How will the courts respond to an anticipated deluge of disputes relating to frustration of contracts in a post-COVID-19 world? Ritin Rai provides an analysis
The law of frustration has developed by reconciling two competing contract law principles. Sanctity of contract, the principle that requires a party to comply with its contractual obligations, is one that underpins all contract law. The principle, though, is not absolute, and is to be reconciled with a competing principle that certain unforeseen events may occur during the performance of a contract that discharge a party from the performance of its contractual obligations.
The exercise of reconciling these two competing principles will be tested as courts are called upon to deal with the inevitable flood of cases where a party to a contract will assert the COVID-19 pandemic as an unforeseen event that has frustrated the contract and rendered performance impossible.
Reliance on force majeure clause
The relatively simpler cases will be ones where the contract in question contains a force majeure clause and provides for the consequence upon the occurrence of that force majeure event. Force majeure clauses typically contain inclusive (and not exhaustive) definitions of what constitutes a force majeure event, and courts also interpret such clauses liberally. Force majeure clauses typically contemplate the suspension of parties’ obligations during the occurrence of the event, and may even contemplate a right to terminate a contract if the event continues for a specified duration of time.
If the parties have agreed – expressly or impliedly – that a contract is to be performed (or not performed) upon the occurrence (or non-occurrence) of an event, sections 32 and 33 of the Indian Contract Act give effect to that agreement. These provisions provide that obligations that are contingent on the occurrence (or non-occurrence) of a contingent event cannot be enforced until that event has (or has not) occurred.
An office memorandum issued on 19 February 2020 by the Ministry of Finance is instructive as to how the government understands COVID-19 as a force majeure event. The office memorandum reads:
“A force majeure means extraordinary events or circumstance beyond human control … An FM clause in the contract frees both parties from contractual liability or obligation when prevented by such events from fulfilling their obligations under the contract …
A doubt has arisen if the disruption of the supply chains due to spread of coronavirus in China or any other country will be covered in the force majeure clause (FMC). In this regard, it is clarified that it should be considered as a case of natural calamity and an FMC may be invoked, wherever considered appropriate, following the due procedure as above.”
It bears repetition that these force majeure clauses are events within the contemplation of the parties at the time of contract formation, and principally suspend performance of the contract. When a party relies on such a clause, the courts undertake an exercise of contractual interpretation in determining whether the force majeure (or contingent) event has occurred, and then apply the contractual provisions to determine the consequence of the occurrence on the performance of obligations by the parties to the contract. Given the sheer scale and reach of this pandemic (and also that it has been recognized as such by the government), it is difficult to imagine cases where a party’s performance of its contractual obligations will not be suspended for the duration that the pandemic affects such performance.
Reliance on Indian Contract Act
But those are the easier cases. The cases that are harder and more likely to engage the attention of courts (and arbitral tribunals) are situations where a party asserts that the occurrence of COVID-19 has made performance of the contract impossible, and that the contract has therefore become void (as opposed to merely suspending the obligation to perform). Here, the party does not rely on a contractual provision that suspends performance or gives it a termination right, but rather relies on section 56 of the Indian Contract Act, which provides that a “contract to do an act which, after the contract is made, becomes impossible … becomes void”.
In examining these cases and engaging in the reconciliation of the principles outlined above (sanctity of contract versus discharge on account of an unforeseen event), Indian law departs from English law. The judgment in Taylor v Caldwell (1863) is recognized as the earliest decision where English courts departed from the rule of absolute sanctity of contract and absolved the defendant of his contractual obligation to permit the plaintiff the use of a music hall in a situation where the hall was destroyed by a fire.
The basis for the court’s conclusion was that the contract must be regarded “as subject to an ‘implied condition’ that the parties shall be excused, in case, before breach, performance becomes ‘impossible’ from perishing of the thing without default of the contractor”. The court therefore embarked on an exercise of contractual interpretation to determine if the contract contained an implied term that the contract was to be discharged on the occurrence of a particular unforeseen event.
Consistently, Indian courts have not accepted this position. In deciding cases on frustration, Indian courts do not embark on exercises of contractual interpretation where they search for an express or implied condition that discharges performance.
In an early decision in Satyabrata Ghose v Mugeneram Bangur (1954), the Supreme Court explained that, “in cases where the court gathers a matter of construction that the contract itself contained, impliedly or expressly, a term according to which it would stand discharged on the happening of certain circumstances, the dissolution of the contract would take place under the terms of the contract and such cases would be outside the purview of section 56 altogether. Although in English law these cases are treated as cases of frustration, in India they would be dealt with under section 32 of the Indian Contract Act, which deals with contingent contracts or similar other provisions contained in the act.”
In contrast to the position under English law, the Supreme Court has held that the doctrine of frustration contained in section 56 is applied “not on the ground that the parties themselves agreed to an implied term”, but the “relief is given by the court … when 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 agreement.”
In Satyabrata Ghose, the Supreme Court further explained that, “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 that can pronounce the contract to be frustrated and at an end”.
In determining whether the event is so fundamental that it strikes at the root of the contract, Indian courts will (in the language of the Supreme Court in Satyabrata Ghose) “undoubtedly … examine the contract and the circumstances under which it was made. The belief, knowledge and intention of the parties are evidence, but evidence only on which the court has to form its own conclusion of whether the changed circumstances destroyed altogether the basis of the adventure and its underlying object.”
The subsequent decisions of the Supreme Court have also explained what is meant by the word “impossible” in section 56. The Supreme Court made clear that the word impossible is not used in section 56 in “the sense of physical or literal impossibility”. The decisions recognize that 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 that the parties had in view; and if an untoward event or change of circumstances totally upsets the very foundation upon which the parties rested their bargain, it can very well be said that the promisor finds its impossible to do the act that he promised to do.”
The decisions of the Supreme Court show that this is a high standard to meet and, “that the performance of a contract is never discharged merely because it may become onerous to one of the parties”. Thus, for example, in Satyabrata Ghose, the government – acting under the Defence of India Rules – temporarily requisitioned certain land that was the subject matter of an agreement for sale between the plaintiff and the defendant.
The defendant’s contention that the agreement for sale stood frustrated was negated by the Supreme Court, including for the reasons that war conditions existed even when the contract was entered into, in 1940, and that there was no time limit provided for consummation of the sale.
Similarly, in Alopi Parshad & Sons Ltd v Union of India (1960), the plaintiffs, agents selling ghee (clarified butter) to the army at contractually stipulated rates, sought enhancement of such rates for the supply of ghee, citing the onset of the Second World War as an uncontemplated event that had so altered conditions as to make the original contract impossible to perform. The plaintiffs reasoned that the outbreak of war had resulted in an enormous increase in the demand for ghee from the government, and the prior rates had been established during peace time.
The Supreme Court rejected the plaintiff’s argument, stating that more onerous treatment owing to a circumstance not anticipated by parties, even such as war, did not meet the requisite standard for impossibility of contract.
Again and more recently, in Energy Watchdog v Central Electricity Regulatory Commission (2017), the Supreme Court dealt with the argument that a significant increase in the price of Indonesian coal, which was an input for the generation of electricity, should be treated as a force majeure event, justifying a revision to the tariff at which electricity was to be supplied.
Here, too, the court rejected the contention holding that it “is clear that an unexpected rise in the price of coal will not absolve the generating companies from performing their part of the contract for the very good reason that when they submitted their bids, this was a risk they knowingly took”.
How will courts respond?
This article has outlined two critical Indian law principles that guide courts to identify events that frustrate a contract and discharge a party from performance of its obligations. First, Indian law treats frustration as a rule of positive law within the purview of section 56, and not an issue that is based on an implied agreement between the parties. Second, when determining whether a contract has become impossible to perform, Indian law does not allow discharge to a party merely because contractual performance has become more onerous, but only when the event totally upsets the very foundation on which parties made the bargain.
Being aware that each case will turn on its particular facts, how will these two principles play themselves out in the flood of disputes that will confront the court in a post-COVID-19 world?
Indian courts do not analyse an event of frustration only from the prism of contractual construction of the intent of the parties, and this may have implications for the conclusion that the courts reach on the issue of whether an event results in frustration of the contract. Inasmuch as the court asks the question as to “whether the changed circumstances destroyed altogether the basis of the adventure and its underlying object”, it brings in additional and broader parameters into the analysis.
Given the interconnectedness of world markets and supply chains, and given the global reach of the COVID-19 pandemic, a consideration of these additional and broader parameters is more likely to enable a court to find in the pandemic an event that discharges contractual performance and renders the contract void. Put differently, it is more likely that a court will find that COVID-19 changed the basis of the contractual adventure or object, as opposed to finding that both parties agreed and intended that the contract be discharged in the event of a pandemic similar to COVID-19.
Similarly, the test of impossibility that courts adopt may also likely lead to acceptance of pleas of discharge from contractual performance. The pandemic has affected the economies of all nations, and with it also the business plans and financial wherewithal of individual business entities.
These considerations – which an Indian court will have regard to – may well be regarded as a change of circumstance that “totally upsets the very foundation on which the parties rested their bargain”, to borrow the expression used in Satyabrata Ghose, and more easily enable a conclusion that the event has frustrated the contract and rendered it void.
The manner in which courts approach the issue of frustration also has implications for which of the parties to a contract may successfully take this plea. Ordinarily, a plea of frustration is taken by the party who is providing services under the contract, as opposed to the party making the payment, as it is difficult for a paying party to assert that the payment has become impossible (absent, for instance, any foreign exchange control or similar restrictions).
But in the context of cases where the entire purpose or object of the contract may have been overtaken by the unforeseen event of the pandemic, a party may, under Indian law, be more able to successfully argue that its payment obligation has become impossible to perform, given the impracticability and uselessness of the underlying contract. One final observation is also worth making, as this article examines how Indian courts will treat contractual disputes arising out of COVID-19, and that is its reference to decisions of foreign courts. In its decision in Satyabrata Ghose, the Supreme Court held that, “to the extent that the Indian Contract Act deals with a particular subject, it is exhaustive upon the same, and it is not permissible to import the principles of English law dehors [outside the scope of] these statutory provisions”.
However, the court went on to state that the decisions of the English court possess a “persuasive value”, and may be helpful in showing how those courts have decided cases under circumstances similar to those that confront the Indian courts. This reference to foreign case law, especially decisions of English courts, has continued and is reflected in several Supreme Court decisions, including in Energy Watchdog, where the court cited more recent English law authority.
It is fair to say that, even as the Supreme Court will not be bound by decisions from other jurisdictions, it will consider them and accord them a limited persuasive value.
Ritin Rai is a senior advocate designated by the Supreme Court, and is based in New Delhi. His practice spans appearances in a wide range of commercial and regulatory disputes in the courts and tribunals situated in Delhi, and before arbitral tribunals in India and abroad. He is also a door tenant at 7 King’s Bench Walk, London.