Credit Crisis May Have Rendered Performance Of Contract Impossible Says 7th Circuit In Affirming Temporary Injunction

Last week the Seventh Circuit Court of Appeals affirmed (opinion here) a district court's decision to issue a temporary injunction preventing John Hancock Life Insurance from enforcing its contractual rights under a complicated sale/lease-back transaction with Hoosier Energy Rural Electric Cooperative.  In doing so, John Hancock was prevented from enforcing a surety bond from Ambac Insurance and the credit default swap Ambac obtained from Hoosier because Hoosier had the potentially viable defense that its own performance under the contract was commercially impossible because of the credit crisis.  Despite affirming the injunction, the court recognized the potential problems with excusing performance of a contract based on the credit crisis, and therefore expressed some skepticism about whether such an argument would ultimately be viable, and narrowly construed the application of the doctrine of commercial impracticality.

Case Background

Hoosier Energy, which is rural electrical cooperative, owns and operates a power plant in rural Indiana.  It entered into the sale/lease-back transaction with John Hancock, which was designed to allow John Hancock to reduce its income tax exposure.  Essentially, John Hancock purchased the power plant and then leased it back to Hoosier, taking the tax deductions for the depreciation on the property.  Since John Hancock was not in the business of running power plants, it had various protections in the contracts, including a credit default swap and a surety bond through Ambac.  As part of the deal, if Ambac's credit rating fell below a certain level, Hoosier had 60 days to find a replacement or John Hancock could force Ambac to pay on the bond. 

In turn, Hoosier would have to pay Ambac under the credit default swap.  This would have forced Hoosier into bankruptcy, and so the district court decided to issue the injunction, deciding this was irreparable harm.  In light of the irreperable harm, the district court held that "the credit crisis facing the world's economies in recent months is un-precedented" and that Hoosier showed a likelihood that it could not obtain a substitute surety at the height of the crisis at any price.  Thus, Hoosier's performance was excused under the doctrine of temporary commercial impracticality.

The Seventh Circuit's Decision

The Seventh Circuit held that  Hoosier could avoid the consequences of failing to find a replacement for Ambac if Hoosier can prove (1) that it had a contractual duty, rather than an option, to find a replacement for Ambac within the 60 day period, (2) that the 2008 credit crunch was unforeseeable to the parties at the time of contracting, and (3) that Hoosier really could not find any replacement for Ambac because of the credit crisis.  The court wrote, that, assuming a contractual duty rather than an option, "it might be possible to make out a real impossibility defense, meaning that (a) all parties to the transaction assumed, when they negotiated the terms, that it would be possible to find some other intermediary with adequate credit standing, and (b) as a result of a financial crisis, no such intermediary existed in late 2008, no matter how much Hoosier Energy offered to post in liquid assets to secure its obligations."

If the contract provision was simply an option -- Hoosier had the option of either finding a replacement surety for Ambac under the CDS or letting Ambac pay John Hancock -- then Hoosier's inability to find a replacement for Ambac to exercise its option would not excuse performance, the court said.  Using one of two football-related hypotheticals, the court noted that "Suppose that Hoosier Energy had an in-the-money option to purchase the Indianapolis Colts by the end of December 2008, and that as a result of the reduced availability of credit it was unable to find a lender to finance the transaction.  That would not make performance 'impossible' and extend the option's expiration, effectively giving Hoosier Energy a new option (for 2009) for free."  That is because the commercial impossiblity doctrine "never justifies failure to make a payment, because financial distress differs from impossiblity."

As a warning to other potential litigants that may want to seize on the commercial impossibility defense in light of the credit crisis and recession, the court noted "it is hard to see how an economic downturn can be alleviated by making contracts less reliable [because] [e]nforceable contracts are vital to economic productivity."  The court throughout the opinion attempted to limit the scope of the impossibility defense to prevent widespread use of the defense by financially troubled businesses attempting to get out from under bad contracts. 

It even took the somewhat unusual step of instructing the district court to vacate the injunction if Hoosier is unable to find a replacement for Ambac by the end of the year, noting that "what was impossible in fall 2008 may well be possible in fall 2009" and the "longer this impass continues, the more the balance of equities tilts in favor of John Hancock."  Given Ambac's credit rating had been downgraded twice during the pendency of the appeal and Hoosier, by its own argument, is financially troubled itself, the court reasoned that allowing the "temporary to drag out in the direction of permanence" would deprive John Hancock of the security it negotiated in the contracts.