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Can a contract be terminated if COVID-19 or government sanctions prevent performance?

26 May 2020

The COVID-19 pandemic has had a significant impact on businesses worldwide. Lockdown restrictions, disruption to supply chains, increased pressure on cashflow and reduced capacity have all affected the ability of businesses to fulfil contractual obligations. Many will find themselves in a position where either they or the counterparty will be unable to perform their obligations and will be in breach of contract.

An issue facing many businesses is whether commercial contracts can be terminated because of a breach and depending on how that termination occurs whether it could result in claims for loss and damage.

Check the contract terms

It is an obvious place to start, but the first port of call should be reviewing and checking the terms of the contract.  Termination must always be considered in the context of the terms of the contract that may be terminated.

Force majeure & frustration

A party should check whether there is a force majeure clause and, if there is one, the precise wording.  The purpose of such clauses is to protect an innocent party, such that on the occurrence of an event beyond their control which is the sole cause preventing performance of their contractual obligations, it may be excused from performance, without being liable to the other party.

Whether such a clause will be effective in the current circumstances will depend on the exact wording of the force majeure clause, and whether it makes express reference to say pandemics, outbreaks of notifiable diseases or government actions as being events which the contract recognises as being ones which excuse performance of obligations.  If the clause permits the contract to be terminated on the occurrence of the specified event (as opposed to performance just being suspended), then the innocent party may be entitled to terminate the contract without incurring liability to the counterparty.

In the absence of an express force majeure clause, in rare circumstances the doctrine of frustration may apply.  This will only be the case where the performance of the contract has become physically or commercially impossible as a result of an event beyond the control of the parties, or where the contract has been rendered radically different to that envisaged by the parties at the time they entered into the contract.  If the contract has been frustrated, then it is automatically terminated.

Further information can be found in our force-majeure and frustration flowcharts.

Contractual breach provisions

If force majeure and frustration do not apply, then the failure of performance should be assessed against any express contractual breach provisions.  Many contracts will include clauses entitling one or both parties to terminate the contract in certain circumstances.  Such clauses may give a right to terminate for “material”, “substantial” or, more rarely, “any” breach of contract.  If the contract does not define what constitutes a relevant breach, it may only be possible to assess whether the particular breach would trigger a right to terminate by looking at previous decisions made by the courts. 

As well as giving a right to terminate in the case of particular breaches, the contract may also require the party in breach to be given a period of time to remedy their breach.  If there are any ‘remedy’ or ‘cure’ clauses, they will typically require the party not in breach to serve written notice identifying the breach and requiring the party in breach to remedy the position within a specified period.  If the breach is not remedied within that period, then the innocent party may be entitled to serve a further notice terminating the contract.

Where there are ‘remedy’ or ‘cure’ clauses, they should be complied with strictly, notwithstanding the current circumstances, otherwise an innocent party may find themselves in repudiatory breach of contract. 

Repudiatory breach/renunciation

As well as considering whether it has an entitlement to terminate the contract under its express terms, an innocent party should also assess whether the breach by the other party entitles them to terminate the contract under common law. 

Unless excluded by clear wording, a party will have a right to terminate a contract if the counterparty commits a ‘repudiatory breach’, namely a breach which is so serious that it deprives the innocent party of the substantial benefit to which it is entitled under the contract.

A statement or conduct by one party which demonstrates it is unable or unwilling to perform its contractual obligations could amount to a repudiatory breach, entitling the innocent party to treat the contract as at an end and itself discharged from its own future obligations under the contract.

Election

When faced with a breach of contract which gives a right to terminate (be that under the express terms or at common law), the innocent party has a choice: either it can exercise that right and terminate, or it can affirm and let the contract continue.

That fundamental choice has not been changed by the COVID-19 pandemic.  The position remains that if an innocent party waits too long, it could be found to have waived its right to terminate and to have affirmed the contract.  It may be possible for the innocent party to notify the offending party of the breach and reserve its position, but that will at best only be effective for a short period. 

Postponing the decision as to whether to terminate or not until the COVID-19 situation improves or until restrictions are lifted is a very risky option, and not one to entertain if the innocent party will be required to fulfil its contractual obligations in the interim.  If the innocent party does continue to fulfil its contractual obligations, it may be taken to have affirmed the contract by its conduct.  Even if that is not the case, the innocent party may still be running the risk that if it later tries to rely on the earlier breach as the basis for terminating the contract, the party in breach is likely to assert that the contract had been affirmed and the innocent party lost its right to terminate.

Compliance with contractual termination/variation provisions

If an innocent party does decide to terminate the contract, then provided that the termination is notified in compliance with any express notice requirements set out in the contract, it will be effective notwithstanding the pandemic.  Any failure to comply with the contractual requirements may render the termination notice invalid. 

If an innocent party has a right to terminate both under the contract and at common law, it must give careful consideration as to how to frame any termination notice, so as to ensure that all potential claims it may have are preserved. 

If the breach leads to a dialogue between the parties to renegotiate the terms of the agreement, they should also ensure that any contractual variation requirements are complied with (see our related first guidance in this series on agreeing contractual variations in lockdown here).

Government guidance

On 7 May 2020, through the Cabinet Office the Government published a guidance note titled “Guidance on responsible contractual behaviour in the performance and enforcement of contracts impacted upon by the COVID-19 emergency”.  This note set out guidance and recommendations applicable at that date regarding contractual behaviour by those impacted by the pandemic.

Paragraphs 14-15 of the note listed a number of circumstances in which reasonable and proportionate behaviour was encouraged, including:

requesting, and giving, relief for impaired performance, including in respect of the time for delivery and completion, the nature and scope of goods, works and services, the making of payments and the operation of payment and performance mechanisms” (para. 15(a)); and

claiming breach of contract and enforcing events of default and termination provisions” (para. 15(h)).

This guidance note was, as it recorded, only Government advice and recommendations.  It was not statutory, and accordingly did not have any legal effect.  Accordingly, it would not displace the terms of any contract (as paragraph 7 of the note itself admitted).  In the circumstances, businesses should treat the guidance with caution and continue to look to their own contractual terms and make their own decisions as how to best protect their commercial positions based on those terms.  Attempts to rely on the Government guidance to justify behaviour rather than the express terms of any given contract are unlikely to be successful in later disputes or litigation.

Conclusion

When faced with a potential breach of contract in current circumstances, businesses should have regard to the following key points in any commercial decisions they make:

  • consider the express terms of the contract, including whether there is an applicable force majeure provision;
  • consider whether the conduct concerned amounts to a breach giving rise to a contractual right to terminate;
  • adhere to any remedy or cure provisions;
  • consider whether the conduct amounts to a repudiatory breach giving rise to a right to terminate at common law;
  • an innocent party should make an election on whether to terminate or affirm the contract without unnecessary delay; and
  • ensure that any termination notification complies with any express terms of the contract.

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