Birch Horton Bittner & Cherot attorneys Jennifer Alexander and David Karl Gross joined forces with RISQ Consulting for a round table discussion on what businesses and organizations must consider when reopening to protect against legal liabilities. RISQ Consulting is an Alaskan company providing customized insurance programs and comprehensive employer services and hosts monthly webinars based on trending topics.
Below is the recording of the webinar and the link to find all resources mentioned in the presentation:
There is a famous scene in the Marx Brothers’ film Night at the Opera in which Groucho, representing an opera company, tries to get Chico, representing a singer, to sign his singer up with the opera company. They begin with a lengthy contract on legal-size paper and as Chico reviews and rejects the various provisions, Groucho tears them off, until he is left only with a thin horizontal bit of the document. He tells Chico that he (Chico) has got to like this one, because it merely requires each party to represent that he/she is of sound mind. Chico is adamant in rejecting this clause: everyone knows there is no “Sanity Clause.” After reviewing the rest of this piece, the reader may feel just like Chico.
As we are warned of an avalanche or tsunami of bankruptcy cases (depending upon one’s preference for earth or sea), it will be useful to look at a situation that could face any business at any time: a customer, a supplier or a vendor files for bankruptcy with the objective of getting rid of all that pesky debt, cleaning up an ugly balance sheet and having a fresh start. Usually, when this happens, the bankrupt is already in default under your contract: for example, it has not paid for things you sent or it has not sent items that you paid for and you are prevented from doing anything about it by the automatic stay of creditor action against the debtor after bankruptcy is filed.
Let us also say that you as a supplier, in order to compete effectively in a tough marketplace, gave terms to the debtor – let us say 30-day terms – and that the debtor orders more than $1 million in products from you during a given 30-day period (that is part of the reason that you gave the debtor terms). Now, however, the debtor has filed a bankruptcy case, owing you almost $1 million for products already sent, and now contacts you asking that you continue to ship on terms. You throw the cell phone across the room and don’t think about this situation any longer because it is so ridiculous. Then papers are delivered to you in the debtor’s bankruptcy case, demanding performance under your contract. Do you treat the lawsuit the same way you did the cell phone? As you may guess because this article appears in a law firm blog, the answer is no.
Many business debtors file for bankruptcy not only because they have substantial debts but also because they are parties to bad contracts with suppliers, other businesses or landlords. Think of a retailer that is paying too much for the products in its stores and too much in rent to have the use of stores it no longer wants to operate. In addition to providing some relief from debt generally, bankruptcy also allows the debtor to review its contracts and leases, determine which are good for the business and which are not, and essentially divest itself of the contracts and leases that are not good for the business. Divestiture takes the form of “rejection” of a contract under Section 365 of the Bankruptcy Code. Once a contract is rejected, the other party has a claim for damages that is treated as if it arose before the bankruptcy case was filed. If the debtor wants to continue with the contract, it is “assumed,” or instead “assumed” and then assigned to someone else (usually a purchaser of assets from the debtor who wants the benefit of the contract along with the assets). If a contract is assumed, the debtor/assignee must cure all defaults under the contract and provide “adequate assurance of future performance” (that is, not provide immediate and glaring evidence of inability to pay or perform).
In order for a contract to be subject to assumption or rejection, some performance must be due on each side or, in bankruptcy language, the contract must be “executory.” Although the Bankruptcy Code provides a list of definitions for various terms it employs, somewhat surprisingly, “executory contract” is not among them. Nevertheless, the definition I have provided is uniformly accepted by the courts and disputes regarding whether a contract is executory or not arise in connection with how much, or how little, performance is required to keep a contract “executory.” The answer is: not much. Even a license agreement, under which the licensor is allowing the licensee use of a trademark – for example “Motel 6” – is executory because the licensor must maintain and defend the trademark. Thus, if you have a contract with a debtor that obligates you to do anything at all, you should at least assume that it will end up being executory. Contracts to lend money or to extend financial obligations are not, however, executory, no matter how much they may look like they are. Why? Because the Bankruptcy Code says so in Section 365(c)(2).
Now, of course, bankruptcy cases, even if planned, often have to be planned in a hurry, and a debtor will need time after the filing to figure out what it wants to do, what its creditors will allow it to do, and what the court will determine is appropriate under the circumstances of the case. What happens to executory contracts while the debtor is trying to figure out which ones to assume or reject? Suppose the debtor requires performance under an executory contract in order for its business to survive? For example, take the case of a bankrupt airline to which you supply fuel to keep the planes in the air. The debtor might want to see if it can get a better deal on aviation fuel before it decides what to do with your contract, but, in the interim, it needs the fuel. Suppose the debtor owes you $2,000,000 for fuel supplied before the bankruptcy was filed: may the debtor force you to supply fuel under the terms of the contract, including credit terms, before it decides whether to assume or reject your contract?
Most bankruptcy courts answer ”yes” to this question, on the general theory that this result “preserves” the contract for assumption or rejection and provides the debtor with the necessary time to make intelligent decisions about its executory contracts. “[A] debtor-in possession’s ability to continue to perform and to compel performance with respect to assumable executory contracts is usually the life blood of its reorganization,” says the United States Bankruptcy Court for the Southern District of New York. In re McLean Industries, Inc., 96 B.R. 440, 449 (Bankr. SDNY 1989). (In a liquidation case under Chapter 7 of the Bankruptcy Code, early rejection of executory contracts is compelled, because there is no business to reorganize.)
You will notice that I said that “most courts” agree with the SDNY – most, but not all. If you happen to be involved in a bankruptcy case in the Western District of Michigan, which includes Grand Rapids, headquarters of Amway and birthplace of President Gerald Ford, you will find that the matter of executory contracts is handled differently. First, one starts with the proposition that what comes into bankruptcy is not magically transformed by its transit from ordinary business life into a bankruptcy estate. Second, under general principles of contract law, if the other party is in material default under your contract, you have no obligation to continue performing until the default is cured. Restatement,Second, of Contracts, Sections 225, 242. Therefore, a debtor that is material default under your contract cannot force you to perform until the contract is assumed and the default cured. In re Lucre, Inc., 339 B.R. 648 (W.D. Mich. 2006) (yes, the debtor company in this case was called Lucre, Inc. – as Nietzsche said, we have art to protect us from the truth).
So, which approach is correct? Lawyers will often answer this question by identifying the client they represent. Or, one can say that, unlike science, in law, you begin with the answer and work your way back to the question. Nevertheless, it is important to realize that, in the absence of a Sanity Clause, all we have are the analytical and logical tools that the law provides, which are often more extensive than we might think. Those tools, properly employed, often lead to just results, or, at a minimum, results that we can understand, if not endorse. Therefore, the next time you hear the words “executory” and “contract” applied to any contract to which your business is a party, have your bankruptcy lawyer on speed dial.
Even with recent cuts in state spending, the Alaska Department of Transportation and Public Facilities (“DOT”) still provides about $500 million in contracts every year to Alaska’s contractors and subcontractors. That’s about seven percent of all construction statewide (federal spending is by far the biggest driver in construction). Thus, for most builders in Alaska, there is a good chance DOT construction is going to account for some portion of their job portfolio.
A recent decision by the Alaska Supreme Court, Department of Transportation v. Osborne Construction Company, underscores the importance of reading these contracts closely and following their requirements carefully. DOT hired Osborne Construction to build soil structure improvements at the Fairbanks International Airport in 2013. Osborne’s subcontractor encountered soil conditions different from those anticipated. The subcontractor also struggled to procure sand for the project. Following conclusion of the work, Osborne sent a claim to DOT demanding additional compensation for expenses incurred because of these unexpected conditions. The DOT contracting officer denied the claim because Osborne had failed to submit the claim “within 90 days of becoming aware of the basis for the claim.” Osborne unsuccessfully appealed the denial to the DOT Commissioner and then the Alaska Superior Court.
The Alaska Supreme Court upheld the prior rulings. Osborne argued that it did not fail its contract obligations by submitting its claim more than one year after discovery of the costly conditions, because it was only “aware of the basis for the claim” after the contracting officer denied additional reimbursement, breaching the contract. But the Court noted that an act serving as “basis for a claim” was defined in the contract as an act giving rise to a demand for additional compensation, not a denial of such demand. Osborne knew or should have known that it had a claim immediately after incurring the additional costs to address the unexpected condition. Osborne waited so long that it waived its right to make a claim.
The Alaska Supreme Court’s strict adherence to the State’s contract requirements regarding demands for additional money echoed a decision from seven years ago, North Pacific Erectors, Inc. v. State, Department of Administration. In that case the builder had encountered unexpected difficulty removing asbestos, then failed to submit a claim documenting the “actual costs” it incurred. The contract clause governing differing site conditions had specified “complete, accurate, and specific daily records concerning every detail of the potential claim, including additional costs incurred.” The contractor had submitted a claim cost summary that was generalized, providing no specificity as to actual labor hours or additional materials. The Alaska Supreme Court held that the contractor was barred from recovery because it had failed to follow the express provisions of the contract.
While the Osborne decision highlights the importance of making claims promptly, North Pacific Erectors highlights the importance of documenting claims thoroughly. The decisions also demonstrate a restrictiveness in state contracting that is not necessarily present at the federal level. Courts in some jurisdictions may take the attitude that contractors are not lawyers and cannot be expected to follow the hard letter of the lengthy terms and conditions they agree to. The Alaska Supreme Court has once again indicated that it will grant no such leniency.
There is a seldom-used legal doctrine called “frustration of purpose” that provides a party with the ability to walk away from a contract when the purpose of a contract is totally defeated by an unexpected event. This doctrine was first established in English law with a case called Taylor v. Caldwell. In that case, which was decided in 1863, a party contracted to rent a music hall for the performance of a concert. After the contract was signed, but before the concert was set to take place, the music hall burned to the ground. Since the concert could not go forward, Judge Blackburn ruled that the contract had an implied condition that the music hall must be in existence at the time of the concert. Since the concert hall was no longer in existence at the time of the concert, both parties were required to walk away from the contract.
Another example, which is found in the Restatement (Second) of Contracts, is where a person rents out a balcony to watch a parade. Due to the illness of an important parade official, the parade is cancelled. The person does not pay for, or use, the balcony, effectively breaching the contract. However, the parade watcher is not liable for a breach of contract due to the doctrine of frustration of purpose, as the entire purpose of renting the balcony was to enjoy the parade.
This doctrine was quite prevalent in 1919 when the Eighteenth Amendment was passed, making the manufacture, transportation, and sale of alcohol illegal. With the passage of this Constitutional amendment, many establishments had to go out of business, in particular, bars and saloons. If a party rented out a space specifically to operate a bar prior to Prohibition, and where after Prohibition the bar could no longer sell alcohol, case law demonstrated that the purpose of the lease (i.e. to sell alcohol to the public) was frustrated, meaning that the tenant could break the lease without liability.
Now that we are facing a global pandemic as a result of COVID-19, there are a number of circumstances where the doctrine of frustration of purpose will apply. For example, taking the case of Taylor v. Caldwell, one can envision a situation where a music hall or stadium is unavailable because of federal, state, or local mandates. If someone rented out such a venue for a concert or sports event, the doctrine of frustration of purpose will likely result in a finding that no rent need be paid when the venue is unavailable due to an unexpected event. Certainly, a strong argument can be made that closures caused by COVID-19 are certainly unexpected, unanticipated, and unforeseeable.
When considering whether this doctrine may apply to your particular situation, there are a few things to consider. First, when this doctrine has been successfully applied in the past, there has typically been nothing in the contract that discusses what happens if there is an unexpected event, such as a force majeure clause. If the contract specifically sets forth what happens in an unexpected event, the contract language will apply, and not the doctrine, even if there is a legitimate frustration of purpose.
Second, the doctrine only applies as long as the unexpected event frustrates the purpose of the contract. For example, if we again look to the facts of Taylor v. Caldwell, but we assume that the rental of the concert hall was for an entire year, the doctrine of frustration of purpose would only last until the music hall was rebuilt. This is true because once the music hall was again available to hold concerts, the purpose of the contract would no longer be frustrated.
Finally, in order for this doctrine to succeed, the entire purpose of the contract must be frustrated. If the contract provides for a number of things, but only a few of them are frustrated, this doctrine may not apply. Or, if the contract is just hampered or hindered (such as if the arrangement can continue, but is no longer as profitable to one of the parties) that doctrine may not apply to excuse performance. In other words, the doctrine is most applicable when the entire contract simply cannot be performed or no longer makes any sense.
If you find yourself in a situation where your business is closed or operating in a limited capacity due to COVID-19, or if your business is impacted by travel restrictions, you may benefit from the application of the doctrine of frustration of purpose. Of course, every situation is different, and this doctrine is very dependent on the particular facts involved. If you think this doctrine may be available to you it would be prudent to have an attorney consider your specific circumstances. The attorneys at Birch Horton Bittner & Cherot are prepared to discuss your obligations and potential remedies with you.
If the COVID-19 Pandemic makes it impossible – or even illegal – for a contractor to maintain the necessary workforce on a project, the resulting delay in progress is almost certainly outside the contractor’s control. But can the project owner terminate the contract in this situation? The answer lies in the language of the parties’ contract. And even when the language is as clear as possible, the final answer, like so many other times in the legal world, is “it depends.”
Most contracts for construction give two possible scenarios for the owner’s unilateral termination of the contract. One is a termination “for default.” If the contractor, due to some fault of its own, cannot progress the work, the owner can terminate the contract. It is a severe measure. Following such a termination, the contractor receives no further reimbursement of any kind for work it has performed, and the owner can even demand that the contractor pay for completion of the project. However, because a contractor is generally not at fault for an unforeseen and uncontrollable problem like a pandemic and shutdown, the owner cannot terminate for default in this situation. Doing so would be a breach of contract.
Of course, every situation has its nuances. Perhaps the contractor had known about the pandemic earlier in the project, and had nevertheless promised the owner that it could finish the job on time and under budget. In that situation, the delay experienced by the contractor may not be excusable, and the owner may be able to terminate the contractor for default. We are back again at “it depends.”
The second type of termination is “for convenience.” Many contracts state that an owner can terminate a contract unilaterally and without even giving a reason why. The only requirement is that the owner give the contractor sufficient written notification of the impending termination, so that the contractor can demobilize from the project. Once demobilization is complete, the contractor sends the owner a cost bill summarizing work performed as of the date of termination and asking for reimbursement for termination-related costs such as the demobilization. As long as the cost bill is reasonable, the owner usually has to pay it. The one thing the contractor generally cannot ask for is reimbursement of profit for work that it expected to do in the future but did not get a chance to do.
Can an owner terminate a contract for its own convenience because of the COVID-19 Pandemic? The answer is yes, and that scenario is playing-out all over the country right now. It is important to remember that an owner does not have to explain why it is terminating the contract for convenience. A contractor may argue that it is helpless against the effects of the COVID-19 epidemic, but that does not weigh on the owner’s right to terminate.
But there is one last wrinkle to consider. A termination for convenience provision is an agreement creating the option to end the contract and at the same time limiting the liability of the owner. Some jurisdictions hold that an owner cannot terminate a contract just to take advantage of that limitation of liability. For example, an owner cannot terminate for convenience only because doing so would allow it to avoid paying money otherwise due to the contractor. This is called a “bad faith termination.”
The line being drawn here is extremely fine, and the Alaska Supreme Court has never clearly explained whether the line is there at all. In City of Dillingham v. CH2M Hill Northwest, Inc. the Alaska Supreme Court considered a contractor who experienced severe cost overruns due to design problems. The owner pointed to a provision of the contract limiting liability to $50,000. The Alaska Supreme Court stated that a contractual limitation of liability is not effective if the party taking advantage has acted “fraudulently or in bad faith.” See 873 P.2d 1271, 1272 (Alaska 1994). In another case, Pierce v. Catalina Yachts, Inc., the Alaska Supreme Court suggested that the enforceability of such provisions was fact-sensitive. See 2 P.3d 618 (Alaska 2000). The answer lies in whether the parties were equally sophisticated, transacted at arms-length, and did not actively seek to harm each other.
“Bad faith termination” usually comes into play when the owner enjoys a substantial advantage in sophistication and resources over the relatively small contractor. Such an owner may use its position to make unreasonable demands of the contractor and then threaten to terminate “for convenience” if the demands are not met. In a pandemic situation, an owner may use the threat of termination simply to intimidate a contractor in the midst of a bad economic environment. In the middle of the COVID-19 Coronavirus Pandemic, no contractor wants to lose any work, if possible. But such intimidation by an owner is bad faith. If the intimidation concludes with a termination – even a termination for convenience – then the owner may still be liable for essentially using the contract as a tool to act like a bully. Like everything else in the law, the specific facts of the situation determine what is and isn’t permitted.
Birch Horton Bittner & Cherot (“BHBC”) has always prided itself in being a full-service law firm. Our goal has been to provide our clients with support no matter what legal issues they may be facing. This commitment is unaltered in the face of the COVID-19 pandemic. Over the last two weeks, BHBC has been called upon to address a wide array of issues. In each instance, we have been able to provide the advice and resources our clients needed to address the problem. The following is a list of some of the issues we have tackled and the names of the attorneys at BHBC who handled each issue.
Debt-relief strategies (including bankruptcy and non-bankruptcy solutions).