An International Crisis Impacts Your Business — Contracts and Excuses for Nonperformance

By Peter V.K. Funk, Jr.
Mission Critical magazine
February 2012

In 1956, the Suez Canal was taken over by Egypt. In response, Britain, France, and Israel attacked to protect their interests in the canal. Egypt retaliated by blocking the Suez Canal, which caused an extreme disruption in international trade. In 2012, we are faced with threats by Iran to close the Strait of Hormuz, which provides passage for approximately 20 percent of the world’s oil, in retaliation for sanctions relating to Iran’s nuclear program.

Does your company’s agreements with its customer’s provide an “excuse” for not performing if history repeats itself at the Strait of Hormuz? Or a volcano erupts? Following such events, the bad news may arrive in the form of notices from your energy suppliers variously stating:

• That it cannot deliver; or
• It is allocating limited supplies among its customers; or
• That its prices will rise substantially effectively immediately.

First, you check the agreements immediately only to find that, yes, the seller appears to have the right to take the action they took. You then look at your company’s contracts with its customers and, when you find a “force majeure” provision in your contract that excuses your performance in the event of war, natural disasters, or events beyond your control, breathe a sigh of relief, right? Will your seller’s or your company’s performance be excused in this situation?

The answer is that it depends upon the wording of the contract and which country or state’s law will be applied. The two primary legal doctrines arising from a long history of court decisions are impossibility of performance and commercial impracticability. In addition, if the transaction involves the sale of goods, Uniform Commercial Code (UCC) Section 2-615 provides specific statutory excuses. Relying on case law or the UCC may not be sufficient, so force majeure clauses are often included to provide specific contractual excuses and limit liability in the event of specified occurrences and circumstances beyond the control of the parties.

Such clauses may also include other situations, such as when a newly enacted law prevents performance. You should be aware that weather-related events are typically included in force majeure provisions, but, even so, not all courts will excuse the affected party from performing if there is only a general reference to weather—it is better to be specific and, for example, refer to “hurricanes.” Otherwise, the result may be litigation.

There are also cases in which a party seeks to be excused from its contractual obligations based upon economic reasons. In the early 1970s, when the first round of OPEC oil price increases struck, a utility had been purchasing oil as power plant fuel from a major oil company at $2/barrel. The OPEC prices that the oil company had to pay for oil soon rose above $10 a barrel and continued to rise. The utility demanded that the oil company continue to supply oil at $2/barrel. The force majeure provision in the sales agreement between the oil company and the utility did not mention an economic event such as an OPEC price increase. Faced with huge financial losses if it continued to supply oil far below its cost, the oil company sought a court order requiring the utility to pay the increased prices. The court granted the oil company relief based upon commercial impracticability.

The requirement to pay higher oil prices affected the utility and its customers, since the utility’s tariff included a fuel adjustment clause (FAC), which increased its customer’s bills to cover the higher oil costs. Certain commercial customers then brought a legal action asking the court to issue an order blocking the utility from implementing the FAC and limiting its charges to those approved in its most recent rate case. The utility prevailed since the FAC was lawfully approved for inclusion in the tariff. The court also recognized public-policy considerations. Requiring the utility to provide electricity below the cost of production would imperil the utility’s ability to fulfill its statutory role of providing reliable power to its customers.

This was an interesting case since oil was, in fact, available. Nevertheless, it was commercially impractical for the seller to deliver it at the contractual price since the price had been driven up by an international event beyond the control of the seller. It was also significant to the court that the OPEC oil price increase was not foreseen by the parties when they entered into their agreement. Yet the outcome of the oil company’s court case was not a foregone conclusion since economic events do not typically provide an excuse from performance unless specifically mentioned in the force majeure clause.

In addition, it is not unknown for commodity prices to rise and fall sharply, and both sellers and buyers have the ability to hedge against such risks. The court might have found against the oil company by ruling that to allow a fixed-price contract to be voided when prices fluctuate would defeat the whole purpose of having a fixed price and could provide an unbargained for advantage to the excused party.

In order to address the potential uncertainties of court treatment of supply-related excuses, a buyer may be able to enhance its opportunity for an effective excuse by including specific references to cessation or allocation of supply in the force majeure clause.

It is important to realize that courts may treat buyers differently than sellers. In another case, a buyer unsuccessfully tried to “get out of” its contract to purchase fuel oil by seeking relief in court when oil prices dropped as certain producers in the Mideast sought to regain market share, in part by undermining the economic basis for alternative energy and for energy conservation. A sharp decline in energy prices was not among the events permitting the buyer an excuse and the general language in the clause referring to events beyond the parties’ control was insufficient to permit a party to avoid its obligations simply because of a change in prices. The court did not permit the buyer an excuse since, while this particular change in pricing may not have been foreseeable, it was foreseeable that there would be price fluctuation.

Historically, the grounds under which an excuse for non-performance was permitted have been largely limited to “impossibility for performance.” There are courts that now recognize that the defense of impossibility can be unreasonable in requiring that performance be absolutely impossible and instead set the standard at commercial impracticability. Although it is desirable to have enforceable contracts, most courts will find that performance is impracticable when an event or circumstance is beyond the control of the party seeking to be excused and the cost of performance is excessive and unreasonable.

To have a valid excuse under UCC Section 2-615, a seller must show that a contingency occurred that made performance impracticable, and that the parties assumed that the contingency would not occur when they entered into the contract. If a seller whose supply has been limited can meet those criteria, the seller must allocate production and deliveries among its customers, and then must notify the buyer of any delay or non-delivery and, if an allocation is to be mad—of when and how much.

To sum up, whether relief is available under a force majeure clause depends upon the wording of the clause. Usually, it will list the events that constitute force majeure followed by a “catch-all” phrase such as “other events beyond the reasonable control of the parties.” Even events beyond the control of the parties, for example, a truck accident, which are beyond the control of the parties may not provide a valid excuse if bases upon a “catch all” phrase since truck accidents are commonplace and not unforeseeable. For that reason, it is important to list specific events in the force majeure clause since reliance on a catch-all phrase is problematic and can be unsuccessful.

The discussion in this column is not intended to be legal advice and you should consult your attorney for advice on the points discussed above.