A Proposal for Dealing With Force Majeure Clauses Under Contract Law

[Post
by Siddharth Bajpai, who is a 4th
year student at the National Law School of India University, Bangalore.


Other
posts related to this topic are available here
and here.]


Introduction

In
2013, Adani Enterprises entered into a power purchase agreement (PPA) with Gujarat Electricity Regulatory
Commission and Haryana State Regulatory Commission. Under the terms of the
arrangement, Adani was bound to procure coal. The coal was imported from
Indonesia. However, a change in the Indonesian law led to a substantial rise in
the price of coal. In light of this, Adani sought to dissolve the contract on
the grounds of frustration due to sudden escalation in prices.

At
the outset, it must be highlighted that Adani incorporated a broadly worded force majeure clause (FMC) and
chose the cost plus method for pricing of coal in the PPA. This implied that
the coal charges would be fixed and not escalable. This was an aggressive and
competitive factor which gave Adani an edge in the bidding process it won.[1] In this post, the author
has two objectives: first, to analyse
the correctness of the judgement regarding the frustration of the contract and second, to discuss the usage of FMC in
commercial practice.

Judgement 

In
the above matter, the Supreme Court of India (SC) held in its judgment that
the contract was not frustrated, and it did so by relying on the interpretation
of section 56 of the Indian Contract Act, 1872 (the Act). It relied on precedents
and the terms of the contract to draw two conclusions regarding the FMC. First, the escalation in price of coal
had only made the performance onerous
and not impossible. Second, mere escalation of price could
not be construed as a hindrance to prevent performance under the contract,
and Adani could not be discharged from performance of the contract. 

Analysis

In
India, section 32 of the Act is applicable if the terms of a contract expressly
state that, upon happening of certain contingencies, it would stand discharged.
Therefore, FMCs have to be interpreted in accordance with section 32 of the Act
and the doctrine of proper construction will be applicable.[2] It entails the
construction of the FMC with the events which preceded or followed it. Due
regard must be given to the nature and general terms of the contract.[3] The rule of ejusdem generis also acts as an external aid in the interpretation in a
manner so as to include only the happening and eventualities of a similar
standard.[4] This is the legal position
on the FMC in India.

In
the present case, the Court extensively relied on cases in which the agreement
in contention did not contemplate an FMC and an application of section 56 was
sought. The Court came to the conclusion that economic downturns did not alter
the fundamental basis of the contract. It must be highlighted that the
application of this doctrine of fundamental basis is limited to the cases under
section 56 where an external event that has not been contemplated by the
parties radically changes the object of the agreement.[5]

The
author is of the opinion that the judgement is sound in concluding that
economic downturns cannot be considered as a factor for frustration of a
contract. However, the SC has deviated from the crux of reasoning adopted by
it. The author sets forth two main arguments regarding the analysis in this
judgement. First, there was a
pre-existing FMC and the application of section 56 was erroneous. Second, the interpretation of the hindrance was redundant because there
was a specific exclusion in the agreement.

Regarding
the first submission, section 32 of the Act should have been relied upon to
enforce the agreement terms. The SC was bound to apply the doctrine of proper
construction to the agreement. This doctrine has two main limbs: first, the court must evaluate the
allocation of the risks in the agreement and second, the ejusdem generis
rule must be employed to interpret the terms of the contract.[6] With regard to the first
limb, the court must identify whether any party has expressly assumed the risk
of the events which have occurred. In the present case, construction of risk
allocation manifests in the fact that Adani expressly undertook the risk by
choosing the cost plus method for pricing while being aware of the volatile
prices in the coal market.[7] Although the SC has made
an oblique reference to this fact in its judgement, it failed to discuss this
issue in greater detail. As per the second limb, the rule of ejusdem generis should have been
employed to determine if the economic downturns were within the ambit of the FMC. The two relevant considerations
that the Court should have taken into account are: first, that the events mentioned in the FMC belong to the class of
an act of God, war or unlawfulness; second,
clause 12.4 of the PPA made a specific exclusion regarding the cost of fuel not
being within the ambit of the FMC. With respect to the first consideration, the
SC failed to rely on those precedents where facts were in pari materia with the present case. In such precedents, it had been
held that the court would not interpret the FMC broadly to construe economic
downturns within its ambit.[8]

The
Court has skirted the issue of protecting the sanctity of the contract by
relying on unrelated precedents and not construing the contract itself. This
opens a Pandora’s Box where the court will be free to apply the principles of section
56 to the cases of contingent contracts, which should otherwise fall under section
32. The author submits that in a similar factual matrix, the terms of the
agreement may provide for economic downturns as a force majeure event. In
such cases, these precedents will not be directly applicable. Instead, the
burden will fall on the courts to apply the doctrine of proper construction to
ascertain the intention of the parties in that specific agreement.

Proposals 

Assuming that these clauses are not drafted in a broad,
inclusive manner, the author would like to argue in favour of disbanding the
practice of drafting such FMCs.
Professor Berman’s “enumerative
principle laid down this practice.[9] As per this practice,
parties list a number of discharging contingencies, intending that all the
risks will be borne by the promisor. However, there are number of significant
drawbacks to this approach. First, it
is extremely onerous on the obligor. Assuming but not conceding that nothing is
unforeseeable, it is unjust to hold the promisor liable for the risk of events
that are not specifically mentioned.[10] Second, a logical corollary of this principle could suggest that
the promisor can minimize his liability by specifically listing all the
imaginable events. Third, due to the
high drafting costs involved, it is a reality only in high value contracts.
Hence, the author would like to suggest an alternative approach.

The fundamental
purpose of the contract is to maximize its economic efficiency by fulfilling
its purpose. The fact that the performance is to extend into the future
introduces uncertainty, which in turn creates risks. Therefore, another
incidental fundamental purpose is to allocate these risks between the parties
to the exchange. At this juncture, the author submits that parties should not
bargain with the future events because they cannot be anticipated. The courts
in such cases should bear the duty of the allocation of risks after considering
the implied or express terms of the contract. A two-step test should be
applied. First, it should be
determined whether the obligor is the superior risk bearer in the particular
contract. This here is to be understood as the party which can bear the risk
more efficiently.[11] Discharge from
performance would be unjust and inefficient in cases where the obligor could
have prevented the risk from materialising at a cost lower than the expected
cost of the risky event. Cases may also arise where although the obligor was
the superior risk bearer, he could not have prevented the risk from
materialising.[12]
In such cases, the court should proceed to the second step, i.e., evaluate which party could have insured itself
at a lower cost. The author submits that insurance is a method of reducing the
costs associated with the risk that performance of a contract may be costlier
than anticipated. The author would also like to provide an illustration for
this model.

Consider
A, a printing machinery manufacturer, contracts with B, to install a customised
and a totally unique model for printing. Since it is customised, its value to
any other printer will be marginal. Just before its installation, a fire
destroys B’s premises and puts B out of business. Since the machine has no
value in the market, A accordingly sues B for the full price. B’s defence is
that since the fire was not caused due to its negligence, it should be
discharged from the performance. Applying the two-step test, it is clear that
since the fire occurred in B’s premises, it had the superior ability to prevent
the fire. However, considering the fact that it was not due to B’s negligence,
B could not have prevented the incident. Therefore, the court should proceed to
the second step in the test. Which of the parties could have obtained an
insurance protection at a lower cost? Here, although B would be able to
determine the probability that a fire would occur, A is in a better position to
determine the actual loss. A is better aware than B of the stages of production
of the machine and the salvage value at each stage. A could have easily known
the contingencies and the magnitude of loss since the machine was highly
unique. In such contracts, A could have charged a premium from customers like
B. On the other hand, the cost of B’s insurance would be higher, i.e., not only
against loss caused by the fire but also against its contractual liability to A.
Thus, B should be discharged from performance.

Conclusion 

The Indian Contract
Act is an exhaustive and lucid statute. The principles under every section are
codified and the mode of their application has been provided in the
illustrations. The Act solemnly protects the sanctity of contracts by also
delimiting the jurisdiction of the court. However, in cases like Adani, the court has encroached upon
this sanctity of contracts. Adani
manifests that the courts often overlook the correct principled justification
by finding an easy way out. Further, such precedents open the Pandora’s Box for
further abuse of courts’ discretion. Added to this, considering the drawbacks
of drafting the FMCs, the author has argued for their disbanding. Instead, a
two-step test has been suggested for the courts to allocate the risk among the
parties.

Siddharth Bajpai



[1] Adani Power Limited v. UHBVN Ltd, Order in
Petition No.155/MP/2012(I).

[2] Ganga Singh and Ors v. Santosh Kumar and
Ors, AIR 1963 All 201.

[3] Mahadeo Prosad Shaw v. Calcutta Dyeing and
Cleaning Co, AIR 1961 SC 70.

[4] Dhanrajamal Gobindram v. Shamji Kalidas
and Co, (1961) 3 SCR 1020.

[5] Satyabrata Ghose v. Mugneeram Bangur &
Co., 1954 SCR 310.

[6] Md. Serajuddin v. State of Orissa, 1969
SCC Online Ori 4. Davis Contractors Ltd v. Fareham Urban District Council,
[1956] 2 All ER 145.

[7] Adani Power Limited v. UHBVN Ltd, Order in
Petition No.155/MP/2012(I).

[8] British Machinery Supplies Company v.
Union of India, 1993 Supp (2) SCC 76. Madras Society Ltd v. O. Ramalingam,
(1976) 1 MLJ 136. Pioneer Shipping Ltd v. BTP Tioxide Ltd, [1981] 2 All ER
1030.

[9] See Michael G. Rapsomanikas, Frustration of
Contract in Commercial Practice
, 18 Duquesne
Law Review 551, 562 (1979).

[10] Rapsomanikas,
at
563.

[11] Richard A. Posner, Impossibility and Related Doctrines in Contract law: An Economic
Analysis
, 6(1) The Journal of Legal
Studies
83, 99 (1977).

[12] Posner, at 105.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

Add comment

Subscribe to Blog via Email

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Recent Posts

Topics

Recent Comments

Archives

web analytics