11.09.2020

Practice Areas: Corporate and M&A

Regime of Modification and Suspension of Contracts in 10 answers

1. In light of a change of circumstances, should the party or parties opt in the first place to modify the contract and then to terminate it, or may they freely choose one of these aforementioned options?

The party or parties must consider modifying the contract in the first place and only if this is not possible or workable, consider the hypothesis of terminating it unilaterally, as well as the risks associated with this. The COVID-19 crisis has had a major impact on the execution of contracts, it’s estimated that the negative effects of the crisis will intensify with a second wave of the virus. Even though in practice it has been demonstrated that in the majority of cases the contracted parties obtained, through negotiation, a modification of the terms and clauses that were initially contracted, it is expected that in the future conflicts could intensify. Therefore, in this context of a change in circumstances the doubt arises about whether, in the terms and bases covered by article 437 of the Civil Code, the parties may opt straight away to terminate the contract or whether they must, in accordance with the principle of good faith, maintain the contractual relationship and modify the contract in line with the new circumstances. In fact, following normative principles, good faith is a guiding principle and the basis of normative conduct in contractual relationships. In this way, against a backdrop of a change of circumstances, even though the right to terminate the contract is a right that may be invoked by one of the parties, there exists, even though it isn’t standardised in legal doctrine, a duty of (re)negotiation and of cooperation, in the name of the legitimate expectations of both parties and with a view to reestablishment of the contractual balance, which consequently implies that the parties should choose to arrive at a consensus and modify the contract (if that’s possible and achievable).

 

2. Is there an obligation to renegotiate contracts when a change of circumstances is proven to have taken place?

In general the best response is yes. Even though it’s not possible to speak about an obligation to renegotiate ipso iure it’s not unreasonable to expect that on the basis of good faith, a duty to negotiate in favour of the defence of the interests of the parties and the maintenance of the contract and contractual expectations falls on the parties. However, this issue isn’t standardised in the legal doctrine, on the understanding that if one of the parties refuses to accept a change to the contract, the other party can take it to court. In this case, the party that refused the change may encounter a further change imposed by the court, thereby missing out on the possibility of terminating the contract based on the notion of change of circumstances.

 

3. The circumstances on which I based my decision to enter into a contract changed. Until when may I invoke the regime provided for by article 437 of the Civil Code?

The regime covered by article 437 of the Civil Code should be invoked as soon as the circumstances justify it. In fact, the law doesn’t define any deadline for the parties to invoke the regime of change of circumstances. However, the law determines that the parties can’t make use of the regime when they find themselves in a situation of arrears, in the case of obligations that have a fixed period, or failure to comply with their obligations. In the case of obligations without deadlines, it falls on the parties to follow the rules of good faith and that the party that intends to appeal to the mechanism provided for by article 437 of the CC, should act in a reasonable period of time, with a view to not frustrating the legitimate expectations of the other party and ensuring the mitigation of potential losses incurred in virtue of the exceptional circumstances.

The regime provided for by article 437 of the Civil Code can be actioned by the aggrieved party, that is, by the party affected by the supervening change of circumstances and provided that the requisites of the law are followed.

Two final points apply: the first is that the regime covered by article 437 of the Civil Code must be actioned before the aggrieved party enters into arrears, that is before the party that saw its ability to pay affected enters into breach of contract, at the same time, it is taken in good faith that the aggrieved party will take the relevant legal action as soon as they find themselves in a position in which it’s clear that they may fall into late payments, with a view to mitigating the losses caused to the counterparty.

 

4. Changes to the contract on the basis of fair play necessarily involve judicial recourse? Or can the parties modify the contacts by mutual accord?

The parties aren’t prevented from proceeding to modify the contracts by mutual accord, but the modification of the contract on the basis of fair play necessarily implies recourse to the courts. In spite of the fact that the issue isn’t standardised in the legal doctrine, with there being authors that understand that the change to the contract, in accordance with the assumptions of the article 437 of the CC and on the basis of fair play can only be done with judicial recourse, the majority of authors tend to defend the position that, in the name of the procedural economy, and relying on the principles of good faith and contractual freedom, the parties may proceed to modify the contract whether on a qualitative or quantitative basis by mutual accord. However, where there is a lack of agreement, the modification on the basis of fair play necessarily implies recourse to the courts in the terms of article 437 of the Civil Code.

 

5. Can the parties invoke the Covid-19 pandemic as a basis for contractual change and afterwards, having had the contract changed, request termination of the contract based on the same principle?

We believe that article 437 of the Civil Code makes it quite clear that where the requisites of change of circumstances of the Civil Code are met, the parties will decide between modification of the contract and its termination and it’s not possible afterwards, based on these same changed circumstances, to then opt to terminate the contract. The application of this regime presupposes that very rigid and demanding requisites are met. As a matter of fact, the right to terminate or modify the contract as a result of an abnormal change of circumstances presupposes that (i) the relevant alteration is in relation to the circumstances in which the parties based their decision to enter into a contract in the first place (ii) these basic circumstances have undergone an abnormal change (iii) the maintenance of the contract implies damage to one of the parties (iv) maintaining the contract or its terms seriously affects the principles of good faith (v) the situation isn’t covered by the risks inherent to the contract and lastly, (vi) the aggrieved party is not in arrears.

We understand that the pandemic provoked by SARS-CoV-2 may be sufficient to argue that there has been a change in circumstances in order to make use of the provision of this legal norm, being the case that a definitive response will depend on the analysis of each concrete case.

 

6. And if one of the parties, after modifying the contract, doesn’t comply with their payment or service obligations? What mechanism does the counterparty have at their disposal in order to be compensated?

If the change to the contract comes into effect, and one of the parties doesn’t comply with their payment or service obligations, the applicable rules will be the general ones in relation to breach of contract, i.e. articles 798 and the following ones of the Civil Code. It’s therefore important to distinguish between the cases in which the contractual default is the result of a simple delay or, if it’s based on a situation of a definitive breach.

If we’re discussing a case of simple delay, the affected party has the right to demand the fulfilment of the obligation, potential compensation in the form of late payment interest and can even call upon the defaulting party to meet their obligation within a determined timeframe, at the end of which it will be considered to be a definitive breach, proceeding to explain the reasons that justify it.

On the other hand, in the cases of definitive breach, the affected party that can be objectively be considered to have had its interests affected in relation to the late payment or late service delivery of the counterparty, has the power to terminate the contract, by means of a unilateral declaration directed to the counterparty, to whom they must address the reasons justifying the termination, the aggrieved party additionally having the right to receive compensation for the losses caused.

 

7. How does the termination of the contract work?

The termination can happen in or out of court, although the latter possibility is debated. Termination implies the end of a contractual relationship and is covered by the terms of the articles 432 and the following being equivalent, in terms of its consequences, to the annulment of the legal relationship, with some specificities (articles 289 and the following ss. ex vi article 433, all of the Civil Code).

The termination may have a retroactive effect, except where it contradicts the will of the parties or the purpose of the termination itself which can be assessed by means of the concrete case. However, in general, for example in the case of ongoing payments, it will be more appropriate that the consequences of the contract termination are valid only from the moment in which the end of the contract comes into effect. In cases where the effects of the termination apply retroactively, all that which was loaned or provided must be returned and if that isn’t possible, its corresponding value.

 

8. And if, in the context of the pandemic, one of the parties refuses to make their payment or service delivery or makes this difficult, can this be considered part of the risk to be absorbed?

The duty to act in good faith over the course of the contractual relationship is one of the basic principles of law (article 762 of the Civil Code). In the context of the pandemic, if a party refuses to pay or provide a service or makes this difficult, this should be taken into account by the court, particularly for the purposes of redistribution of initial contract risk in the modified contract.

In the same way, the behaviour of one of the parties with the aim of reducing the damages caused from the change in circumstances should also be taken into consideration.

 

9. What is the meaning of the clause commonly referred to as “force majeure”?

The so-called “force majeure clause” commonly included in contracts, covers a number of situations that where they’re found to be the case, may temporarily or definitively impede the fulfilment of the contractual obligations agreed between the parties and when it is confirmed that these events took place, it’s no longer considered that a breach of contract occurred, and/or the contractual penalties for delays in payment or breach won’t be applied.

As a rule, these situations refer to facts that aren’t foreseeable and that are out of the control of the parties, who can’t stop them happening, as in the case of wars, natural disasters or pandemics.

Confirming that a situation of force majeure has taken place doesn’t allow in itself, the termination of the contract but rather the possibility for the late payment to be made over a different and more extended period.

 

10. In what way is it possible to establish specific rules in the contract itself that allow for its modification and suspension?

The parties are free to stipulate in the contract their own way of regulating the modification and suspension of the contract, beyond the legal framework referred to above (falling back on the answer to question number 4). In these cases it’s important that the procedure that permits the modification and suspension of the contract is defined in a clear and express way.

However, it’s important to emphasise that in the face of situations with some level of indeterminacy and uncertainty, namely in relation to the reasons that determine the right to demand the modification and/or suspension of the contract, it’s fair to say that we’re facing exceptional situations that only become apparent in extreme circumstances.

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