Contract Law 2. April 2020

Fulfilment of contractual obligations and possible consequences

2. April 2020

The exceptional circumstances caused by the declaration of the state of emergency as a result of the COVID-19 pandemic have opened up the possibility of applying force majeure and rebus sic stantibus clauses to contractual relations. Being the force majeure the option most easily accepted by the Spanish courts, the implementation of said solutions must fulfil certain requirements based on the good faith of the contracting parties and on the reduction of the damage.

  1. Introduction

Since on 11 March 2020 the World Health Organization declared COVID-19 as an international pandemic, a high uncertainty has arisen in the frame of commercial and civil contracting. This situation became aggravated in Spain as a result of Royal Decree 463/2020, of 14 March, declaring the state of emergency for the management of the health crisis caused by the COVID-19 (the “Royal Decree“),being one of the consequences the appearance of situations that make it impossible (or significantly difficult) to comply with the contractual obligations and which, contrary to the administrative and judicial deadlines, have not been suspended.

This legal note is intended to provide an initial overview of situations arising from the state of emergency and other measures adopted at both national and international level.

In this sense, our starting point is the mandatory nature of contractual obligations or pacta sunt servanda and, secondly, the review of mechanisms for contractual flexibility provided for in our legal system, in order to finalize with an extract of the general principles to be applied.

  1. Contractual obligations: pacta sunt servanda

From the beginning of these lines it should be noted that the general rule is that contracts have the force of law between the parties and bind the contracting partners in all aspects, a principle not modified, annulled or suspended either by the Royal Decree or by the other rules approved in the following weeks.

Spanish case law has traditionally interpreted broadly the application of this general principle in two ways: (i) first, in the event that a specific mechanism is provided for by the contract in question, this will be of preferential application (i.e., force majeure clauses) and (ii) the parties must make their best efforts to fulfil the contractual obligations.

Therefore, in case of exceptional situations that challenge the performance of contractual obligations, our legal system does not provide for automatic mechanisms of contractual modification, suspension or termination and, in view of the specific fact, the first thing to be checked is whether the relevant agreement contains a specific clause regulating the exceptional situation and, otherwise, whether it is possible to comply with the obligations, even with greater effort than usual.

  1. Mechanisms of contractual flexibility: force majeure and rebus sic stantibus

Notwithstanding the above, it is clear that we face an absolutely anomalous and unforeseen situation that leads us to wonder should the declaration of a state of emergency or the pandemic itself would constitute cases of force majeure because of their capacity to affect and alter the fulfilment of contractual commitments.

Here below are some considerations to keep in mind to determine whether we are faced with a situation for which contractual flexibility could be envisaged:

A) Force majeure

The concept of force majeure is specifically provided for by our Civil Code in article 1105: “(…) no one shall be liable for events which could not have been foreseen, or which, if foreseen, were unavoidable“.

As a result of the not very concise wording of said provision, the jurisprudence of the Supreme Court has established the following requirements for the application of force majeure: (i) unforeseeable or unavoidable event in the strict sense; that is to say, it does not apply if it is a remote event. For example, the Supreme Court does not grant this character to economic crises because it considers that they are cyclical in nature; (ii) event without a causal link to the parties, that is to say, that they have not intervened in any way; and (iii) that as a consequence of the event the parties cannot comply with their obligations by any means.

The question is therefore whether the above requirements are met in the case of COVID-19 and the restrictive measures taken in response to the exceptional situation arisen. A priori, without prejudice to the necessary analysis of the specific circumstances of each case, the situation arising from COVID-19 could lead to the application of force majeure.

Example: Contract for the provision of catering services. Requirements (i) and (ii) are met by the very nature of a global pandemic and (iii) also due to the state of emergency that prevents the holding of any type of event.

Thus, once the requirements have been met and being no longer possible to continue with the fulfilment of the contractual obligations, the order of action should be as follows:

  • Check if the contract in question contains a force majeure clause. If so, this will apply on a preferential basis to any other mechanism.
  • In the event that the contract does not contain a force majeure clause, the legal provisions must be complied with. In this regard, Article 1. 105 of the Civil Code mentioned above, stating that “no one shall be liable for events which could not have been foreseen or which, if foreseen, were unavoidable” and Article 1184 of the same legal text, providing that “the debtor shall be released from his obligations when performance is legally or physically impossible”, indicate the guideline to be followed: no one shall be liable if he cannot fulfil the obligations of a contract because he is in front of “events which could not have been foreseen or were unavoidable”, unless the law or the contract itself so provides.
    However, we deem necessary to note that the degree of foresight required with respect to the occurrence of events outside the normal course of events is not the same for a person considered from a personal or individual capacity as it is for a person from a business or professional perspective.
  • To act in good faith in the evaluation of the impossibility and, in the event of persistence, to communicate individually to the other contracting party the impossibility of carrying out the compliance, and evaluating (with diligence, transparency and good faith) the option to agree a modification of the conditions increasing terms, relaxing demands, reviewing alternative channels of compliance, etc.
  • In any case, the Royal Decree and other legislation in force must be complied with, being not offered alternatives in conflict with them.
  • Ultimately in response to the question whether force majeure is applicable to all types of contracts, it is important to highlight that our Supreme Court understands that non-compliance with a pure pecuniary obligation (i.e. regular payment of a price or amount in money) is not susceptible to be covered by force majeure assumption as the event of impossibility does not occur, since money always exists as such, which must be taken into account in those cases where the party’s obligation is exclusively pecuniary.

B) Rebus sic stantibus

Unlike the previous case, the rebus sic stantibus clause is a figure of doctrinal and jurisprudential construction, applicable when there is an imbalance or an excessive burden for any of the parties in the performance of the contract and which allows the terms of the contract to be unilaterally modified or even the call for its termination.

This remedy, undoubtedly radical in its effects and of very restricted application by the Spanish courts, is based on such an extreme alteration of the contractual circumstances that the obligations are de facto unbalanced for one of the parties.

Without prejudice to the subjective component that may impregnate the assessment of contractual decompensation, the case law emerged to date allows us to extract the following requirements: (i) the occurrence of a significant alteration with respect to the circumstances existing at the time the contract was signed and that said alteration responds to unforeseeable circumstances, which cannot by any means be attributed to one of the parties; (ii) that as a consequence of the foregoing a situation of major imbalance between the contracting parties occurs; and (iii) that it is impossible to act differently and in a less burdensome manner.

However, the jurisprudence is very restrictive to accept the rebus sic stantibus doctrine as a consequence of the radical nature of its consequences, which could lead to the unilateral termination of the contractual relationship. For this reason, Spanish courts do not admit that there is a simple imbalance between the parties, but require that such an imbalance put one of the parties in an extreme situation.

It is also important to note that this doctrine does not apply when the contract already provides, explicitly or implicitly, for mechanisms to assume risk, or when such assumption is of the essence of the relevant contract.

Example: Spanish courts considered that some financial products offered to consumers caused extreme imbalance at the height of the economic crisis in 2008.

  1. Conclusions

The exceptional circumstances caused by the COVID-19 and the impossibility or difficulty of continuing to fulfil contractual obligations have opened up the possibility of applying force majeure or rebus sic stantibus clauses.

However, after the above analysis, we can draw the following conclusions:

  • The declaration of the state of emergency and the approval of the regulations developing it do not imply the suspension or cancellation of contracts in force, which retain their full validity and effectiveness.
  • Notwithstanding this statement, there are sufficient circumstances to be able to allege force majeure.
  • Given the force of law of contracts between the parties, the first step should always be the complete analysis of the force majeure clause that the parties would have agreed to in the negotiation of the agreement.
  • In the absence of contractual provision, the Civil Code expressly indicates that no one shall be liable for the performance of contractual obligations the observance of which has become impossible because of “events that could not have been foreseen or were unavoidable”.
  • The rebus sic stantibus clause has a very restrictive application and will come into force not for situations of impossibility of compliance but for those of major imbalance for one of the parties, as a consequence of the occurrence of unforeseeable circumstances.
  • The duty of diligence and good faith is maintained in any case and, as a general rule, any action must tend to moderate and minimize damages.