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March 12, 2020

Preparing for the Impact of the Coronavirus on Your Supply Chain and Beyond

Coronavirus: Multipractice Advisory

To help our clients navigate the coronavirus (COVID-19) crisis, Arnold & Porter has established a Coronavirus Task Force covering a wide range of issues and challenges. Subscribe to our "Coronavirus (COVID-19)" mailing list to receive our latest client Advisories.

Introduction

The coronavirus (virus: SARS-CoV-2, disease: COVID-19) has now been documented on every continent except Antarctica and has rapidly spread from its epicenter of Wuhan in the Hubei province of China, a worldwide manufacturing hub, where the virus emerged late last year. The virus has now been detected in more than 80 countries worldwide, with recent outbreaks in East Asia, Italy, and Iran. More than 120,000 coronavirus cases and 4,000 deaths have been confirmed worldwide and these figures only continue to grow daily. At a recent press briefing, Dr. Anne Schuchat, the Principal Deputy Director of the Centers for Disease Control and Prevention (CDC), warned that the "current global circumstances suggest it is likely that the virus will cause a pandemic." Indeed, on March 11, 2020, the World Health Organization officially declared the coronavirus a pandemic.

In addition to following the CDC's recommendations to prevent exposure to the coronavirus,1 it is also important to prepare for the significant impact the coronavirus may have on your life and your business. It is no longer a question of if this impact will occur, but when and how soon.

Now Is the Time to Develop a Coronavirus Supply Chain Strategy

The coronavirus has already had a significant impact on global supply lines and cross-border industries and has the potential to touch virtually every sector and affect companies across the world. Manufacturing operations, for example, have been interrupted or suspended in many areas and while the initial impact of the coronavirus may have been mitigated by excess inventory or suppliers' safety stocks, those supplies will inevitably run short. Moreover, in some cases, it only takes one missing critical part to shut down a production line and cause ripple effects throughout the supply chain.

As coronavirus outbreaks continue to increase both domestically and abroad, now is the time to take proactive steps to develop a supply chain strategy so your company can mitigate long-term consequences. One of the most important steps you can take now is to carefully review supplier and customer agreements to understand whether and how they address interruption of operations. With the caveat that it is always necessary to review which law governs those agreements (and to be familiar with any dispute resolution provisions), a close review of any force majeure provisions and the doctrine of commercial impracticability under Section 2-615 of the Uniform Commercial Code (U.C.C. or the Code) are two advisable first steps when confronted with a supply chain interruption.

Is There a Force Majeure Clause?

Many commercial agreements include a force majeure clause that can relieve a party from liability for nonperformance if certain enumerated circumstances beyond a party's control prevent that party from fulfilling its contractual obligations. The relief available under a force majeure clause will vary substantially depending on the precise wording of the clause. While the typical force majeure clause may not mention disease, epidemics, or quarantines specifically, they may include more general language covering "acts of God," acts of government, "other circumstances beyond the parties' control," or other catch-all terms that could arguably apply to the coronavirus crisis because it has both a naturally-occurring component (i.e., the virus) and a government-action component (e.g., quarantines, lockdowns, etc.). For a full examination of "What to Do When Your Receive a Coronavirus-Related Force Majeure Notice," please see our related Advisory.

"Commercial Impracticability" Under Article 2 of the U.C.C.

But what if there is no applicable force majeure clause (because, for example, business was conducted on a purchase-order-to-purchase-order basis) or the force majeure clause is narrow in scope and does not expressly reference circumstances or events similar to the coronavirus crisis? In that case, U.C.C. § 2-615—"Excuse by Failure of Presupposed Conditions"—will likely dictate whether non-performance from a supply chain seller of goods may be excused.2

Under U.C.C. § 2-615(a), three conditions must be met before a seller's non-performance can be potentially excused. Although what each of these conditions means varies somewhat based on which state law applies, the standard conditions are that:

  • The seller did not assume the risk of the unknown event or contingency;
  • The "non-occurrence" of the unforeseen event or contingency was a basic assumption underlying the contract; and
  • Performance in accordance with the contract has become "commercially impracticable because of unforeseen supervening circumstances." U.C.C. § 2-615, official cmt. 1.

The first condition is really an exclusion: excuse of non-performance under Section 2-615 may be available "unless the Seller may have assumed a greater obligation" than is apparent from the four corners of the contract. See U.C.C. § 2-615(a). But it bears emphasis that there is no requirement that the seller's "assumption of risk" was memorialized in a document signed by both parties. Just the opposite, courts have inferred that "greater obligation" from the parties' course of performance or course of dealing, and/or usage of trade (see U.C.C. §1-303). This latter category, usage of trade, is a particularly broad one that encompasses any practice or method of dealing that is so regularly observed in a particular business, trade, or industry that there is a justified expectation that it will be observed for every similarly situated transaction. See U.C.C. §1-303(c). In sum, the question most courts will ask with respect to this first condition is: Was the risk of the occurrence or event allocated to either party by agreement, practice, or custom?

To satisfy the second condition, the seller generally must show that the event was not foreseeable. This is because, if the event was foreseeable, the "non-occurrence" of it could not have been "a basic assumption" underlying the contract. But foreseeability in this context does not necessarily mean that the parties specifically contemplated the "non-occurrence" of the event or contingency before entering into their agreement. Instead, courts will generally find that an event or contingency was foreseeable if it was "sufficiently foreshadowed at the time of contracting" and recognized as potentially impacting performance. See U.C.C. § 2-615, official cmt. 8. Stated differently, courts often examine whether the event is so unusual and unforeseen that the consequences of enforcing the agreement would be commercially unreasonable and/or provide the buyer with an unjustified windfall. Because these tests are, by definition, fact-specific and often industry-specific inquiries where there are few, if any, bright line rules, it is advisable that all supply chain participants dealing with non-performance issues seek legal advice from counsel with substantial experience litigating matters under U.C.C. Article 2.

Finally, the "commercially impracticable" requirement—while easier to satisfy than the "impossibility defense" at common law—is still a rigorous test not easily met. For example, increased costs alone will not excuse performance unless "the rise in cost is due to some unforeseen contingency which alters the essential nature of performance." See U.C.C. § 2-615, official cmt. 4. That typically means that delivery in accordance with the contract's terms could only be performed at an excessive or unreasonable cost. Indeed, even substantially increased (and unexpected) costs are not enough.

The classic example of this principle that courts frequently cite was the claim that increased costs to ship goods around the Cape of Good Hope (due to the unexpected closure of the Suez Canal in 1956-57) made the performance of certain shipping contracts impracticable. All or nearly all courts to consider that claim held those facts did not constitute commercial impracticability and therefore enforced the contracts as written. Those holdings also form the foundation for the broader principle that the sudden unavailability of a party's "expected" way to perform, without more, will not excuse non-performance under the Code. In contrast, however, "a severe shortage of raw materials or supplies due a contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply" will generally excuse performance if the unforeseen event or circumstance caused a "marked increase in cost or altogether prevents a seller from securing supplies necessary" to perform. See U.C.C. § 2-614, official cmt. 4. It is easy to see how a coronavirus pandemic could lead to such extreme circumstances in some industries.

But even where a seller has satisfied the three conditions precedent set forth above, the seller also must comply with additional obligations under U.C.C § 2-615 (b) and § 2-615(c) before its non-performance may be excused, including that:

  • A Fair Allocation of Goods If Partial Performance is Possible: Where a seller's ability to perform is only partially impacted or if the seller retains inventory, it "must allocate production and deliveries among [its] customers," but may allocate them "in any manner which is fair and reasonable." See U.C.C. § 2-615(b). A strict, pro-rata allocation is not required, but this rule clearly prohibits a seller from favoring buyers that offer to pay a higher price. See U.C.C. § 2-615, official cmt. 11 Courts also generally favor an allocation based on some objective standard tied to the parties' prior purchasing practices.
  • Seasonable Notice: The supplier must also "seasonably notify" the buyer that there will be delay or non-delivery and—when an allocation under subsection (b) is required—a quantification of the estimated quota that will be available for the buyer. See U.C.C. § 2-615(c). The Code defines "seasonable notice" as "within the time agreed" or "if no time is agreed, within a reasonable time" and what a "reasonable time" means, in turn, "depends of the nature, purpose, and circumstances." See U.C.C. § 1-205. Given those definitions, it is safe to say that, in your typical crisis situation, "seasonable notice" should probably be understood to be a matter of days, not weeks.

When a buyer receives notice from a seller asserting commercial impracticability and the nonperformance substantially impairs the value of the contract, the buyer has two options under the Code. See U.C.C. § 2-616. First, the buyer may except a modification to the contract proposed by the seller in writing or by acquiescing to the seller's adjustment of the time of delivery or other material terms. See U.C.C. § 2-616 (1)(b). The second option available is to terminate the contract and discharge the seller from any further obligation. See U.C.C. § 2-616 (1)(a). If the buyer does not modify or terminate the contract within 30 days, then the contract lapses after 30 days. U.C.C. § 2-616 (2).

In conclusion, whether the commercial impracticability doctrine under U.C.C. § 2-615 will constitute a valid legal "excuse" for a seller's non-performance—and how the buyer should respond to a seller's assertion of that defense—are complicated factual and legal questions for which an in-depth analysis is often required to arrive at definitive answers. Nevertheless, a general familiarity with the principles described above should help companies impacted by supply chain disruptions better recognize when undertaking such an analysis might be advisable or prudent.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

  1. https://www.cdc.gov/coronavirus/2019-ncov/about/prevention-treatment.html

  2. Although a buyer may argue that if the contract contains any force majeure clause, that clause should govern exclusively and that Section 2-615 should not be available as a vehicle to excuse the seller's nonperformance, the case law is far from uniform on this point. Accordingly, the practical reality is that, unless the sale-of-goods agreement at issue expressly states that the force majeure clause supersedes or precludes any other claim of commercial impracticability, the seller will likely try to rely on Section 2-615 to defend against any claims of nonperformance or breach that the seller believes were caused by the coronavirus crisis.

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