible when it comes to what kinds of circumstances are considered impediments to performance and what kinds of effects impediments have on the obligations of the parties. If the clause is formulated ambiguously or only in general terms, it may be difficult to interpret in case of a dispute.
It is also worth noting that the circumstances listed by force majeure clauses that release the parties from their obligations generally include natural disasters, war and terrorism, as well as industrial actions. In contrast, clauses drafted before the pandemic somewhat rarely take infectious diseases into account. If this is the case, disruptions to the performance of an agreement caused by the pandemic may not necessarily release a contracting party from their obligations.
Adjusting Contracts Possible Only in Exceptional Circumstances
An unforeseen change in circumstances that is beyond the control of the contracting parties may constitute grounds for adjusting the contract. In the context of the COVID-19 pandemic, the issue of adjustment has come up, for example, in situations where a party's turnover has reduced or the pandemic has caused the contract to be less profitable than originally expected. Tenants in commercial properties, in particular, have made claims for adjusting (i.e. lowering) agreed rents against landlords due to reduced customer traffic and government restrictions on, for example, the restaurant business.
The principle of pacta sunt servanda means that a contract can only be adjusted in exceptional circumstances. The threshold for amending commercial contracts between undertakings is particularly high, because the contracting parties typically have equal expertise and are independent of one another and have been able to freely negotiate the terms of the agreement and consider whether to commit to them.
On the other hand, an unforeseen change in external circumstances may be exactly the kind of exceptional event that would provide grounds for adjustment also between undertakings. However, even in this case, adjustment requires that the change in circumstances has had a significant impact on the balance of the contract and that applying the contract—as originally agreed—would be unreasonable taken as a whole.
Just because a contract has become unprofitable for one of the parties is not sufficient grounds for adjustment as such. The chance of loss is always present in business. Thus, the taking of risks, which is inherent in all business operations, must be considered when assessing the possibility of adjusting a commercial contract. If a contracting party has taken a conscious risk on a factor when entering into the contract, it is generally not possible to adjust the contract based on such a factor.
As a rule, a contract is binding even in changed circumstances. The COVID-19 pandemic or any other change in circumstances in and of itself is not enough to release a party from its contracting obligations. Contracting parties must seek to perform the contract despite disruptions caused by changed circumstances.
If disruptions to the performance of the contract or other changes occur that make the contract less beneficial than originally expected, careful consideration has to be given to what the actual underlying causes are.
If the actual causes are the pandemic or some other unforeseen change in circumstances, there may be grounds to invoke an impediment to performance or even to demand adjustment of the contract. However, the legal position of the contracting parties must be assessed on a case-by-case basis, and the particular characteristics of the circumstances and the contractual relationship must be taken into account.
A careful examination and legal assessment of each case is important. This ensures that a company does not breach the contract when it is the party encountering disruptions. This also makes it possible for a company to determine whether its contracting partner invoking an impediment to performance or claiming for adjustment may have grounds for its demands.
It would also be advisable to seek to take the impacts and legal implications of the COVID-19 pandemic and potential future changes in circumstances into account when negotiating a contract. The more specific the agreement on these matters, the better. This will help prevent disputes that are open to interpretation from arising between the contracting parties.
I believe that these lessons will continue to be valuable even after the pandemic has been consigned to history. Many global phenomena, such as the globalisation of business, the increasing complexity of contractual arrangements, the increase in legal regulation, and climate change, point towards companies facing an increasing number of changed circumstances and unforeseen events in the future.