The current Covid-19 pandemic and the imposition of various social distancing and other restrictions in India and elsewhere in the world is likely to cause significant disruption to supply chains and potentially make the performance of contracts challenging. In this note, we outline the position under Indian law with regard to whether performance of obligations can be excused on the grounds of frustration through “force majeure” and “material adverse change” (“MAC”) clauses.
INTRODUCTION
The current Covid-19 pandemic and the imposition of various social distancing and other restrictions in India and elsewhere in the world is likely to cause significant disruption to supply chains and potentially make the performance of contracts challenging. In this note, we outline the position under Indian law with regard to whether performance of obligations can be excused on the grounds of frustration through “force majeure” and “material adverse change” (“MAC”) clauses.
In addition to analysing these considerations, which apply to all contracts, we have also set out some additional Covid-19 issues relevant to parties in M&A transactions.
EXECUTIVE SUMMARY of potential “outs” from contracts
As a general matter, like other common law jurisdictions, Indian Courts will seek to enforce the bargain that parties have struck. However, there are two sets of limited exceptions to this, as summarized below.
§ Contractual outs: The contracts themselves may excuse performance in certain cases through contractual risk allocation provisions such as “force majeure” or MAC clauses. The former often feature in certain commercial contracts, supply agreements and various infrastructure / project finance related documents, and the latter are common in the context of M&A or financing transactions.
o There is no “automatic right” to assert a force majeure or a MAC “out” and this will only apply if the contract expressly provides for this.
o As far as force majeure contracts are concerned, the coverage of an event, for instance, Covid-19, will depend on the drafting of the relevant clause, as will the process for asserting such an event and the outcomes that follow (e.g. delay, no liability or termination).
o Although Indian case law on MAC provisions is yet to evolve in a manner similar to that in the US or England and Wales, US case law suggests that enforcing MAC provisions is not always straightforward.
§ Frustration: In the absence of being able to assert a force majeure or MAC event (which will only be possible if the relevant agreements contain such clauses and their occurrence can be established), the doctrine of “frustration” operates to excuse performance of obligations on the basis of either impossibility or unlawfulness; or the failure of a contingency to be satisfied. However, this will depend on the tests under Section 56 (or to a lesser extent Section 32) of the Indian Contract Act, 1872 (“ICA”) in this regard being satisfied. In general, Indian courts will look to enforce contractual obligations and the bar set in case law for the assertion of frustration in India is high.
These are considered further below.
CONTRACTUAL “OUTS” THROUGH RISK ALLOCATION PROVISIONS
Force majeure clauses
Parties sometimes contractually deal with future risk through force majeure clauses. These clauses provide for certain pre-agreed outcomes (e.g. excusing performance, delay or other measures) in certain pre-agreed situations. Force majeure clauses are not a feature of all contracts, but where they have been used, some key considerations are:
§ Covid-19 coverage: Certain force majeure clauses may cover epidemics and pandemics. Clearly, asserting coverage of Covid-19 will be more straightforward if the clause includes this reference and because the World Health Organisation has labelled Covid-19 as a pandemic. As to references to acts of god or natural disasters, these do not appear to have been interpreted to cover pandemics in the past and establishing Covid-19 coverage on this basis may not be straightforward. Some force majeure clauses include catch all or residual provisions on other potential uncontrollable events at the end of the force majeure clause may also help, these are likely to be interpreted by a court, by reference to the earlier list of events in the clause (the so called “ejusdem generis” principle). If so, such residual clauses may be of limited use.[1] Alternatively, if government shutdowns are listed as force majeure events, then these could open up another avenue to assert force majeure.
§ Impact: Even if an event is covered in the list of force majeure events, parties will need to consider how the force majeure clause is drafted. In particular, the aspects will need consideration:
o Is the occurrence of a force majeure event, by reference to such events preventing performance or delaying performance or affecting performance in some way?
o What is the outcome that is contractually defined – i.e. does this permit a delay or suspension in performance, or does it act as a carve-out to liability or does it confer a termination right?
Ultimately, the ability of a party to apply Covid-19 as an out will depend on the drafting of the relevant provisions.
§ Causality: There will need to be a link between the force majeure event and the default or potential default.
§ Interpretation: Force majeure will likely be narrowly construed, and the contract will as a whole need to be considered in determining whether an event falls within the scope of the relevant clause.
§ Mitigation: Force majeure clauses often require mitigation action on the part of the party seeking to assert it. Also, even if not explicit, if any “catch all” item in the definition of this term is drafted by reference to other circumstances beyond the parties’ “control”, this limb may also imply a duty to mitigate the outcome on the party seeking to assert the force majeure provision.
§ Relationship with the concept of frustration: The Supreme Court has clarified that when a contract contains a force majeure clause pursuant to which a party has established the occurrence of force majeure event, Section 56 of the ICA can have no application.[2] This presents one interesting issue. In the unlikely scenario that pandemics are specifically excluded from a force majeure clause, will a party be able to assert frustration? Judicial precedent suggests that this will be difficult. [3] This will obviously place the affected party in some difficulty.
Applicability in relation to the Covid-19 pandemic: The application of force majeure clauses to the Covid-19 pandemic will depend on the drafting of the provision, the causality, mitigation steps and various other factors. Note that various government ministries have issued certain memoranda in this regard.[4] However, these do not carry any actual legal significance, because only courts can interpret whether a certain event qualifies as being force majeure. Also, they are limited to the subject matter they deal with (e.g. in the case of the office memorandum issued by the Ministry of Finance, to public procurement) and has no application to contracts outside their perimeter. In any event, going forward, parties drafting contracts should carefully consider their force majeure clauses and should specifically include pandemics and other potential risks. Parties may also want to consider including force majeure clauses in a broader range of contracts, than is currently market practice.
MAC clauses
Overview
Apart from force majeure clauses, parties sometimes deal with the risk of the unknown through MAC clauses. These feature most commonly, although not exclusively, in M&A purchase agreement and finance documentation. A normal MAC clause will seek to shift the risk of certain significant events from the buyer to seller in an M&A deal (note that these clauses are also used in financing and other transactions too). Sellers normally push back with exceptions in relation to general economic or macro conditions, with the effect that a balanced MAC clause would normally allocate “company” related risk to the seller, with general “market risk” remaining with the buyer, through the exceptions. As a general matter, these clauses are drafted in customary and general terms, so that they are capable of general application. Also, references to “prospects” of the company is seen to favour the buyer, because forward looking company risks then remain with the seller.
MACs can be used in a number of different ways. The absence of a MAC is often a condition precedent to completion. MACs sometimes feature as a qualifier to the standard of “bring down” warranties (i.e. those which are repeated as completion) or they sometimes feature in the body of warranties (e.g. as a qualifier to various warranties or stating that no MAC events have occurred since the date of the last audited accounts date). Therefore, they are used in a variety of ways to allocate contractual risk.
Enforcement
Although considerable value is placed on these clauses, they have proved difficult to enforce in practice. There is a paucity of case law on this in India. Therefore, the only guidance that can be drawn is from the experience in other jurisdictions.
The most comprehensive case law on this is in the US, where a number of landmark cases have tested the efficacy of these provisions. The principles that have emerged from US cases are as follows:
§ Testing of a MAC is over a long-term period. Short term “blips” in themselves have been held not to constitute MAC events.
§ Although there are different judgments on this, prior knowledge of events or circumstances may be unhelpful in establishing the occurrence of a MAC event.[5]
§ There is no fixed threshold or impact, but standard set for its usage is high. [6]
Impact of drafting
The drafting of a MAC provision will drive its usage. In particular, the considerations set out below are relevant.
o Is the occurrence of a MAC linked to a material and adverse effect on the business or financial condition of the target and does it include a reference to “prospects”? A reference to prospects will be helpful to a party seeking to enforce a MAC.
o Is measurement of materiality with reference to a specific metric (e.g. EBITDA) and in relation to a defined time period? Specific references will assist in establishing the occurrence of a MAC event.
o What are these exclusions to the MAC clause? For instance, is there a carve out for matters affecting the industry in which the target operates? If so, does the carve out exclude macro events that have a disproportionate effect on the target? These provisions are critical to the risk allocation in a MAC provision.
Applicability in relation to the Covid-19 pandemic: Indian jurisprudence on the enforcement of MAC clauses, has not evolved to the extent it has in the US or England and Wales. It remains to be seen how these are interpreted in any Covid-19 related litigation or arbitration. For contracts executed prior to the outbreak of Covid-19, the advent of Covid-19 may well be a new event, of which there was no prior knowledge (which addresses one of the concerns in the US case). If Indian courts apply the US principles, part of the outcome may be driven by the duration of the likely impact. Apart from these principles, part of the outcome will depend on how these clauses are drafted. For instance, those drafted by reference to specific metrics (e.g. EBITDA triggers) or by reference to defined time periods or without market events carve outs are likely to be easier to enforce. With regard to contracts that that parties may execute going forward, ironically, the current market dislocations and uncertainty may make it harder for parties entering into agreements from here on to assert a MAC event, because they are entering into an agreement with the knowledge of the risk that Covid-19 creates. Therefore, it is important that, to the extent possible (and indeed to the extent acceptable to the counterparty), drafting addresses this particular concern.
Frustration “OUTS” under Indian law
Overview
The concept of “frustration” under Indian law, which would excuse a party from performance of its obligations, is principally set out in Section 56 of the ICA. This limits the concept of frustration to “impossibility” or “unlawfulness” in the Indian context. Section 32 is also of some relevance here, as this states that in contingent contracts, if the contingency becomes impossible, the contract is void. Most of the law around frustration in India has been around the former provision.
Key factors
With regard to Section 56, the following principles apply:
§ Concept: Impossibility is to be construed in its literal sense. Section 56 establishes positive law and does not leave the matter to be determined by the intention of the parties. In order to succeed, a party should demonstrate that the performance of the contract is “impracticable and useless from the point of view of the object and purpose which the parties had in view at the time of entering into the contract”.[7]
§ Commercial inconvenience insufficient: The test, by reference to impossibility and reference to impracticability in the quotation cited above, does not mean that commercially inconvenient transactions can be avoided and case law establishes that mere difficulty or increased cost or hardship will not be sufficient to establish frustration in themselves. Indeed, the Supreme Court has quoted English case law where the court observed “a contract is not frustrated merely because the circumstances in which it was made are altered. The Courts have no general power to absolve a party from the performance of his part of the contract merely because its performance has become onerous on account of an unforeseen turn of events.” [8]
§ Awareness or foreseeability of the risk: This will make it difficult for a party to successfully assert frustration.
§ Availability of alternative means of performance: This will likely negate any claim of impossibility.
§ Duration: As to temporary versus longer term impossibility, the issue is likely to turn on whether “time is of the essence” in the contract, but in general, longer-term impossibility is more likely to establish frustration, than shorter term issues.
§ Interpretation: Courts have been very careful in considering the concept of frustration and have interpreted it within narrow limits.
§ Outcomes: The outcome would depend on the facts and circumstances of each case.
o If Section 56 is established, the party affected by the failure of the counter-party’s performance is not without remedy. For instance, because frustration both under Section 32 and Section 56 of the ICA results in a contract being treated as void, restitution under Section 65 of the ICA (which applies in relation to void contracts) may also be an option that could be considered.
o Also, if only part of the contract is frustrated with some part being capable of performance or if the contract can be split into separate sets of obligations, then the party seeking performance may still have some recourse under Section 12 of the Specific Relief Act 1967 (“SRA”).[9] This provides, in circumstances where the entirety of the contract is not impossible (i.e. part performance is possible) or separate parts of the contract can be separately performed, for recourse on the part of such counterparty.
o Of course, if the party seeking performance succeeds in litigation (meaning that the other party fails to establish Section 56 applies), the plaintiff can seek the normal remedies for breach (damages or specific performance, unless the contract is determinable or if the person seeking specific performance is debarred from doing so[10], in which case, specific performance will not be possible).
Applicability in relation to the Covid-19 pandemic: Frustration as a concept has traditionally been narrowly construed and there is a high bar to establishing its applicability. Therefore, any attempt to assert frustration will need to be viewed against this backdrop. Ultimately, whether it may be asserted to excuse performance, will depend on the nature of the contractual obligations relative to the restrictions, the duration of any “lock-down” restrictions, the possibility of alternative means of performance and a number of other factors. The position will be bespoke to the bargain struck in each case and will depend on how the pandemic and government responses evolve. Parties should also be aware that the length of litigation in India may mean that these issues, if litigated, are likely to be finally resolved after resolution of the current crisis[11]. Note also that frustration is a contract law concept and will have no application to schemes under the Companies Act 2013 and to resolution plans under the Insolvency and Bankruptcy Code 2016, as these are not contracts (although the terms of these may provide other forms of comfort).
Lessees right to avoid agreement under Transfer of Property Act, 1882, in the absence of an Force Majeure clause
Leases are a special class of agreements that are governed by statute, i.e., the Transfer of Property Act, 1882 (“TP Act”). Section 108 of the TP Act stipulates certain rights and duties of the lessor and lessee to a lease agreement, in the absence of a contract or local usage to the contrary. Section 108 (e) of the TP Act entitles a lessee to a property to avoid such a lease, if, by fire, tempest or flood, or violence of an army or of a mob, or other irresistible force, any material part of the property is wholly destroyed or rendered substantially and permanently unfit for the purposes for which it was leased. Therefore, with the onset of the COVID-19 pandemic, in the absence of a contract to the contrary, lessees to a lease agreement may seek to avoid the lease, provided this meets the high standard stipulated under Section 108(e) of the TP Act. A three-judge bench of the Supreme Court has held that the Doctrine of Frustration under Section 56 of the Contract Act would not apply to leases.[12]
COVID-19 IMPACT ON OTHER CONTRACTUAL PROVISIONS IN M&A TRANSACTIONS
Impact on key contractual provisions
Given the current uncertainty and the difficulty of conducting “business as usual” with the social distancing restrictions in place, parties in M&A deals will need to be mindful of a number of other provisions:
§ Undertakings: Sellers will need to be mindful of “best endeavours” undertakings (as opposed to “reasonable endeavours” undertakings). There is limited Indian case law on these terms, but English case law on this is likely to have some precedential value. Sellers will not be under obligations which may require them to sacrifice their commercial interests. For buyers, the provision will of course, be the reverse.
§ Viability: Section 56 of the ICA contains another provision which may be of relevance. A party who promises to do something which he knew or ought to have known (with reasonable diligence) was impossible or unlawful will need to compensate a counterparty for any losses incurred. Given the uncertainty of the current situation, parties will need to consider what is possible, before making a contractual commitment.
§ Controls: As far as phrases such as the “ordinary course of business” are concerned, for example, when used in the context of warranties and representations or pre-completion undertakings, parties will need to consider whether this is appropriate in the current circumstances. Buyers may want more prescriptive provisions or greater control in the current environment.
§ Disclosure: Sellers may need to carefully consider the impact of Covid-19 on disclosure or any bring down disclosure. Bring down disclosure is often contractually limited to “new events”, but parties will need to consider how these are drafted and when the impact of Covid-19 is measured (e.g. by reference to what outbreaks) to confirm what is possible by way of bring-down disclosure which are normally related to new matters.
§ Warranties: To the extent that warranties and representations are qualified by “awareness” and there may be a potential breach of warranty claim due to Covid-19 issues, are the contractual provisions sufficiently clear on whose awareness is imputed and as to the standard of awareness? The contractual limits of any imputed knowledge and the parameters against which such imputed knowledge is to be measured will have to be considered.
§ R&W insurance: Although warranty and representation insurance is still new in India, parties will need to check to confirm the coverage of policies in the current environment.
§ Purchase price adjustments: In relation to purchase price adjustment provisions, the Covid-19 situation may impact normalized levels of working capital and estimated cash and debt and debt-like items.
§ Completion: Completion mechanics or satisfaction of conditions precedent may be affected by current “lock-down” restrictions in various jurisdictions. Buyers may be able to use the failure to satisfy conditions precedent as an opportunity to renegotiate price, even if the MAC fails, and sellers may need to seek extensions of longstop dates for completion (if buyers are still willing to proceed).
§ Damages: If Covid-19 will give rise to a warranty breach in relation to contracts provided in purchase agreements executed over the last few months, the question is what measure of damages will apply and how should foreseeability be assessed for this purpose? The standard of damages or losses that can be claimed under Indian contract law are those that “naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.”[13] Although the magnitude of the current market dislocation has surprised many, the Covid-19 situation has been playing out over a number of months as it spread globally and concerns as to the impact have been raised for a number of months. It remains to be seen as to how courts will treat the issue of foreseeability, in the context of assessing damages in this context.
CONCLUSION
Covid-19 is undoubtedly a shock event, but whether or not it is capable of giving rise to an “out” will depend on a number of factors, partly relating to the business impact of Covid-19, partly relating to the continued presence of restrictions, and partly relating to the drafting of various contractual provisions.
As a general matter, and noting that the analysis is fact dependent and may therefore vary depending on the circumstances of a case, asserting force majeure, if there is such a clause in the contract, and provided the clause is appropriately drafted, may in practice be easier in comparison to frustration, where historically there has been a high bar to surmount. As to MAC provisions, although Indian jurisprudence on this is yet to evolve, parties would be well advised to be guided by the principles in other markets such as the US in this regard.
Covid-19 will also undoubtedly influence risk allocation and other provisions in M&A transactions from here on. Parties should carefully be mindful of the considerations set out in this note and shape their deals accordingly.
-Nikhil Narayanan (Partner, Corporate / M&A), Kingshuk Banerjee (Partner, Dispute Resolution) and Zacarias Joseph (Senior Associate, Dispute Resolution)
[1] There is no inflexible rule that this is the case, but case law suggests that courts are strongly influenced by this approach.
[2] Energy Watchdog v CERC & Ors., 2017 14 SCC 80 at paragraph 47.
[3] In Satyabrata Ghose v. Mugneeram Bangur & Co., AIR 1954 SC 44, at paragraph 19, it was held that where the parties have considered an intervening circumstance and expressly provided that this should not affect performance, then Section 56 of the ICA cannot apply.
[4] For instance, on 19 February 2020 an “office memorandum” issued by the Ministry of Finance states that the COVID-19 may be considered as a ‘natural calamity’ (listed in some of the force majeure clauses in the Manual for Procurement of Goods, 2017) and that accordingly, the force majeure clause may be invoked in relation to Covid-19 “wherever considered appropriate, following the due procedure as above”. However, this has little significance. Similarly, the Ministry of New & Renewable Energy has issued an office memorandum date dated 20 March 2020 inter alia in respect of the grant of extension of time for the development of renewable energy projects. Further, the notification of the Ministry of Shipping on 24 March 2020, which states that “major port trusts may consider COVID-19 pandemic as a valid ground for invoking force majeure clause on port activities and port operations also”.
[5] There are different judgments on the effect of prior knowledge in the US, so commentators feel that this remains an open issue until the position is conclusively judicially determined.
[6] For instance, in Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018), the court ruled in favour of the occurrence of a MAC, in circumstances where the company’s revenues had declined by 25%, its operating income had declined by 105% and its EBITDA had declined by 86%. The court quoted expert opinions on other metrics and thresholds but noted that lower thresholds might apply in different cases, so the bar is high, but it appears that there is no fixed or inflexible threshold requirement.
[7] Satyabrata Ghose v. Mugneeram Bangur & Co., AIR 1954 SC 44.
[8] Naihati Jute Mills v. Khyaliram Jaganath, AIR 1968 SC 522, quoting Earl Loreburn in F. A. Tamplin S. S. Co. Ltd. v. Anglo-Mexican Petroleum Products Co... Ltd. [1916] 2 A.C. 403, 404.
[9] This applies if the contract is “unable to be performed”.
[10] Sections 14 and 16 of the SRA respectively.
[11] In our experience in India, large number of disputes are resolved at the interim stage itself. Thus, while final resolution/ adjudication can potentially take a few years, interim determinations by courts (arising out of interim applications) often drive parties to settle disputes without waiting for the final decree or judgment.
[12] AIR 1968 SC 1024.
[13] Section 73 of the ICA.