Protection of long-term contracts from adverse consequences of emergencies

Recently we are being asked by our clients about duration of the rights and obligations arising out of long-term contracts in view of the current situation caused by the coronavirus epidemic (COVID-19). The related matter announces itself – how one can effectively protect oneself in the future if the other party is unable to meet its obligations under concluded contracts.

Change in circumstances and duration of contractual obligations

A general principle of the Contracts Law states that contracts are to be fulfilled (pacta sunt servanda). There are a few generally accepted exceptions to this principle which may mitigate in its otherwise disproportionately harsh effects. In particular, these are cases where after the conclusion of the contract the circumstances change to such an extent that the performance of the contract becomes significantly difficult or even impossible for one party or the other.

The described situation is often addressed in long-term contracts with application of the specific clauses based either on national regulations (such as the Czech Civil Code) or international regulations (e.g. the Convention on the International Sale of Goods or the principles of UNIDROIT). The most commonly used clauses include a force majeure clause and a hardship clause. Both apply if there is an unexpected change in circumstances after the conclusion of the contract which significantly affects the position of the parties.

  • (i.) The Force Majeure Clause shall be applied in the event that the fulfillment of the obligation becomes at least temporarily impossible and it releases the obliged party from its liability for failing to fulfill his contractual duty.
  • (ii.) The hardship clause allows the party affected by the change in circumstances to enter into negotiations to amend the contract in order to restore the balance which has been shifted to the detriment of the party concerned.

It should be noted that the applicability of the described clauses to future consequences (if any) associated with the effects of coronavirus COVID-19 is at least questionable. Although epidemics are generally considered to be events of an unpredictable nature (force majeure), one need reasonably assume that the COVID-19 epidemic may paralyze economy again in the near future. Under such a scenario, however, it would no longer be an unexpected event which the parties could not foresee. When entering into contracts, it will therefore continue to be necessary to pay increased attention to the steps taken by the parties in the event that a similar epidemic situation as we face today occurs during the term of the contract. At the same time, one should remember that the usual regulation by means of the said clauses may not be sufficient under the new circumstances.

In addition to the frequently used force majeure and hardship clauses, other instruments of protection of the parties in the event of unforeseeable circumstances may also be applied. These include, for example, a MAC (Material Adverse Change) clause which is used mainly in mergers and acquisitions and larger investment projects. MAC allows to unilaterally terminate the contract or to postpone performance of the contract in the event that (negative) circumstances described in the contract occur that have a material impact on the rights and obligations of the parties. It is of interest that MAC clauses act as a kind of mirror reflecting investors’ faith in the stability of the economic situation. Adverse expectations regarding future developments have been repeatedly reflected in the past in the form of increased attention paid to the wording of MAC clauses which have thus become more elaborate and specific in uncertain times.

All the described clauses apply primarily if the performance of the contract has become impossible or significantly difficult, but the parties continue to be interested in keeping the contract alive. We also want to deal with a situation where one of the parties is not willing or able to meet its contractual obligations and how it is possible to prepare for this possibility in the contract.

Project Management and Cash Flow

In case of long-term investment projects, it is crucial that the parties to the contractual relationship have sufficient resources to meet their contractual obligations. An unfavorable economic situation which may be caused by external circumstances – such as the current epidemic of COVID-19 – may affect the parties so fundamentally that they will not be able to meet their obligations. It is essential for the clients to make sure that an unfavorable economic situation of the general contractor (if any) does not result in the premature termination of the project, especially if the general contractor fails to meet its obligations towards its subcontractors. The possible solution to such an outcome is guaranteed option for the customer to pay directly to the subcontractors if there is a risk of suspension of payments by the general contractor. Similarly to the provision of Section 106 of the Public Procurement Act which allows such a process to be laid down in the tender documentation.

Another suitable instrument – although not often used in Czech Republic – is a special project account. Customer pays to the project account respective payments to the general contractor. Subsequent payments by the general contractor to the individual subcontractors are made through the project account as well. The client has access to this account and can supervise the management of project funds by the general contractor.

If the general contractor is no longer able to fulfill its contractual obligations, the customer should be allowed to take over individual contracts with subcontractors and continue with the project. It is further necessary to contractually ensure that the client obtains all rights related to the implementation of the project, incl. intellectual property rights, in particular the right to use the project documentation.

On the other hand, the general contractor or supplier should protect itself against the insolvency of the customer by properly defined cash flow conditions and milestones. From a supplier’s point of view, the contract should contain clearly defined milestones that trigger payment of the relevant part of the contract price by the customer. In the event that the customer is in arrears regarding payment, the supplier shall be entitled to immediately suspend work until the customer restores his payment morale.

Other suitable risk allocation tools among project participants can also be used. One of the most frequently used is a bank guarantee which enables securing of monetary and non-monetary obligations arising from contractual relations. In particular, a price guarantee, a guarantee for warranty repairs or a guarantee for retention fees are possible. The main benefit of a bank guarantee consists of an entering of the creditworthy guarantor which offsets any risks associated with non-performance of the contract.

Furthermore, we strongly recommend carrying out a review of the existing contractual documentation regarding long-term projects and/or acquisitions, especially from the following points of view:

  • (i) Which law governs the contractual relationship, does other than Czech law apply?
  • (ii) How does the contract regulate the issue of a substantial change of circumstances / impossibility of performance, especially in connection with any consequences of an epidemic or related crisis measures?
  • (iii) Does the contract contain enough guarantees in the event that one of the parties fails to fulfill its obligations?

Our law firm has been dealing with these and related issues for a long time and we are ready to provide legal advice in these matters, incl. an analysis of contractual documentation and proposals for modifications thereof with regard to potential risks.