Brexit: Implications for contracting parties

In our recent Law-Now article Brexit: What does it mean for cross-border disputes, we recommended that parties review existing contracts to identify clauses which might be affected by the outcome of the recent referendum on whether the United Kingdom (UK) should leave the European Union (EU), the UK’s formal withdrawal from the EU, and associated events. In this article we consider the most obvious of these clauses, and how parties might use contractual mechanisms to terminate or vary an existing contract as a result of these events. Before doing so, it is worth noting that the general approach of the English courts when interpreting a written contract is to give effect to the objective intention of the parties. What the court will not do, is “favour a construction which fits the likely purpose, influenced by knowledge of what has happened after the event, and forgetting other factors that may have influenced the parties at the time” as to do so would be to “seek to mend or improve the bargain that was actually made. The agreement must be construed as it was, not as subsequent events might suggest would have been wise to have made it.” Bank St Petersburg v Savelyev [2013] EWHC 3529 Ch [73].

BREXIT is not the first event in recent history to have a potentially material effect on contractual relationships. In considering options that may be available to contracting parties, it may also be useful for businesses to consider recent periods of turbulence, including the credit crisis (2007-2011) and the introduction of the Euro (1999).

BREXIT clauses

In the period leading up to the referendum, some parties incorporated a ‘BREXIT clause’ into their contract/s, permitting termination upon the occurrence of BREXIT (or some other event related to it). Keeping in mind that the UK’s formal withdrawal from the EU has not occurred, and is unlikely to occur for at least two years, if a contract contains a BREXIT clause, only clauses which give a right to terminate upon a majority leave vote in the June 2016 referendum would be capable of being exercised at this time.

Parties may still seek to include similar clauses in their contracts, although we would expect such clauses now to be more nuanced, for example, giving a party an option over certain performance obligations depending on, say, the outcome of negotiations between the UK and the EU over access to the Single Market. As such, clauses are likely to be less common and arise only in the case of long term contracts.

Force majeure clauses

There is no independent legal concept of force majeure under English law. Accordingly, unless a contract is frustrated (considered below), a party would need to rely on a contractual ’force majeure’ clause to excuse it from performing the contract. The form of force majeure clauses can vary widely, but all should (i) specify the event or events that would give a party a right to invoke the clause; and (ii) identify the performance obligation from which the party is released. Clauses will usually impose additional obligations on the parties, for example, that the force majeure event must not be within the control of the party seeking to rely on it, and that measures will be taken to mitigate the effect or impact of the event in question.

Whether or not the UK’s withdrawal from the EU (or some related event) will qualify as a force majeure event will turn upon the specific wording of the applicable clause and the facts of the case. Indeed, it is likely, based on typical force majeure clauses, that the results of the referendum itself, and the political consequences themselves will not amount to a force majeure, but the effect of those events could do so.

However, it is unusual for an economic impact on a party to be the basis of a force majeure right. Parties contemplating termination of a contract by reason of force majeure should be aware that the English courts have previously rejected an argument that the credit crisis and corresponding inability of a party to obtain lending satisfied a force majeure clause excusing performance for specified events and “any other cause beyond the seller’s reasonable control” (Tandrin Aviation Holdings Ltd v Aero Toy Store LLC [2010] EWHC 40 (Comm)). Performance must be physically or legally impossible – it is not enough for performance to be made more difficult or for the contract to become unprofitable.

Turning now to another turbulent period, prior to the introduction of the Euro, Council Regulation (EC) No 1103/97 was introduced, which provided that the introduction of the Euro would not have the effect of “discharging or excusing performance under any legal instrument, nor give a party the right unilaterally to alter or terminate such an instrument” (subject to the parties’ contrary agreement). It is possible that legislation introduced to give effect to the UK’s withdrawal from the EU may include a similar mechanism, in order to provide certainty to contracting parties. Of course, (as noted above) parties may, in anticipation of such legislation, seek to incorporate specific contractual provisions to reserve certain rights in any event.

Material Adverse Change clauses

Material Adverse Change (MAC) clauses can be used in corporate acquisitions to allow a buyer to withdraw from a transaction if there is a materially adverse change in circumstances affecting the business, operations, assets, or liabilities of the target entity. What constitutes a material adverse change will of course depend upon the specific wording of each clause and clauses are usually carefully negotiated. Contracts entered into before the referendum with a MAC clause may provide the best opportunity for a party to terminate. Subject to the specific terms of the contract, it is likely that events would need to have caused an actual adverse change rather than the risk of adverse change. MAC clauses will continue to feature in many contracts and parties will need to be aware of the potential for them to be invoked as a result of the UK’s withdrawal from the EU, or related activities or events.

Hardship

Many long term contracts are based on detailed financial modelling and forecasting in order to determine the long term profitability (or viability) of the contract. For those entering into such contracts, a hardship clause may be sought, for example to protect against a material shift in the value of Sterling, the available pool of appropriately qualified resources to perform a party’s obligations, or a significant change in the cost of raw materials or energy. Where hardship clauses are invoked, it may entitle a party to renegotiate certain parts of the contractual arrangement, or provide a mechanism for the binding determination of certain alternative financial modelling (for example, gas pricing contracts). Care, however, will need to be taken that such clauses are sufficiently certain to be enforced. A right to renegotiate a contract may not be enforceable, without some additional mechanism dealing with the consequences of not reaching agreement.

Future legislation provision

A standard provision in many contracts, but one particularly common in contracts with warranties and indemnities, is that a party will not be liable if the liability occurs, or is increased, as a result of a change in legislation or withdrawal of any agreements/concessions made by the government.

With the UK’s withdrawal from the EU, there may be various changes in legislation that will have an impact on the way businesses operate. As such, in some circumstances it may be advisable to include a mechanism to resolve the issues that arise where legislative change could have a material impact on the operation of the contract.

The doctrine of frustration

In very limited circumstances, a party may find that the doctrine of frustration will apply, in which case the contract will be automatically discharged. A frustrating event must occur after the contract has been formed, and that event must render the contract physically or commercially impossible to fulfil, or transform the contractual obligations into something that is radically different from that which was agreed by the parties when the contract was entered into. Although parties seeking to exit a contract might be buoyed by the existence of this doctrine, it is not easily invoked. Allocation and assumption of risk goes to the heart of a contractual relationship, and the English courts are extremely reluctant to permit parties to avoid such obligations simply because a contract has become more difficult or less profitable to perform. In Larrinaga v Societe Franco-Americaine des Phosphates (1923) 14 Ll.L.Rep. 457, 464, the court stated that “rarely, if ever, is it a ground for inferring frustration of an adventure that a contract has turned out to be a loss or even a commercial disaster for somebody” [emphasis added].

Next steps

For existing contracts, parties should review the relevant provisions and, if seeking to bring a contract to an end, consider whether or not the above clauses might be relied upon (whether now or upon the occurrence of the UK’s withdrawal from the EU, or other related events).

However, parties should be aware that if the contract does not expressly allow a party that is disadvantaged by BREXIT to pass some of the liability on to the other party, the courts will be inclined to assume that each party accepted the risk that they would be adversely affected by BREXIT, particularly if the contract was entered into after the referendum. The court will not “rewrite” the bargain or allow termination where the parties have not otherwise agreed this. In any case, terminating a contract is a serious endeavour and parties should be aware of the potentially serious consequences of terminating a contract in circumstances where they are not entitled to do so, as this may give rise to very material liabilities.

Businesses will be assessing the impact of the referendum and the UK’s withdrawal from the EU to their commercial arrangements and parties can expect to see the allocation of any new risks being tabled for negotiation. For future contracts parties should be mindful of the range of contractual protections that may be sought by either or both parties, and be ready to resist, or negotiate them!