The tolerance of contractual default with Covid-19

We have been asked by some clients about the impact of the Coronavirus pandemic (Covid-19) on commercial contracts they have signed, given that many will be defaulted due to the impossibility of fulfilling the obligations agreed thereupon, mainly due to the measures of prevention adopted by the government, such as mandatory quarantine, closing of commercial establishments, restrictions on the movement of people, lack of liquidity and financial difficulties. The question at hand has three main aspects to be analysed: the fortuitous event / force majeure, the adverse material effect and the excessive cost of the contract.

Regarding the “fortuitous event / force majeure”, it is worth mentioning that this institute is only applicable if the effects are unpredictable and unavoidable. It seems to us that Covid-19 fits this criterion (if the contracts were signed before the pandemic). Therefore, if there is a contractual provision for exemption from liability, the debtor will not be liable for damages resulting from unforeseeable circumstances or force majeure. But, what if there is no contractual provision? In this case, the debtor will not be liable for the impossibility of the service if it proves exemption from guilt or that the damage would happen even if the obligation was timely performed. It is worth mentioning that, if the impediment, although concrete, is only temporary, compliance with the obligation should, in principle, be suspended, except if the resulting delay justifies the termination of the contract.

Regarding the second part, although there is no legal provision, many contracts in Brazil contain a material adverse effect clause (Material Adverse Change Clause, or MAC Clause – imported from countries such as the United States and England) to allow a party to “jump out” of the business in the event of some of the hypotheses that cause a significant adverse effect on the other party, such as financial difficulties, political and economic crises, among others. A MAC Clause, therefore, varies from contract to contract and aims to describe those events that may have an adverse impact on the party’s activities, in order to affect its ability to fulfil its obligations under the contract. It is unlikely that a MAC Clause drafted before the times we are currently living will predict a pandemic in the proportions of Covid-19, however, many may encompass effects that Covid-19 is bringing to everyone.

Thus, if any of the events or circumstances described in the clause negotiated between the parties occurs, the aggrieved party will have the right to terminate the contract. For the other party, it is possible to try to negotiate terms and other adjustments in the contract in order to circumvent the effects of MAC Clause.

Now, even though the contract does not have any of the above institutes, it is possible to analyse Covid-19 from a third perspective: the hypothesis that the execution of a certain contract would become excessively costly for one of the parties, generating a contractual imbalance.

Our Civil Code establishes that, in the contracts of continuous or deferred execution, if the performance of one of the parties becomes excessively costly, with extreme advantage to the other, due to extraordinary and unpredictable events, the debtor may request the termination of the contract , which can be avoided by equitably modifying the terms of the agreement in order to avoid excessive burdens.

In order to identify whether or not a particular company can use the exclusion of liability based on the above institutes, contractual provisions, such as general business conditions, must be assessed on a case-by-case basis; if there are clauses for exemption from liability for unforeseeable circumstances / force majeure, “clauses with a material adverse effect”, and, if any, as defined; and, if in the absence of a contractual provision, the parties can, in fact, avail themselves of the consequences of Covid-19.

However, in view of the exceptional and notorious circumstance of the coronavirus pandemic, we recommend that the parties always seek amicable ways to resolve conflicts arising from the situation, aiming at reducing losses to all involved, mainly through the renegotiation of existing contracts.

By Marcella Bertolini, associate at Candido Martins Advogados