30 April 2020
Introduction
Ovreview
On March 11, 2020, the World Health Organization (WHO) declared the novel coronavirus disease a pandemic. On the same day, the Government of India imposed visa and other travel restrictions. Soon thereafter, many states in India declared a ‘lockdown’, an emergency measure [under the Epidemic Diseases Act, 1897 and the Disaster Management Act, 2005 (“Disaster Management Act”)] to prevent and contain the spread of SARS-CoV-2, and also issued prohibitory order(s) under Section 144 of the Code of Criminal Procedure, 1973. A stricter lockdown was then imposed by the Central Government, which will presently remain in effect till May 3, 2020. During the lockdown, whilst certain commercial activities have been classified as essential and are permitted to continue operations, subject to following preventive measures (including social distancing), several others remain stalled and suspended.
Impact of SARS-CoV-2 on business continuity
Disruption of trade and commerce on account of such measures has already spiraled. The measures will prevent (and may have already prevented) several businesses from fulfilling their obligations under contracts and could lead to termination/cancellation of the same, as well as expose businesses to the risk of litigation. Undoubtedly, there will be a spate of litigation by promisees seeking enforcement of contractual obligations or compensation for non-performance of contractual obligations, and possibly even by promisors seeking recovery of dues withheld by promisees or compensation for termination of contracts.
Contractual jurisprudence is founded upon the commandment that contractual terms are supreme and parties must be held to their bargain. The parties may, as part of their pact, also identify certain events or occurrences (including price fluctuation), which would not affect the obligations of the parties under the contract. Parties would also normally include certain exceptions or exclusions in the contract, which they believe would affect the performance of their obligations under the contract, recognising that the performance of certain aspects of the agreement may not always be within their contemplation or control. Such clauses, like force majeure clauses, have garnered a lot of importance over time, and have been brought into focus during the present epidemic. Depending on the terminology adopted by the parties, a force majeure clause may be all-encompassing or restricted to only certain situations beyond the control of the promisor and/or the promisee. The occurrence of an identified or ‘covered’ event/circumstance may suspend the performance of the contract, or render it void. Historically, force majeure clauses, also referred to as act of God clauses, include within their fold circumstances such as floods, natural calamities, war, strikes, riots, etc. However, as a matter of law, force majeure clauses are also to be narrowly construed.[1]
Contracts with widely worded force majeure clauses, are also usually eloquent in relation to the steps to be taken and the rights and obligations of the parties in that situation. In the absence of a force majeure clause (or one which is not widely worded/all-encompassing), parties will be required to examine whether the outbreak of SARS-CoV-2 or the restrictions imposed in view thereof, make it “impossible” for them to perform their obligations. If so, and depending on the facts and circumstances, such parties who are unable to perform their contractual obligations, may have no option but to invoke the doctrine of frustration (i.e. that such obligations have become impossible to perform) to defend any action initiated against them.
In a crisis of this nature, many will try to ride on the force majeure/frustration wave. Some will float, others may sink. Courts may or may not be inclined to take a lenient view, but this will most likely be based on the facts and circumstances of each case, given that the determination of whether a contract is frustrated (or impossible to perform) is quite subjective. This may include determining the nature of the obligation to be performed (including whether the same is part of the fundamental bargain between the parties), whether the outbreak or state measures were the direct or substantial cause of the inability to perform such obligation, whether the promisor was diligent and explored all alternatives, etc. It is entirely possible that courts may not consider the lockdown to ipso facto be an event that renders the performance of obligations under a contract impossible, given that the lockdown is temporary.
The Bombay High Court recently refused to restrain encashment of letters of credit on applications by purchasers of steel products, who contended that their contracts with a South Korean supplier were unenforceable on account of frustration, impossibility, and impracticability. Pertinently, the seller had already shipped the goods from South Korea and the relevant force majeure clause provided protection only to the seller and not to the buyers. The Bombay High Court rejected the applications by the buyers on the grounds that (a) the letters of credit are an independent transaction with the bank and the bank is not concerned with the underlying disputes between the parties, (b) the force majeure clause is applicable only to the seller and not the buyers, (c) the fact that the buyers would not be able to perform their obligations as far as their own purchasers are concerned and/or would suffer damages are not factors that can be held against the supplier, (d) steel, ports, warehouses, etc., have been declared as an essential service and there are no restrictions on the movement of steel and (e) the lockdown is only for a limited period and cannot come to the rescue of the buyers so as to enable them to resile from their obligation of making payment to the supplier.[2]
The advantage of a force majeure clause is essentially that it provides agreed alternatives for the parties to consider in such a situation, including suspension of obligations under the contract, extension of time for performing obligations or even renegotiation of the terms of the contract. This also means that the underlying project or transaction can still be salvaged, and parties can agree as to the best way to do this. However, the aforesaid options may not be available as a matter of course in the absence of a force majeure clause, unless the parties can agree to exercise them, nonetheless. Frustration can be used only as a defence in an action brought against a party for non-performance of contractual obligations, and whether the contract stands frustrated is subject to determination by a court or arbitral tribunal ex post facto. If the contract is found to be frustrated, then it is automatically void. In such a case, the party invoking the doctrine will be found to be released from the performance of its contractual obligations and will not be penalised. However, if the contract is found to have become void, then any party who has received any advantage under the contract is bound to restore it or to compensate the party from whom such advantage was received.[3]
Doctrine of frustration of contract
The doctrine of frustration of contract allows parties to cease performing contractual obligations where it becomes impossible to do so in circumstances beyond the control of the parties. Section 56 of the Indian Contract Act, 1872 (“Contract Act”) provides that a contract to do an act, which becomes impossible after the contract is made, becomes void when the act becomes impossible. Naturally, the threshold to prove that a contract stands frustrated is very high, and parties will have to prove that the contract is impossible to perform i.e., not literal impossibility, but that it is impracticable and useless from the point of view of the object and purpose of the parties.
Some key takeaways from Indian precedents on frustration of contract are as follows:
- A contract can be said to be frustrated if its performance is impracticable and useless from the point of view of the object and purpose of the parties, though the performance of the contract itself is not necessary literally impossible.[4]
2. If an untoward event or change of circumstance totally upsets the very foundation upon which the parties entered into their agreement, it can be said that the promisor finds it impossible to do the act which he promised to do.[5]
3. Where there is no time agreed between the parties for performance of the contract, delay in performance of the contract cannot be said to seriously affect the object and purpose of the contract, or the fundamental basis upon which the parties entered into the agreement.[6]
4. The doctrine of frustration is usually applied by the court where it finds that the whole purpose or basis of a contract was frustrated by the intrusion or occurrence of an unexpected event or change of circumstances which was beyond what was contemplated by the parties at the time when they entered into the contract. When such an event or change of circumstance occurs, which is so fundamental as to be regarded by law as striking at the root of the contract as a whole, it is the court which can pronounce the contract to be frustrated and at an end.[7] Therefore, even if a contract contains a force majeure clause which does not contemplate a particular event, if such an event strikes at the root of the contract and renders it impossible to perform, then the court may find that the contract has been frustrated.
5. Where a contract contains a force majeure clause, and the court finds that the force majeure clause would apply in the facts of the case, Section 56 of the Contract Act has no application.[8]
6. Where the contract provides for contingencies upon the happening of which the contract cannot be carried out, and also provide for consequences, such cases will be governed by Section 32 of the Contract Act and not by Section 56. If an act becomes impossible at a future date and that exigency, which is beyond the control of the promisor and could not have been prevented by him, is not provided for in the contract, then the contract becomes void as provided in Section 56 of the Contract Act.[9]
7. If the parties expressly stipulate that the contract would stand despite the occurrence of a particular intervening circumstance, which might affect the performance of the contract, there can be no case of frustration.[10]
8. The court may infer impossibility of performance by examining the nature of the contract and the surrounding circumstances in which it was made viz., whether the parties made their bargain upon the basis that a particular thing or state of things would continue to exist and because of the altered circumstances, the bargain should no longer be held binding. The courts may also infer that the foundation of the contract had disappeared either by the destruction of the subject-matter or by reason of such long interruption or delay that the performance would really in effect be that of a different contract for which the parties had not agreed.[11]
9. Impossibility of performance may also arise where contractual obligations become incapable of performance without any default of either party, because the circumstances in which performance is called for are radically different from that undertaken by the contract.[12]
10. A contract is not frustrated merely because the circumstances in which it was made are altered. It is only when a consideration of the terms of the contract, in light of the circumstances existing when it was made, shows that the parties never agreed to be bound in a fundamentally different situation which unexpectedly emerged, that the contract ceases to bind.[13]
11. The courts have no general liberty to absolve a party from liability to perform his part of the contract merely because the performance has become onerous on account of an uncontemplated turn of events.[14]
12. The doctrine of frustration of contract cannot apply where the event which is alleged to have frustrated the contract arises from the act or election of a party.[15]
Commercial difficulty not to be construed as impossibility
The English position on frustration,[16] which has been recognised by the Indian Supreme Court,[17] also recognises the following:
- The factors that have to be considered are the terms of the contract itself, its matrix or context, the parties’ knowledge, expectations, assumptions and contemplations, in particular, with respect to risk, as at the time of entering into the contract, at any rate so far as these can be ascribed mutually and objectively.
2. Another important factor is the nature of the supervening event, and the parties’ reasonably and objectively ascertainable calculations as to the possibilities of future performance under the new circumstances.
3. Since the subject-matter of the doctrine of frustration is contract, and contracts are about the allocation of risk, and since the allocation and assumption of risk is not simply a matter of express or implied provision, but may also depend on less easily defined matters such as “the contemplation of the parties”, the application of the doctrine can often be a difficult one.
4. In such circumstances, the test of ‘radically different’ is important: it tells us that the doctrine is not to be lightly invoked; that mere incidence of expense or delay or onerousness is not sufficient; and that there has to be as it were a break in identity between the contract as provided for and contemplated and its performance in the new circumstances.
It is clear that a high threshold exists for establishing that a contract is frustrated. In order to (a) avoid going down this road and (b) be able to make out a case for frustration of contract, if required, it becomes important to be as pro-active and cautious as possible, at the outset. The present crisis is unprecedented, and whilst companies in many sectors may be given relief by relaxation of certain obligations, this cannot be presumed on an inter-party contractual level as parties at the receiving end of force majeure or frustration invocations are also going to be severely impacted. Therefore, we proceed to set out certain indicative measures, which parties can consider taking in case they foresee delay in their ability to perform contractual obligations, or that they are not going to be able to perform such obligations at all.
Pre-emptive steps which may be taken where parties foresee difficulty or delay in performance of contractual obligations
- If the difficulties in performance are still at a nascent stage, consider contacting the counterparty and commencing without prejudice discussions for extension of time for performance of obligations, suspension of obligations or even renegotiation of the contract.
2. Notify the counterparty in writing that circumstances have arisen which may prevent you from performing your obligations under the contract or may lead to delay in such performance. Set out in detail what the circumstances are and specify that these factors (arising from the outbreak of SARS-CoV-2 or the measures taken in view of the same) are preventing the performance of your obligations, as opposed to any other ancillary factors.
3. Ensure that all possible steps towards performance (in the circumstances) have been taken and continue to be taken, and that all possible alternatives have been explored. Set these out as well in your communication to the counterparty, and if no alternate modes of performance exist then state this also.
4. Provide regular updates in the above fashion to the counterparty, to ensure that the record is clear, insofar as diligence and mitigation on your part are concerned.
5. If there are any other obligations under the contract which can still be performed remotely (submission of reports and accounts, backend technical support, etc.), then ensure that performance of such obligations is continued.
6. If your business is barred from operating during the lockdown period in India and the contract requires delivery of goods or performance of works within this period or immediately thereafter, this clearly may not be possible. If without prejudice discussions as suggested above were not successful, you could write to the counterparty formally requesting an extension of time for performing your obligations under the contract, as well as a waiver/relaxation of the liquidated damages clause (if any) in such a situation. If your requests are rejected and you choose to adopt the position that the contract stands frustrated on account of impossibility to perform, the fact that you made such requests and they were rejected may put you in a better position to defend your position and establish impossibility.
7. If your customer is a government agency, consider making a representation (individually or jointly with other companies in your sector) to the Central/State Government (as applicable) requesting that time extensions or waiver/relaxation of liquidated damages clauses be granted. Ensure that you make out a strong case in your representation, including by setting out all factors that are affecting the performance of your obligations and the repercussions you will have to face if this request is not granted. Annex any relevant documents/proof in this regard.
For instance, the Ministry of New and Renewable Energy inter alia directed all renewable energy implementing agencies to (a) treat delay on account of disruption of supply chain due to outbreak of SARS-CoV-2 in China and other countries as force majeure and (b) consider applications for extension of time in such situations objectively and grant such applications based on the facts therein. Thereafter, the Ministry also directed that agencies may treat the lockdown as force majeure and grant extension of time for renewable energy projects equivalent to the period of the lockdown, and an additional 30 days for normalisation after the end of such lockdown. Several Indian ports have also declared force majeure in anticipation of difficulties in movement of labour, personnel, vehicles, etc., even though ports have been categorised as essential services in order to ensure normal functioning of supply chains.
- Keep extensive records of all communication issued, and representations made as above, as well as underlying documents and internal office memos/correspondence. These will be crucial if and when you have to defend claims made/actions initiated by the counterparty, or when you need to file proceedings for recovery of contractual dues (payments for deliveries/works already completed earlier may be withheld by the counterparty on account of your inability to complete subsequent deliveries/works on account of SARS-CoV-2) or for seeking any other compensation.
- Communicate the above steps by way of an office memo to the relevant managers/heads across regions and functions.
- Analyse your insurance arrangements (if any) i.e. whether such circumstances are covered under your insurance policies (such as business interruption insurance). In the event such circumstances are covered, insurance claims must be made in time and as per the requirements of the policy.
- Consider re-negotiating the terms of the contract if this is commercially viable. This can be done by amending the contract to introduce, remove or modify terms/clauses (such as time for performance or rates), which will eliminate the possibility of the contract being frustrated. Amendments to a contract are commonly carried out by executing a signed addendum.
- Assess the dispute resolution mechanism along with governing law designated in the contract (if any). In the event arbitration is the dispute resolution mechanism, arbitration must be invoked as per the procedure set out in the arbitration clause and/or in accordance with the Arbitration and Conciliation Act, 1996 or any institutional rules which have been designated in the contract. If there is no arbitration clause and the dispute qualifies as a commercial dispute under the Commercial Courts Act, 2015, the mandatory step of pre-institution mediation will have to be completed before filing of any proceedings, unless urgent interim relief is being sought.
For further information, please contact:
Aditya Mehta, Partner, Cyril Amarchand Mangaldas
aditya.mehta@cyrilshroff.com
[1] Energy Watchdog v. Central Electricity Regulatory Commission & Ors. (2017) 14 SCC 80
[2] Standard Retail Private Limited v. G.S. Global Corp. (Order dated 8th April 2020 passed by the Bombay High Court in Comm. Arbitration Petition (L) No. 404 of 2020)
[3] Section 65 of the Indian Contract Act, 1872
[4] Satyabrata Ghose v. Mugneeram Bangur & Co. 1954 SCR 310
[5] Ibid
[6] Ibid
[7] Ibid.
[8] Energy Watchdog v. Central Electricity Regulatory Commission & Ors. (2017) 14 SCC 80
[9] National Agricultural Cooperative Marketing Federation of India v. Alimenta S.A. (Judgement dated 22nd April 2020 passed by the Supreme Court in C.A. No. 667 of 2012)
[10] Satyabrata Ghose v. Mugneeram Bangur & Co. 1954 SCR 310
[11] Naihati Jute Mills Ltd. v. Khyaliram Jagannath (1968) 1 SCR 821
[12] Ibid
[13] Alopi Parshad & Sons Ltd. v. Union of India 1960 (2) SCR 793
[14] Ibid
[15] Boothalinga Agencies v. V.T.C. Poriaswami Nadar AIR 1969 SC 110
[16] Sea Angel case, 2013 (1) Lloyds Law Report 569 (paragraph 111.)
[17] Energy Watchdog v. Central Electricity Regulatory Commission & Ors (2017) 14 SCC 80
