The English word “pandemic” derives from two Greek words: pan meaning “all” and demos meaning “people”. The Chinese word – 全球大流行 – is much more direct, meaning “great global spread”.
During the course of the COVID-19 pandemic, the social isolation measures, the closure of borders and the restrictions on business activity (including the provision of goods and services in the ordinary course of business) have seriously disrupted private contractual arrangements between commercial parties on both a domestic and cross-border basis.
As in other crises, such as the Global Financial Crisis of 2007-2008, contracting parties inevitably focus their attention on the terms of commercial contracts and their respective rights and liabilities. In terms of rights, the relevant questions include whether they have the right to terminate contracts, or to take steps to protect their financial and commercial interests. In terms of liabilities, the relevant questions include whether they will be liable for any delay or failure in the performance of contractual obligations, and what steps they can or should take to mitigate any losses that might be incurred.
Drawing on previous Lexicons, this article examines the contractual impact of pandemics on corporate and financial transactions in three areas: material adverse change clauses; force majeure clauses; and the doctrine of frustration. The focus is on the treatment of these areas in common law jurisdictions, but the article also makes comparative reference to the position in other jurisdictions.
Material adverse change clauses
A key purpose of commercial contracts is to allocate risk between the parties, and to identify what consequence should arise if any commercial or financial risks increase as a result of a change in circumstances, or the occurrence of an adverse event after the contract was signed. Often the change in circumstances or the adverse event was not foreseeable by the parties on the date on which the contract was signed.
In general terms, a material adverse change (MAC) clause allows one party to exercise certain rights in the event that a material adverse change occurs (for a discussion about MAC clauses, see China Business Law Journal volume 7, issue 1: MAC clauses). The clause might trigger the right of the relevant party to terminate a contract, or to choose not to perform, or continue to perform, its obligations under a contract. As a result of its potential impact, an MAC clause is often heavily negotiated between the parties and their lawyers.
MAC clauses are common in the context of loan agreements, where a material adverse change that affects the ability of the borrower to perform its obligations allows the lender to refuse to advance funds to the borrower, or to accelerate the loan and demand repayment of all of the funds that have already been lent. In addition to loan agreements, MAC clauses sometimes appear in underwriting agreements and acquisition agreements.
In the context of an acquisition agreement, the MAC clause can operate as a condition precedent to completion, under which the failure to satisfy the condition by the completion date allows the purchaser to terminate the acquisition agreement and to withdraw from the transaction.
In common law jurisdictions, an MAC clause will be interpreted in accordance with the general principles of contract law, namely, the courts will ascertain the intention of the parties primarily by reference to the words that the parties have used to draft the clause. As a result, the drafting of an MAC clause is of critical importance, as it will determine when the clause can be triggered.
If the agreement was entered into after the onset of a pandemic, it will be more difficult to trigger the MAC clause, as it could be argued that the impact was foreseeable on the date of the agreement. In addition, it will be a question of proof as to whether the pandemic-related event has resulted in a material adverse change as defined by the MAC clause.
Proving the likelihood that the event will have a material adverse change will be complicated by uncertainties about the duration of the pandemic and its impact, and other relevant factors, such as the availability of government measures (including grants and loans) to assist businesses to recover from the effects of the pandemic.
Force majeure clauses
As noted in a previous article (see China Business Law Journal volume 8, issue 5: Force majeure), the term force majeure, as used in English, is actually a French word that means “superior force” or “superior strength”. It is not certain how the term came to be used in English, but it is likely that it was inserted in English commercial contracts by parties who were familiar with the term as it was used in the French Napoleonic Code. Accordingly, it is an interesting example of how a concept that was originally embodied in the laws of a civil law jurisdiction came to be adopted for use in contracts governed by English law.
In general, force majeure refers to an unforeseen event that is outside the control of the parties to a contract, and prevents or delays the performance of obligations by one or more of the parties. Two questions are of fundamental importance in understanding how the concept works: (1) what is the definition of force majeure; and (2) what are the legal consequences of force majeure?
The laws in England and other common law jurisdictions do not provide a statutory definition of the concept of force majeure. Unlike the position in many civil law jurisdictions, it is not a term of art with a legislative definition. Instead, the concept is incorporated into contracts by the parties based on their own free will and is therefore subject to the principles of contractual interpretation.
These principles include the rule known as contra proferentem, namely, the rule that a clause excluding the liability of a party to the contract should be interpreted narrowly. Further, if the clause is ambiguous, it should be interpreted against the interests of the party who is seeking to rely on it. In addition, the burden of proving that an event of force majeure has occurred is on the party that is seeking to rely on it.
Because the concept is not governed by written law, but instead by the contractual terms between the parties, the relevant clause often lists the events that qualify as events of force majeure. These may include the following events: (1) an act of God, such as a natural disaster; (2) laws and changes in law that prevent the performance of obligations; (3) war and civil disturbance; (4) epidemics; and (5) strikes.
The legal consequences of a force majeure clause will depend on how the clause is drafted. For example, the clause may suspend the performance of obligations by the affected party for the period that the event of force majeure continues. Alternatively, or in addition, the clause may provide that one or both of the parties have the right to terminate the contract after a certain period of time. In general, the clause will provide that the affected party has an obligation to notify the other party, and to mitigate the effects of the force majeure.
Similar to the position with an MAC clause as discussed above, a determination of whether a force majeure event has delayed or prevented performance as a result of a pandemic-related event may be complicated by uncertainties about the duration of the pandemic and other relevant factors, such as government measures (including grants and loans) to assist businesses to recover from the effects of the pandemic.
In some countries, government authorities issue companies with force majeure certificates in circumstances where an event has occurred that has a broad impact (i.e., an impact beyond an individual company). These do not have any legal effect under contracts governed by the law of common law jurisdictions, except where the force majeure clause is expressly triggered by the issue of such a certificate. They are, however, likely to have probative force in countries where force majeure has a legislative basis. The China Council for the Promotion of International Trade (CCPIT) announced on 30 January 2020 that it would offer force majeure certificates to help companies deal with disputes with foreign trading partners arising from epidemic control measures.
Doctrine of frustration
Under the doctrine of frustration, a contract will automatically be terminated if an event occurs that so fundamentally affects or prevents the performance of the contract that it would be unjust to require the parties to perform their obligations (for a discussion of frustration, see China Business Law Journal volume 3, issue 6: Amend or modify?).
It is important to be aware of the difference between force majeure and the doctrine of frustration. Frustration is much narrower and refers to the situation where an event occurs that renders it physically or commercially impossible to perform the contract, or changes the obligation into a radically different obligation from that undertaken by the relevant party at the time the contract was entered into.
The consequence of frustration is that the affected obligations are discharged. Because of the uncertainty concerning the circumstances in which frustration applies, the parties to a contract usually prefer to include a force majeure clause in the contract rather than rely on the common law doctrine of frustration. Where express provision has been made in the force majeure clause for the event that has occurred, the contract will not be frustrated. Further, the wider the scope of the force majeure clause, the narrower the scope for frustration to be argued.
An event will not be held to be a frustrating event if it was foreseeable, or in the contemplation of parties when they entered into the contract. In light of the 2003 SARS-CoV, the 2015 MERS-CoV and the 2014–2015 Ebola virus outbreaks, it might be argued that a pandemic is no longer an unforeseeable event. That said, it may be possible for parties in the context of the current COVID-19 pandemic to argue frustration on the basis that the scale of the pandemic and the severity of the public health response could not have been foreseen.
In some civil law jurisdictions, the doctrine of hardship provides a basis for permitting a party to request that a contract be renegotiated or, failing agreement with the other party, to request a court to terminate or modify the contract. Some, but not all, civil law jurisdictions recognise this principle in their domestic law. For example, it is recognised by Germany, Italy and the Netherlands, but not in France.
There is an important difference between the doctrine of hardship and the doctrine of frustration as recognised in common law jurisdictions. Under the doctrine of hardship, a court has the power to modify a contract if it would be reasonable to do so. Under the doctrine of frustration, on the other hand, the court only has the power to declare that a contract has come to an end.
This article has provided a high-level overview of the contractual impact of pandemics on corporate and financial transactions in three areas: MAC clauses, force majeure clauses and the doctrine of frustration. The discussion highlights both the complexities of these concepts and also the extent to which their operation is subject to specific circumstances, even in the context of the COVID-19 pandemic.
A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at www.vantageasia