COVID-19 Financial Services update: terminating or disclaiming contracts

In previous weeks our Financial Services Updates have discussed certain proactive measures that lenders and borrowers can take in light of the COVID-19 pandemic. This week our update focuses on the ability of companies to terminate contracts in accordance with their provisions or disclaim or resiliate contracts in the context of a restructuring. Downsizing and reducing operating costs are important strategies for maintaining the viability of a business during an economic downturn, and understanding the available options may allow a company to navigate this process with greater foresight allowing it to achieve a better overall outcome.

Under Canadian law, force majeure clauses and certain legal doctrines may provide some relief to businesses that are looking to terminate certain contracts. Alternatively, companies facing more general financial issues can choose to restructure their business under either the Bankruptcy and Insolvency Act or the Companies’ Creditors Arrangement Act.

Ability to Terminate Contracts

As businesses consider their ability to terminate contracts that have become unprofitable or unrealistic in the current global climate, they should consider the provisions of their contracts and, in cases where there is no force majeure clauses, general legal doctrines governing contract law. As summarized below, force majeure clauses, or one of the legal doctrines of impossibility or frustration, may provide relief to a company in certain circumstances.

For a more detailed overview of force majeure clauses and these legal doctrines in light of the COVID-19 pandemic, please see our previous article.

Force Majeure Clauses

Often contracts contain force majeure clauses which outline possible events (including natural disasters, pandemics, war, etc.) and provide for an agreed upon response should any of those events occur. The responses are determined between the contracting parties at the outset of the agreement, and can include excusing one or more parties from their obligations under the contract or delaying the obligations under the contract for a specified period of time. Businesses should proactively review any such clauses in their contracts to see whether they are applicable in the current circumstances.

Legal Doctrines of Impossibility and Frustration

When there is no force majeure clause in an agreement, the legal doctrines of impossibility and frustration provide for situations where the court will recognize that a contract cannot be completed. It is important to note that neither doctrine applies in situations where the parties are simply inconvenienced or experience a material loss—the threshold for establishing both impossibility and frustration is high.

Under the legal doctrine of impossibility, the court focuses on determining whether a certain event was unforeseeable and whether that event makes it impossible to perform the contract. To conclude that the obligations under a contract are impossible to fulfill, the court will need to determine that fulfilling the contract is objectively impossible and not just more expensive or time-consuming.

On the other hand, the legal doctrine of frustration concerns whether the principal purpose of the contract has been frustrated. In determining this, the court will consider whether the principal purpose of one party’s entering into an agreement has been destroyed or removed.

Counterparty is seeking to cancel its obligations because of COVID0-19

Given our new climate, many companies may be parties to contracts where the counterparty is seeking to cancel its obligations because of COVID-19.  If you find yourself in this situation here are some factors to consider, in order to assess your ability to defend against such counterparty trying to terminate a contract, in your favour.

1. Does your contract have a force majeure clause?
2. When are the counterparty’s obligations due?  Canceling an agreement in reliance on a force majeure clause may be premature in some circumstances.
3. Is COVID-19 the cause of your counterparty’s nonperformance? Consider whether your counterparty would have been able to fulfill its obligations but for COVID-19 or whether your counterparty has other motivations to cancel the contract as opposed to working out an agreeable resolution.
4. Is there a way to mitigate damages? Parties have an obligation to mitigate damages and to perform through alternate means if possible. Consider whether each party is taking appropriate steps to mitigate damages.
5. Is there a way that you can negotiate new dates, times, or obligations rather than cancel the agreement?

Ability to Disclaim or Resiliate Contracts in Formal Insolvency Proceedings

If a business is experiencing serious financial difficulty, it may consider the ability to disclaim or resiliate contracts within the context of a formal insolvency or restructuring proceeding, under either the Bankruptcy and Insolvency Act or the Companies Creditors Arrangement Act. As part of the restructuring process, companies can disclaim or resiliate contracts that have turned out to be far less profitable or advantageous than originally anticipated. A wide range of contracts can be disclaimed or resiliated under the legislation, including supplier or service contracts and commercial leases (if the debtor is the lessee). It is worth noting that certain contracts cannot be disclaimed or resiliated, including eligible financial contracts, collective agreements, financing agreements (if the debtor is the borrower), leases of real or immovable property (if the debtor is the lessor) and agreements granting use of intellectual property rights.

Bankruptcy and Insolvency Act (the “BIA”)

Disclaiming or Resiliating Commercial Contracts

Pursuant to Section 65.11 of the BIA, if a debtor has filed either a notice of intention under Section 50.4 or a proposal under Subsection 62(1), the debtor can terminate an agreement that is impacting the viability of its business. In order for the debtor to disclaim or resiliate the agreement, the agreement must be with either an individual or a corporation and the debtor must give notice in the prescribed form and manner to the other parties to the agreement and to the Trustee appointed under the BIA at the beginning of the process. Once the other party to the relevant agreement has received notice, they have fifteen (15) days to apply to the court for an order preventing the agreement from being disclaimed or resiliated. The court will only grant this order if the other party successfully argues that the continuation of the agreement would not render the debtor insolvent.

In determining whether to allow the contract to be disclaimed or resiliated, the court will consider the following factors:

1. whether the Trustee approved the proposed disclaimer or resiliation;
2. whether the disclaimer or resiliation would enhance the prospects of a viable proposal being made in respect of the debtor; and
3. whether the disclaimer or resiliation would likely cause significant financial hardship to a party to the agreement.

Disclaiming or Resiliating Commercial Leases

While the general disclaiming and resiliating provisions found under Section 65.11 of the BIA do not apply to leases of real property, there is an exception for commercial leases under Section 65.2(1) of the BIA. Pursuant to Section 65.2(1), at any time between the filing of a notice of intention and the filing of a proposal, or on the filing of a proposal, a tenant may disclaim or resiliate a commercial lease of real or immovable property.

In order to do so, the tenant must provide the landlord with thirty (30) days’ notice in the prescribed form and manner. Similar to the process for commercial contracts, once the landlord receives notice they have fifteen (15) days to apply to the court for a declaration that the disclaimer should not apply to its lease. If the landlord applies for the court’s consideration, the onus is on the tenant to prove that the proposal will not be viable without the disclaimer of the lease.

In making a determination regarding vacating the lease, the court will assess the impact of the lease payment on the viability of the proposal and the overall likelihood of success for the proposal. If the court determines that the proposal has only a slim chance of success, even if the lease is repudiated, the landlord’s application is more likely to succeed.

Companies’ Creditors Arrangement Act (the “CCAA”)

The CCAA provides the ability for debtors to restructure their financial affairs through a formal plan of arrangement. Unlike the BIA, only corporations are eligible to restructure under the CCAA and their outstanding debts to creditors must be in excess of five million dollars. In addition to having the power to assign contracts under the CCAA, debtors can also disclaim or resiliate contracts pursuant to Section 32. The process for obtaining a disclaimer or resiliation under the CCAA is similar to the BIA, in that the debtor must provide notice to the other party and obtain approval from the Monitor appointed under the CCAA at the beginning of the process. However, if the Monitor does not provide approval, the debtor may apply for a court order approving the disclaimer instead. Additionally, as with the provisions of the BIA, the other party to the contract then has the opportunity to make an application to the court opposing the disclaimer or resiliation. In determining whether to grant the disclaimer or resiliation under the CCAA, the court will consider the same factors noted above under the BIA.

Conclusion

In practice, terminating or disclaiming commercial contracts can provide businesses with greater flexibility to adjust to economic downturns. For instance, companies may look to terminate service contracts that have become impossible to fulfill, or alternatively, companies with locations across the country may look to disclaim or resiliate contracts in order to close locations that are struggling or downsize to smaller more manageable locations. Generally, the ability to terminate or disclaim certain types of contracts can lead to an effective or actual restructuring of a company’s obligations, and provide it with the opportunity to position itself for future growth.

If you have any additional questions or would like more information, please feel free to contact any member of the Miller Thomson Financial Services Group.

Miller Thomson is closely monitoring the COVID-19 situation to ensure that we provide our clients with appropriate support in this rapidly changing environment. For articles, information updates and firm developments, please visit our COVID-19 Resources page.