Covid 19: Consequences on Contractual Obligations

[Meenal Maheshwari is the lead transactional counsel at Essar Group]

With the pandemic that has subsumed the world, a common question that corporates are dealing with is the impact of the coronavirus epidemic on already contracted obligations. The most relevant question raise is: at what point does Covid-19 pandemic allow a party to delay performance, not perform, renegotiate the existing terms, or terminate a contract? Given the seriousness of the situation the affected parties can take aid of several legal options.

Doctrine of Frustration

Section 56 of the Indian Contract Act, 1972 (“ICA”) lays down the doctrine of frustration. This doctrine excuses the performance of an obligation under a contract if such an obligation becomes unlawful or impossible to perform due to reasons which the promisor cannot prevent. Aid of this doctrine is only available to the promisor as long as she did not know that such an obligation was impossible to perform while making the promise or could not have known its impossibility by carrying reasonable diligence and the promisee did not know that the obligation was impossible to be performed by the promisor.  

Referring to its earlier decision in Satyabrata Ghose v. Mugneeram Bangur & Co., the Supreme Court in Energy Watchdog v. CERC held that:

the word “impossible” has not been used in the section in the sense of physical or literal impossibility. The performance of an act may not be literally impossible but it may be impracticable and useless from the point of view of the object and purpose of the parties. If an untoward event or change of circumstance totally upsets the very foundation upon which the parties entered their agreement, it can be said that the promisor finds it impossible to do the act which he had promised to do. It was further held that where the Court finds that the contract itself either impliedly or expressly contains a term, according to which performance would stand discharged under certain circumstances, the dissolution of the contract would take place under the terms of the contract itself and such cases would be dealt with under Section 32 of the Act. If, however, frustration is to take place de hors the contract, it will be governed by Section 56.

In the absence of appropriate force majeure or material adverse changes clauses as enunciated below, recourse to this doctrine of frustration can be taken by parties not being able to perform their obligations under contracts due to Covid-19. Note that a more onerous method of performance would not amount to a frustrating event. To use this doctrine, the party will have to demonstrate that Covid-19 has totally upset the very foundation of the contract and made it impossible for it to perform the relevant obligation under the contract. 

Contractual Clauses

Commercial parties have long demanded greater certainty on what should happen to their obligations in the event the circumstances go beyond their control and they accordingly include ‘force majeure’ and ‘material adverse change’ clauses in the contracts. These clauses are governed by section 32 of the ICA which deals with enforcement of contracts contingent on an event happening.

Force Majeure Clauses

Force majeure clauses excuse the performance by any or all parties under the contract of relevant obligations that are affected by the force majeure event. The availability of these clauses not only depends on the presence of this clause in the contract but also the way it is constructed including how the force majeure event is defined.

If the force majeure event is defined only as an ‘act of God’ then, at this point, it is moot whether corona virus epidemic will be considered as an act of God. An act of God will be an extraordinary occurrence of natural causes, which is not the result of any human intervention and which could not be avoided by any amount of foresight and care, e.g., fire caused by lightning. An accidental fire, although it might not have resulted from an act or omission of a common carrier, cannot be said to be an act of God.

However, in its Office Memorandum dated 19 February 2020, the Department of Expenditure, Procurement Policy Division, Ministry of Finance, Government of India has taken a view that the disruption of the supply chain by the spread of corona virus in China or in any other country will be considered as a natural calamity under the force majeure clause set out in the Government’s ‘Manual for Procurement of Goods, 2017’, which is a guideline for procurement by the Government. While this view is not tested in the courts, it does hold persuasive value until challenged and overruled.

However, some of the contracts go on to include not only ‘acts of God’ or ‘natural calamities’, but also ‘governmental actions’, ‘epidemics’, ‘disasters’, ‘events beyond the reasonable control of a party’ while defining force majeure events. If force majeure covers these events, then there is a direct recourse to Covid-19 affecting a party’s performance under the contract. It is relevant to mention that some States in India have already declared Covid-19 as an epidemic under Epidemic Diseases Act, 1897 or a disaster under the Disaster Management Act, 2005.   

Material Adverse Change Clauses

In the absence of a force majeure clause in a contract, the parties may resort to the material adverse change (“MAC”) clause. It is customary for mergers and acquisitions or a financing transactional documents to contain a MAC clause. MAC clauses are designed to allow an acquirer or the financier to terminate the transaction if, between the signing and closing of the transaction, an unforeseeable event takes place that deteriorates the financial health or business condition of the seller or the borrower. In India, there is lack of jurisprudence on the interpretation of MAC clauses by the courts. The most proximate is the matter of Jyothi Limited wherein the Securities and Exchange Board of India (“SEBI”) interpreted regulation 23(1)(c) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 that allows parties to withdraw an open offer if the party is unable to meet any condition stipulated in the agreement for acquisition for a reason which is outside the reasonable control of the acquirer. SEBI tested this clause with the yardstick of impossibility and not with onerous burden that is put on the acquirer due to change in the circumstances. This makes this clause akin to the doctrine of frustration, which is not the intention of a MAC clause.
There is a possibility that, going forward, the courts in India will be persuaded by the jurisprudence evolved in the English law around MAC clauses. In United Kingdom, the court in Grupo Hotelero Urvasco v. Carey Value Added SL held that the party seeking to rely on the MAC clause will bear a heavy evidential burden in convincing the court that a MAC has occurred, that the court’s construction of a MAC clause is fact and language-specific and that the change must be of significant or substantial magnitude with effect that must be durationally significant and not merely temporary. However, whether Covid-19 can be demonstrated as a long-term event or not will depend on the case-specific circumstances depending on the nature of obligation and the duration for which this pandemic will continue.    

Other important considerations are:

  • Duty to mitigate: The claims under the aforesaid provisions will not be successful if the party could have reasonably taken steps to mitigate the risk. Also, if there are alternative ways to perform, the party should deliberate on such alternatives.

  • Notice clauses: While taking the benefit of the contractual provisions, the party has to be mindful of the requirements of the notice provisions and deliver them in the manner and time prescribed in such clauses.          

  • Proof: It is very important for the party that is using these clauses to their benefit to retain proof (including documents) that link their inability to perform under contracts due to the Covid-19 outbreak and the steps taken by the party to mitigate the risk.

  • Insurance: Parties should check their insurance policies to see if the language of the policies is wide enough to cover events like Covid-19 and take advantage of them if possible.
Conclusion

The parties who use these provisions to delay performance, not perform, renegotiate terms or terminate the contract should, before doing so, should consider the long-term impact on the relationship with the counter-party and also that of a possible dispute that may arise as a result. Parties who are at the receiving end of such provisions should carefully examine if Covid-19 does actually impact performance by the counter-party, that the counter-party notices under these provisions are received within timelines prescribed under the contract, and that the counter-party is not using Covid-19 to escape their obligations that are not actually affected by Covid-19. Also, before suing the party placing reliance on these provisions, the receiving party should think given the widespread nature of this pandemic, if it will have other vendors, suppliers, business partners to replace. It is recommended that at such time-innovative solutions are developed to reach the best outcome in the present uncertainty.

Meenal Maheshwari

About the author

2 comments

  • The author is very nicely elaborated on the Consequences on Contractual Obligations due to Covid 19. Though I’m not a student of law ever, not having any legal knowledge, even then I understood the things clearly as it is presented in such a manner. Thanks to her to raise this topic and enlighten the issue during this tough time.

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