09.03.2020

Supply relationships in times of COVID-19

Backround

Many companies are already being affected by the economic impact of the COVID-19 epidemic. As a result, it is now no longer just supply and service relationships with Chinese business partners that are affected. Both the extent of the epidemic, which does not stop at national borders, and a globally networked economy have led to the fact that both international and domestic contractual relationships may be affected by the epidemic. This leads to problems with the replenishment of goods or parts and disrupted supply chains, culminating in the threat of production stoppages and numerous cases of potential compensation claims for delayed delivery, some of which are quite substantial.

 

Under what conditions can this lead to suppliers being released from their performance obligations? And what happens to the respective consideration? May one of the contracting parties claim damages? Or do contracts have to be amended?

 

In this situation, the following points are crucial for answering the questions raised:

  • agreed subject matter of the contract and specific delivery obligations
  • terms of delivery and place of performance
  • impossibility of performance - or mere complication
  • obligation to procure replacement goods
  • does the situation meet the definition of ‘force majeure’
  • contractual allocation of risk between supplier and customer
  • basis of transaction between the parties.

This list already indicates: There are no general answers to the questions raised. To put it in a nutshell: A targeted analysis of the individual case is needed, based on the contract in question.

A. Your own contract as a starting point

The following description should help you to make an initial assessment of the situation.

 

I. Force majeure clauses

 

When can a party invoke ‘force majeure’ and thus release itself from its contractual obligations? In many contracts, the parties have agreed a so-called ‘force majeure’ or ‘act of God’ clause. These clauses are usually divided into two parts and regulate on the one hand the conditions of their application and on the other hand the legal consequences thereof.

 

If the requirements of a ‘force majeure’ clause are met, it usually provides for all or at least some of the following points:

  • that the parties are (temporarily) released from their performance obligations;
  • that the parties must try to minimise the adverse effects for the other respective other party;
  • that there is a right of termination or withdrawal after a certain period of time; and/or
  • that damages in the event of ‘force majeure’ shall be excluded.

Epidemics are rarely mentioned explicitly in these clauses as a case of ‘force majeure’. If the clause therefore exhaustively enumerates those cases that are to be considered ‘force majeure’ according to the contract, this can lead to epidemics not being covered by it. If, on the other hand, the contract does not contain a precise definition or if a list is not - as is usually the case - designed to be exhaustive, general principles must be applied. In German law, ‘force majeure’ is understood as an external event that was not foreseeable at the time of the conclusion of the contract and is unavoidable and insurmountable. For example, in the explanatory memorandum to the German Federal Government's bill on the tour operator contract, epidemics are mentioned as cases of ‘force majeure’ alongside war, civil unrest, strikes, sovereign orders, natural disasters and the like.

 

The outbreak of the COVID-19 virus has been classified as an epidemic in Germany since the legislative decree passed by the Federal Ministry of Health on 1 February 2020. An epidemic is defined as the widespread occurrence of an infectious disease that is limited in time and place.

 

However, the decisive factor for the application of a ‘force majeure’ agreement is that the ‘force majeure’ event does not just affect the contract in question in some way. Rather, the ‘force majeure’ must make it temporarily impossible or unreasonable for the party that wishes to withdraw from its contractual obligations to fulfil these. Whether this is the case can only be assessed in relation to each individual case.

 

The mere fact that that people everywhere are talking about an epidemic or even a pandemic does not lead to the impairment of any supply relationships. The decisive factor may be where the supplier - or the customer - is located. If, for example, a supplier produces in one of the sealed-off localities in Lombardy and is currently unable to deliver special castings manufactured to customer specifications to its client in Germany, it is highly probable that a case of ‘force majeure’ may be deduced. Whether or how long this applies, if the supplier in a German domestic contractual relationship cannot deliver a marketable product, which he himself sources from China, to his customer because a container is located at the port of Qingdao and is not being shipped, will again be determined by the circumstances of the specific case. Depending on whether a delivery from Germany for a customer in China is to be made according to Incoterms® 2020 Ex Works or, for example, under DAP Shanghai terms, results will differ. The precise legal consequences stipulated in the contractual arrangement in each case are still to be examined.

 

Please note: As a rule, the affected party is obliged to inform the other party immediately of the occurrence of an event of ‘force majeure’ and its expected duration - and this regardless of whether or not the contract contains any provisions relating to such an event.

 

II.         Impossibility

 

But what applies if the contract does not contain a ‘force majeure’ clause? Then the legal consequences are basically governed by the statutory provisions. In the event that performance is impossible for the supplier or anyone else, the law stipulates that the claim for performance is excluded. This would be the case, for example, if the supplier is unable to perform, for example because he temporarily had to close down his factory completely owing to the outbreak of the virus. However, the principle must be observed here that a case of impossibility exists only if the supplier is also not in a position to procure the goods - even taking into account the assistance of third parties. It is therefore important whether the supplier is obliged to procure the products concerned on the market or whether his obligation to perform is limited to the products concerned, which for example cannot be finished in his factory in Wuhan.

 

Thus, not every form of impediment to performance leads directly to impossibility of performance.

 

It should also be noted that the obligation to perform does not cease to apply simply because a potential replacement purchase on the market is more expensive than planned. There is some disagreement over whether the supplier could refuse to perform in cases of mere commercial impossibility.

 

If a case of impossibility exists, the debtor is released from his obligation to perform and the respective creditor is entitled to withdraw from the contract. Whether this is the case is, like so much else, a question of individual assessment.

 

III.        Interference with the basis of transaction (Störung der Geschäftsgrundlage)

 

A termination of concluded contracts or at least an adjustment of the same may, under certain conditions, also be requested on the grounds of the principles of interference with the basis of transaction.

 

Whether a contract can be amended or even cancelled on the grounds of the principles of interference with the basis of transaction depends on various factors. First of all, the contract would need to be based on a particular factor that had changed significantly since the conclusion of the contract. The next step would be to examine what risk allocation applies between the parties - whether by contract or otherwise - according to general principles by which the typical risk of a contract is to be determined. In other words: Is the actual risk that has become a reality here allocated to one of the two parties alone? Only when the party affected by the interference can no longer be reasonably expected to fulfil the contract unchanged on the basis of a comprehensive weighing of interests, can a contract adjustment or even termination be considered.

 

An adjustment of the contract can therefore be considered only in exceptional cases where circumstances beyond the supplier's control and area of risk result in such a blatant imbalance between services rendered and consideration received that it is no longer possible to adhere to the unaltered contract. However, the hurdles set by case law are quite high.

 

In accordance with the principles of interference with the basis of transaction (Störung der Geschäftsgrundlage) a party may not claim that performance has become more difficult if the supplier has assumed the procurement risk, as is usually the case with so-called market-based generic obligations (Gattungsschulden). Conversely, the supplier would not have assumed the procurement risk, for example, if he were supposed to supply from his own stock. However, the limits of the risk assumed will be exceeded if, as a result of unforeseeable circumstances, such considerable obstacles to performance have arisen that the supplier can no longer be reasonably expected to procure the goods or services.

 

IV.       Damages

 

Whether in one of these scenarios the party who does not fulfil the agreed obligation is obliged to pay damages depends first of all on whether it is entitled to one of the rights described above and whether the supplier (debtor) is responsible for the respective impediment to performance. In principle, the debtor is liable only when he is at fault. This means that in the case of actual or legal impediments to performance for which he is not at fault, e.g. in the event of operational disruptions due to ‘force majeure’ or an official entry ban, he will not be held liable. This applies according to the law and therefore does not require the agreement of a ‘force majeure’ clause. Even without such an agreement, it therefore applies that as a rule the supplier does not owe any damages if he cannot deliver on time owing to an event of ‘force majeure’. However, the debtor will be liable if he has assumed a warranty or the procurement risk.

 

If the supplier has assumed the procurement risk, he is generally liable even if he is not at fault for the impediment to performance. Such cases, however, in which, as a result of unforeseeable circumstances, such significant impediments to performance have arisen that the supplier can no longer be reasonably expected to procure are usually no longer attributed to the assumed procurement risk.


B. Looking ahead: New business opportunity - and now?

Based on the comments above on contracts concluded before the outbreak of the epidemic, the importance of careful contractual arrangements for supply relationships that are currently being negotiated is evident. At present, it is uncertain how long the virus will continue to affect the market; unfortunately, it seems certain that it will continue to do so for some time. Against this background, it is essential to check particularly carefully before concluding contracts whether both parties will actually be able to fulfil the obligations they have assumed. The outbreak of the epidemic and the fact that it will have consequences are no longer unforeseeable, although the actual extent of the consequences is uncertain. It is therefore essential that you make use of the possibilities available when negotiating individual contracts. It would be difficult to invoke ‘force majeure’ for newly concluded supply contracts now - after the outbreak of the COVID-19 epidemic.

 

To this end, arrangements should be agreed to allow the parties to react flexibly to changing and still uncertain circumstances, for example by specifying concrete assumptions under which performance is deemed feasible by the agreed date and concrete mechanisms that will apply if the assumptions change.

C. What applies to services?

German companies often provide high-quality, specialised services. In some cases, it may not be that easy to find a replacement service provider. This may be the case if a German manufacturer should have had a complex specialised machine built, connected and put into operation by its technicians in China, but its employees refuse to travel to China because of the epidemic, or a trip seems pointless because the technicians are not allowed to enter the plant because of quarantine regulations. In such cases it will often be practically impossible to engage other employees or local staff. Whether the German supplier can invoke ‘force majeure’ or impossibility and thus be (temporarily) released from his obligation to perform without being liable for damages, or whether he can demand an adjustment of the contract on the grounds of the principles of interference with the basis of transaction (Störung der Geschäftsgrundlage), depends, as already described above, on the circumstances of the individual case. In the case described here, it will depend in particular on whether the trip to the customer is effectively excluded. If, on the other hand, an employee refuses to travel to Asia without justification, the fault is probably attributable to the service provider.

 

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