COVID-19 and the Impact on English Law Governed Contracts – Force Majeure and Frustration

As more and more countries introduce protective measures and restrictions in order to manage the COVID-19 outbreak, businesses may find that they or their counterparties struggle to meet their contractual obligations. This Update sets out how the COVID-19 outbreak could impact English law governed contracts and obligations and what to do if you or your counterparty is in difficulty. We also consider how the standard industry terms most commonly used by our clients provide for situations of this kind.

How COVID-19 Could Affect Contractual Obligations

Restrictions and limitations arising from the COVID-19 outbreak could enable a party to an English law contract to avoid its obligations by operating a force majeure clause and/or by invoking the common law doctrine of frustration. However, both routes have a high bar to success and parties should take careful advice before pursuing either one.

Force Majeure

The contract must contain a force majeure clause which specifies a type of event capable of encompassing the COVID-19 outbreak. It is important to note that there is no generic definition of force majeure in common law. It is a matter of contractual interpretation in each case. The defaulting party must prove that:

1. one of the events referred to in the force majeure clause has occurred.
2. it has been prevented, hindered or delayed from performance by that event.
3. its non-performance was due to circumstances outside of its control.
4. there were no reasonable steps that it could have taken to avoid or mitigate against the event.

For a force majeure clause to engage, performance must become “physically or legally impossible, not merely more difficult or unprofitable.”¹ Similarly, a downturn in economic conditions (even if caused by an event like COVID-19) will generally not constitute force majeure.²

Frustration 

If the force majeure clause does not cover an event such as the COVID-19 outbreak (or there is no force majeure clause at all), consider the question of whether the contract has been frustrated. A contract will terminate automatically when a frustrating event occurs, i.e., one which is: (1) unexpected; (2) beyond the parties’ control; and (3) makes performance impossible or radically different from that which the parties contemplated at the time of entering into the contract. The frustrating event must “significantly change the nature of the outstanding contractual rights or obligations.” Following the 2003 SARS epidemic, the Hong Kong District Court held that a 10-day period in which a property was uninhabited did not frustrate the tenancy agreement, which had a two-year term.³

How to Deploy a Force Majeure Clause and/or the Doctrine of Frustration

Check whether your force majeure clause includes “pandemic” or similar wording (e.g., the International Chamber of Commerce (ICC) 2003 Force Majeure Clause) or a general catch-all that covers all events “outside the reasonable control of the parties” (e.g., the International Federation of Consulting Engineers (FIDIC) or International Swaps and Derivatives Association (ISDA) standard wording below). Consider whether COVID-19 has made performance actually impossible/radically different or just less convenient and/or more expensive. For example, if the contract requires delivery of payment/goods on a specific date that is now made impossible due to local lockdown measures, that may well be a force majeure event. On the other hand, if the result is that production in the supply chain has to be halted for a few months in a multi-year term contract, that may not meet the high bar imposed by the court.

If a claim of force majeure will not lie, the next consideration is whether any of the following established grounds to founding a successful claim of frustration apply:

• Temporary unavailability – e.g., a person or object that is essential for performance of the contract is temporarily unavailable.
• Method of performance impossible – e.g., a contract for freight services by sea where a travel ban is in place. However, a contract will not be frustrated where performance is possible by a different method, and the difference between the two methods of performance is not sufficiently fundamental.
• Failure of a specific source – e.g., a contract to import goods from a particular country now subject to a travel ban.
• Illegality – e.g., a contract for airline services that are now subject to a flight ban. Consider also whether the illegality clause of the contract is invoked.

If successful, the effect of frustration is automatic termination of the contract. Parties can recover amounts paid under the contract before it was frustrated (less the other party’s expenses).

Parties should also consider other options. For example, if COVID-19 means that a business must temporarily halt production or miss a payment/delivery date, a moratorium could be requested. Force majeure and frustration are “nuclear” options to approach with caution, particularly given the current forecasts of how long COVID-19 will disrupt normal business.

What Should I Do If My Counterparty Claims Frustration/Force Majeure?

Step 1: Check whether the contract has a force majeure clause that could cover COVID-19.

Step 2: Check whether there is a causal link between the force majeure/frustrating event and non-performance.

Step 3: Write to your counterparty and require (i) evidence of the circumstances it relies on, (ii) a full explanation of why its performance is now physically/legally impossible, (iii) evidence of steps it is taking to mitigate and (iv) regular updates as to its efforts to resume performance.

Step 4: If you are satisfied with the response, consider entering into a written variation to the contract. If not, consider escalating to dispute resolution.

Remember that this kind of notice could lead to a formal dispute under any applicable dispute resolution clause(s). Under the current English disclosure rules, all parties (including potential defendants) are required to take reasonable steps to preserve relevant documents as soon as they know that they may become party to proceedings, that is, as soon as the notice of force majeure/frustration is received (or potentially before if there have been prior communications).

Standard Force Majeure Clauses

We set out below the most common industry standard terms relevant to our clients, and how these may operate in the current COVID-19 situation:

Loan Market Association (LMA)

The LMA’s template documents do not contain a force majeure clause, but some of the documents, including those for leveraged finance transactions, contain wide material adverse change provisions. A material adverse change constitutes an event of default and is any event that the majority lenders believe has, or is reasonably likely to have, a material adverse effect on the borrower’s “business, operations, property, condition (financial or otherwise) or prospects” or ability to perform its obligations under the finance documents. Therefore, if lenders can show that it has caused such a material adverse effect, the COVID-19 outbreak could lead to an event of default.

ISDA

The 2002 ISDA Master Agreement defines a “Force Majeure Event” as occurring when a party “by reason of force majeure or act of state” is prevented from making or receiving payment or complying with any other material provision, or where it becomes impossible or impracticable for the party to perform (Clause 5(b)(ii)). The event must be beyond the party’s control and the party must not be able to, after using all reasonable efforts (which will not require such party to incur a loss), overcome such prevention, impossibility or impracticality. “Force majeure” is not specifically defined. Therefore, its meaning would have to be determined in each individual case on the basis of general principles but is understood to cover “Act of God” events beyond the control of the parties or their credit support provider. Notwithstanding that the 2002 Master Agreement contemplates “impracticability” as well as “impossibility,” the mere fact that the transaction has become significantly more expensive is unlikely to be sufficient to trigger a force majeure.

Each party must promptly use all reasonable efforts to notify the other party of the event. Either party may, by no more than 20 days’ notice, terminate early in respect of the affected transactions. No further payments or deliveries will be required, subject to any close-out amounts. Parties to the 1992 ISDA Master may adhere to the ISDA Illegality/Force Majeure Protocol which incorporates a “Force Majeure Event” as a Termination Event, as per the 2002 Master Agreement.

ICC Force Majeure and Hardship Clause 2003

The ICC 2003 Force Majeure Clause applies if a party fails to perform its contractual obligations and proves:

a) its failure to perform was caused by an impediment beyond its reasonable control
b) it could not reasonably have been expected to have taken the occurrence of the impediment into account at the time of the conclusion of the contract
c) it could not reasonably have avoided or overcome the effects of the impediment

A party is presumed to have established conditions (a) and (b) above in the event that the impediment is one of a number of listed events, including “epidemic.” COVID-19 is an epidemic, so it is likely that
conditions (a) and (b) would be established. It would then depend on the facts of the case whether the affected party can prove that COVID-19 caused its failure to perform and it could not have avoided its effects.

If a party successfully invokes the force majeure clause, it is relieved from its duty to perform its obligations. Where the impediment is temporary, then this applies only so far as it impedes performance. Where the duration of the impediment substantially deprives either parties or both parties of what they were entitled to expect under the contract, then either party may terminate the contract.

Incoterms

The Incoterms rules expressly do not deal with force majeure, so any bespoke clause would need to be considered on its own terms.

FIDIC

The 2017 FIDIC contracts (clause 18.1 of the Red Book 2017) use the term “Exceptional Event” (“Force Majeure” is used in the 1999 and previous versions). This is defined as an “exceptional event or circumstance” that:

1. is beyond a party’s control
2. could not have reasonably been provided against before entering into the contract
3. having arisen, could not reasonably have been avoided or overcome
4. is not substantially attributable to the other party

The clause identifies events (not exhaustively) that may constitute an Exceptional Event, including natural catastrophes, which may well include the COVID-19 outbreak.

Notice of the event has to be given, and the affected party is then excused from its obligations (but this does not affect any obligation to make payment). An Exceptional Event also gives the parties the option to terminate the contract in the event the contractor is prevented from executing substantially all the works for 84 days continuously, or for 140 days in total. The contractor can then recover the amounts payable for works carried out, plus the costs of plant and materials and any other cost or liability reasonably incurred by the contractor in the expectation of completing the works.

Joint Contract Tribunal (JCT)

Under the JCT contracts, force majeure is one of the Relevant Events that entitle a contractor to an extension of time to comply with its obligations. If the works are suspended for a period specified in the contract particulars, then, upon the expiration of that period, either party may terminate the contract on seven days’ notice. As with the LMA, “force majeure” is not defined, and so the meaning would have to be determined in each individual case on the basis of general principles.