As the legal and economic fallout from the pandemic works its way through the court system, we are learning more about when courts will excuse performance under a contract for pandemic-related reasons. These issues arise in acquisition contracts (which I discussed in an earlier post at the beginning of the pandemic) and in contracts in general. Regrettably there is no clear rule, and the ultimate conclusion is that boilerplate provisions in contracts, which businesspeople often ignore, really do matter. It is incumbent on businesspeople to understand how risks of the unknown are allocated in their contractual obligations, whether through force majeure clauses, material adverse effect clauses, or otherwise.
In standard commercial contracts, a force majeure clause is used to allocate the risk of unforeseen or uncontrollable events and potentially to excuse one or both parties’ performance. Once the pandemic hit and the economy was shut down, parties turned to these little-used provisions to see if they could enforce or escape their contractual obligations. One recent case — JN Contemporary Art v. Phillips Auctioneers — highlights the operation of force majeure clauses in an interesting art world fact pattern.
According to the court’s decision, in June of 2019, JN Contemporary Art and Phillips Auctioneers entered into two agreements:
- JN agreed to bid £3 million for a piece of art being auctioned by Phillips in June 2019 (with Phillips agreeing to pay JN 20 percent of the sale price over £3 million).
- Phillips agreed to auction off a piece of JN artwork in May 2020 and pay JN a guaranteed minimum price of $5 million.
Separately, JN obtained financing based on the $5 million guaranteed minimum price in the second contract.
The June 2019 auction occurred as planned. However, once the pandemic hit, the May 2020 auction was cancelled, and Phillips used the force majeure clause to terminate the second contract and avoid paying the $5 million minimum price. What is not stated in the Court’s decision, but is a subtext, is that presumably JN defaulted on the loan it obtained secured by the second contract when the sale did not occur. JN then sued Phillips for a host of items, including breach of contract.
An unanswered question is whether this whole series of arrangements is just some form of disguised loan to Phillips that it got out of repaying by exercising its force majeure rights, or some other more complicated, repo-like transaction that the parties felt unable to document directly.
The U.S. Second Circuit Court of Appeals held that the key to the case is the express language of the force majeure clause (emphasis added):
In the event that the auction is postponed for circumstances beyond our or your reasonable control, including, without limitation, as a result of natural disaster, fire, flood, general strike, war, armed conflict, terrorist attack or nuclear or chemical contamination, we may terminate this Agreement with immediate effect.
The key parts of the Second Circuit’s ruling are that:
- Force majeure clauses should be narrowly construed (i.e., as a public policy matter it should not be too easy for parties to avoid their contractual obligations).
- Nevertheless, this is a broadly worded provision, and the list that follows “including, without limitation” is a set of examples and not the sole source of circumstances beyond the parties’ control that would justify termination.
- The force majeure event here is principally the New York governor’s shut-down order (which is a circumstances beyond the parties’ control even if not part of the “including, without limitation” list) and not the pandemic; therefore, the question raised by JN of whether the pandemic is a natural disaster or man-made disaster is irrelevant.
- The words of the two contracts did not support the argument that the two contracts were linked, beyond that signing the second contract was a condition to the first.
- Risk Allocation. In June 2019, the COVID-19 virus was an unknown unknown. JN and Phillips signed a contract with a broad force majeure clause that essentially allocated the risk for uncontrollable events to JN. I wonder if the businesspeople on either side focused on that risk allocation.
- Document the Deal. Also, if there is some more complicated underlying transaction, shoe-horning a bespoke deal into customary documentation exposes parties to potential risk when events do not occur as anticipated.
Understand How a Contract Deals With Unknowns
- Known Unknowns. COVID, government shutdowns, and the like are now “known unknowns.” We know that they are out there, but we don’t know what will happen. Make sure that you address head-on how worsening of those circumstances will affect your contractual obligations.
- Unknown Unknowns. Similarly, consider how unknown unknowns should affect your contract performance and how your obligations interrelate. JN was probably caught between a rock and a hard place, in that it was obligated to repay its loan (generally no force majeure provisions in a loan agreement), but Phillips used a force majeure provision to terminate the underlying transaction that was generating the funds to repay the loan. This created a discontinuity that JN had to repay the loan no matter what, but the contract that they were relying on to generate the necessary funds had a force majeure out. When Phillips exercised the force majeure out, JN was left without its expected source of repayment fort the loan. My guess is that if JN truly understood the discontinuity, then JN would not have agreed to the force majeure clause (or would have sought to have narrowed it) if they had sufficient bargaining power.
Don’t participate in a high-value art auction unless you know what you are doing. It also appears that art auctions are not necessarily a “fair game.” Would it affect how you bid in an auction if you knew that the person you were bidding against received 20 percent of the sale price that you paid if you won? I recall a piece of advice about poker that I received many years ago that seems apt here: Look around the table, and if you can’t identify who the sucker is, get up, because it is you. Or, to paraphrase one of the great lines in the movie The Big Short: know how the other side is going to rip you off before you enter into a transaction.
Maurice Lefkort W86 advises clients on a wide variety of transactions that transform businesses, and occasionally advises on high-value art transactions.
Editor’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, this post may constitute attorney advertising.