Outsourcing companies face severe operational challenges under the pandemic and understanding the impact of the force majeure clause and the doctrine of frustration is important in determining recourse for parties. Arijita Kakati and Aparna Devkar provide advice on how to manage outsourcing contracts
The consequence of COVID-19 on commercial contracts has been discussed extensively since the outbreak. The calamitous effect of the virus has crippled global supply chains, sealed site facilities, increased demands, and caused scarcity of resources and disruption of business across the world.
Companies providing information technology-enabled services (ITeS) or information technology are also facing severe operational challenges under the pandemic. Despite most governments extending their support to the sector by defining parameters for continuing operations of ITeS in different countries, service providers are unable to fully serve their customers, and are therefore unable to meet their contractual obligations, and face the risks of contractual breach and financial losses.
Lockdowns announced by most national governments have increased the complexity of business operations. As a result, customers relying on, and suppliers providing, core outsourcing services through outsourcing contracts are seeking legal advice to better understand the risks and remedies of these contracts.
Parties are revisiting and re-evaluating their contractual options to ensure business continuity while mitigating contractual breaches. However, the inherent complexities associated with such contracts amplify these challenges, because outsourcing contracts are high-value, technical, multi-jurisdictional and critical to business operations.
Clauses in outsourcing contracts
COVID-19 and force majeure. Black’s Law Dictionary defines force majeure as, “an event or effect that can neither be anticipated nor controlled. The term includes both acts of nature (floods and hurricanes) and acts of people (riots, strikes and wars).” Considering the definition, a prima facie view could be that events like COVID-19 can be treated as an event to invoke this clause. But whether it can lead to frustration of contract, which can discharge a party of its obligations under the contract, either wholly or partly, will depend upon the terms of each contract.
No straightjacket formula can be applied while invoking and applying the force majeure clause. However, once it is established that COVID-19 would qualify as a force majeure event, parties would either opt for:
- suspending the services under the contract; or
- terminating the contract because of frustration or impossibility to perform the contract, i.e., the doctrine of frustration of contract.
The Supreme Court, in Satyabrata Ghose v Mugneeram Bangur & Co observed that, to invoke force majeure parties have to assess if the happening of the outward event has disturbed the foundation of the contract, making it impossible for the promisor to do the act that it promised to do.
It was also observed that the dissolution of a contract would depend upon the terms and conditions of that contract. But in a scenario where force majeure occurs outside the scope of the contract, the rule of positive law would apply, where the doctrine of frustration of contract makes the performance of the obligation impossible. The keyword here is the word “impossible”.
In Energy Watchdog & Ors v Central Regulatory Electricity Commission & Ors, the Supreme Court observed that the word “impossible” was not used in section 56 of the Indian Contract Act, in the sense of a physical or literal impossibility. In understanding the word “impossible” in the performance of a contract, it is essential to mention that the performance of a contract may not be, per se, physically impossible, but could be so impractical that it disturbs the fundamentals of the contract, making its performance “impractical”.
In the case of Tsakiroglou & Co Ltd v Noble Throl, the English court held that, despite the closure of the Suez Canal, which was a traditional route, the contract for the supply of groundnut was not deemed to be frustrated. The courts observed that an alternative route was indeed available, even if it was more expensive. It also observed that the contract had become more onerous to perform, but it was not fundamentally altered. The variation in freight charges could not allow parties to discharge themselves from contractual obligations, as the performance was possible.
Courts have consistently been of the view that the doctrine of frustration of contract and its applicability should be used with caution. Courts have observed that the applicability of the doctrine should not be used to defeat the very purpose for which the contract was entered into. It should be invoked and applied cautiously to discourage parties from absolving themselves from contractual performance, as the principle of contractual law is the performance of the contract.
The English courts, in the celebrated Sea Angel shipping case regarding frustration of contract, observed that the mere incident of expense or delay or onerousness is not sufficient to claim the benefits of force majeure.
Similarly, in Alopi Parshad & Sons Ltd v Union of India, the Supreme Court observed that at the time of executing the contract, parties are often faced with events that they cannot anticipate. This shall not enable either party to get rid of the bargain they have made.
For a force majeure clause to be successful, parties need to build a case to establish:
- the parties never agreed to be bound under such unexpected circumstances; and
- the unexpected event fundamentally altered the core of the contract, ceasing to bind the parties.
Bombay High Court, on 8 April 2020, in a group of petitions by steel importers seeking relief on the basis that the outbreak of COVID-19 and the following lockdown is a force majeure event, and as a result the respondent banks should be restrained from cashing letters of credit, held that the principles of force majeure and doctrine of frustration of contracts could not be invoked and made applicable to the case in hand, and rejected the ad-interim relief.
The petitioners were importing steel from South Korea, and the exporters had shipped the steel and performed their obligation, but the petitioners contended that, with the outbreak of COVID-19, the contract with the exporter stood terminated as it became unenforceable on account of frustration, impossibility, and impracticability.
The high court, in passing the order, relied on the following principles:
- Procedure to invoke force majeure as provided in the contract. In the case, the right to invoke the clause was the sole discretion of the exporter, and, therefore, the court observed that the petitioner could not have invoked the clause. Invocation of a force majeure clause needs to be contract-specific. The contract between the petitioners and the respondent was independent of the contract that the petitioner had with their bankers. Therefore, the court observed that the bank was not concerned with the underlying dispute between the petitioners.
- “Frustration”, “impossibility”, “impracticability” and obligation to perform. The respondent had already complied with its obligation and performed its part of the contracts by shipping the goods from South Korea. The petitioners’ failure to perform its obligations could not be held against the respondent. The court further observed that the distribution of steel, which was the petitioner’s primary business activity, was declared as an essential service. The notification of the director-general of shipping, Mumbai, stated that there would be no container detention charges on import and export shipments during the lockdown period. Therefore, it was not a case of frustration, impossibility or impracticability to perform the contract.
- Suspension of contract and business continuity. The court observed that the lockdown was for a limited period, therefore it could not come to the rescue of the petitioners so as to resile from their contractual obligations to make payments to the respondent.
Apart from the force majeure clause, parties need to make a holistic assessment of the risks, legal rights, remedies and duties enumerated in the other clauses of the outsourcing agreement. Although outsourcing contracts differ from one another, the clauses discussed below are incorporated in most outsourcing contracts. Thus, understanding the impact of these clauses is important in determining recourse for the parties.
Clause of business continuity and disaster management plans. Most outsourcing contracts include a business continuity plan, which defines the ability of the supplier to continue the services in a business-as-usual or undisrupted manner in the event of a disaster.
Most business continuity plans would consider measures to work from alternate or remote facilities. However, with the social distancing restrictions imposed, ITeS providers are facing significant challenges in ensuring the continuity of services to their customer base. As a result, while invoking their business continuity plans, service providers are seeking relief from the performance of certain contractual obligations, readjustment of service levels, adjustment of payments, permissions on data transfers, etc., to mitigate liability and risks of contractual breaches.
In order to seek relief and appropriate remedies under the contract, parties need to understand their rights and obligations within the agreed framework prescribed in the continuity plan. To this effect, the parties first need to examine the interplay between the continuity plan and the force majeure clause discussed above.
Would invoking force majeure excuse the supplier from the measures agreed in the continuity plan? Assuming the continuity plan overrides the force majeure clause, parties would need to invoke the continuity plan according to the procedure prescribed in the continuity plan, unless mutually agreed otherwise.
A practicable plan would incorporate:
- the express definition of disaster to include a pandemic/epidemic, as per which the parties can trigger the continuity plan;
- a clear provision and procedure for declaration of disaster;
- identifying critical functions that need to be operational during a disaster;
- spelling out parties’ rights and obligations;
- regularly testing and confirming the plan;
- unexpected constraints of the supplier and practical alternatives; and
- seeking preferential treatment during a disaster to ensure that suppliers do not recuse themselves from their contractual obligations and direct their limited resources to other preferred customers .
Due to unprecedented circumstances, in case the suppliers are unable to provide services agreed under continuity plans, parties need to determine any applicable waivers in the contract. Further, parties need to assess whether the non-performance of the continuity plan would fall under material or willful default, and associated liabilities that may arise.
Change to service level. The quality and output of services undertaken in an outsourcing contract are measured through service levels. All charges and payments towards the services are computed on the basis of the targets achieved in the service levels. As a result of the strict lockdown and social distancing restrictions, alternate delivery sites, travel restrictions, work-from-home advisories, the implementation of disaster recovery and business continuity plans are being significantly challenged.
Service providers are negotiating to suspend or relax the agreed service level measures. The adjustments made to the service levels impact payments and charges, and the scope of the contract. Parties need to meticulously discuss and document the changes to the service levels, and develop a roadmap to restore the services within a specific timeline. They also need to offset costs and adjust service credits on the resumption of service.
Excusing clause. This clause defines a contractual party’s failure to perform an obligation under the contract, and their rights and duties. The clause should demonstrate the intent of the parties to invoke the safeguards (if any) defined in the clause, in case of a disaster. The excusing clause would require the parties to inform, through notice, details on the exact nature of the failure to perform, the potential impact of the failure, expected time of resolution and whether the failure will discharge a party from the performance of the contract or amount to a breach. If performance under the clause depends on “best efforts”, “reasonable endeavors”, a challenge to non-performance would be open to the textual and contextual interpretation of the phrases developed in judicial precedents.
Change in service clause. Most outsourcing contracts provide for express change and modification to service and costs requests, and a procedure. In most instances, documents provide for modifications in event of disaster. Therefore, any change to the service outside the scope of the contract will be considered unauthorized and attract liability of costs on the party making the unauthorized change.
Data protection. Confidentiality is a critical clause in outsourcing agreements. Due to the nature of the contract and the associated risks (i.e., client’s breach of customer data) most outsourcing clients are cautious of confidentiality provisions. Parties safeguard the risks associated with data loss and breach of confidentiality by most often defining these breaches as “material breach”, often excluding them from liability caps.
Therefore, service providers are seeking liability waivers from their clients for employees working from home and dealing with personal data. However, in addition to a waiver depending on the governing law, both parties are bound by the applicable data protection principles of the jurisdiction. Data security obligations cannot be compromised while executing business continuity plans. On 19 March 2020, the European Board of Data Protection released a statement directing data controllers to take necessary steps to ensure principles of data processing are complied with to protect personal data during COVID-19.
Although this statement focuses on processing personal data in the context of employment and mobile data, these guidelines are applicable to all companies processing data. With most governments restricting access to sites and delivery locations, and imposing social distancing norms, compliance with data security principles could be severely challenging. If companies fail to comply with data security principles of the relevant jurisdiction, they will be subject to litigation and unliquidated damages.
Replacement services clause. If either party is unable to perform its obligations, or a part of those agreed in the contract, it would be imperative for the affected party to consider alternate services. If the contract permits a party to seek alternate services from a non-contracting party in the event of a force majeure or disaster, then it would also need to provide for terms of payment, obligations of the parties for the replacement services, and data protection.
Communication. Keeping every line of communication open will be the key to ensuring business continuity and recovery of operations after the resumption of business. Legal teams have to advise their businesses to follow all requirements of notice and duty to inform as prescribed in the agreement. These times call for collaboration, respect and interest-based negotiations to work out practicable solutions with their business partners, as well as management and employees.
On 21 March 2020, the National Association of Software and Service Companies (NASSCOM), an association representing the US$180 billion ITeS sector in India, issued an operational advisory for the industry. The recommendations emphasize the need for companies to develop communication channels between employees and management.
COVID-19 will change all set patterns, however, adversities of this nature can bring opportunities. There will likely be exponential transformations across industries. From a legal perspective, the authors believe that the understanding and strategy of contractual law will be materially altered.
Until the breakout of the pandemic, the force majeure clause itself was neglected. This has thrown a critical light on the legal concept of force majeure and the doctrine of frustration of contracts. The invocation of force majeure would largely depend on the interpretation of the clause in each contract.
The courts have also been rather cautious in applying the doctrine of frustration of contracts. The aim is to ensure that, as much as possible, parties hold good and perform their end of the obligation. One cannot lose sight of the fact that the pandemic has also caused an economic strain, and, therefore, it will be only prudent to ensure business continuity and not attempt to frustrate contracts.
Further, the pandemic will change the way the ITeS sector operates. There will be an increase in digital transformation, system adaptations, automation, etc. Service providers will need to develop stronger business continuity plans, allocate risks and costs, and strengthen third-party contracts, which are consistent with the business continuity and disaster recovery plans. Considering the social distancing norms, all official and unofficial communications are being done electronically, and the increase in digital communications also call for the need for clear recognition of electronic contracts, especially in jurisdictions like India.
Arijita Kakati is an independent legal consultant in the areas of information technology and data security, and Aparna Devkar is an advocate at Bombay High Court.