Legal consequences of the COVID-19 outbreak on contracts: force majeure and frustration

Coronavirus (COVID-19), also known as 2019-nCoV, Wuhan Coronavirus and most recently re-named COVID-19, was first notified to the World Health Organisation (WHO) in December 2019.  Since then the WHO has declared 'COVID-19' a “public health emergency of international concern”, however, at this stage it is yet to formally classify the pathogen as a pandemic.  

Despite this, many nation states have reacted with robust mitigation measures, including closing borders, implementing a range of travel bans and engaging a myriad of internal domestic health and wellbeing procedures.

We are already seeing impacts of COVID-19 (and the mitigation measures), on domestic and international trade and commerce, capital flows, tourism, and migration.  As a result, our firm is receiving questions about the contractual rights (force majeure) and common law / statutory rights (frustration) available to deal with the consequences of these mitigation measures and COVID-19. We expect these issues to intensify.  

The outbreak

Since its initial notification, COVID-19 has spread from the Hubei province within China to over 30 other countries including Australia, Japan, the United Kingdom, Russia, France, Germany and the United States.

At this time globally, COVID-19 has infected more than 70,000 people and has caused more than 1,800 deaths.   Recent media reports have suggested that two-thirds of the world population could ultimately be affected.[1] This analysis is dynamic and changing daily. At this point, there is no vaccine, the timelines for one range from six months, to perhaps one-year to 18 months.

Economic Impact 

While parallels are being drawn to the previous outbreaks of sudden acute respiratory syndrome (SARS) in 2003 and the influenza H1N1-2009, each of which had profound short term impacts, there are signs that COVID-19 may ignite significantly greater impacts (economically, socially and politically).

In a world where markets and economies are intrinsically linked, where corporations and supply chains operate across hundreds of borders, and where the world is connected financially, digitally and socially like never before, a pandemic (or anything close to that) presents as a significant financial and economic risk. 

In 2006, the World Bank forecast that a pandemic could reduce world gross domestic product by around 5%[2]. The SARS outbreak is thought to have wiped 1% from China’s GDP in 2003[3].  

Surely, in 2020, a pandemic that has its epicentre in China - which has already resulted in the quarantine of approximately 60 million people - is likely to have an even greater global impact, particularly when (according to the IMF) as of 2019 China accounted for 39% of global economic expansion[4]?  In Australia the impact may be even more marked, with the Asia-Pacific region accounting for over 70% of Australia's two-way trade[5].

Impacted sectors 

Significant markets that have been, and will continue to be, directly and immediately impacted include[6]:

• Tourism:  DFAT figures revealed that Chinese tourists spent A$11.3 billion during their Australian holidays in 2017-18.
• Education:  International students bring A$32.4 billion to the Australian economy (or 8 per cent of the nation's exports).
• Commodities exports:  Iron ore and coal are Australia's key exports, together worth more than A$120 billion (being 30 per cent of what is sold to foreign countries). These are key commodities purchased by China. As economic activity slows, so too will forward orders.

In addition to markets, it is clear that there are already impacts on:

• Productivity: There will be knock-on effects due to absenteeism and difficulties due to damaged supply lines. These impacts will be felt in various sectors. By way of example, we are already seeing impacts within the construction, projects and infrastructure sector, with disruption and delay claims are already impacting current projects and generating claims.  
• Imports:  Australia imported A$71.3b of its goods from China (18% of all imports) and A$28.7b (7.3%) from South Korea and A$26.3b (6.6%) from Japan last year. These imports are many and varied, including intermediate goods required for production in Australia. Lack of availability of these goods will have economic impacts.
• Employment/OHS: Domestically there will be a range of employment and OHS challenges that must be navigated, particularly if the virus gets a foot hold in Australia and any further isolation regime applied.

In such an environment, commercial and legal risks accelerate dramatically. In addition to problems already being experienced (and anticipated), the outbreak could fundamentally alter assumptions surrounding risk allocation, supply chains and access to markets and materials if the virus persists deep into 2020. In that context, this article narrows its consideration to how COVID-19 may interact with the existing law concerning frustration of contracts and force majeure events.  

Force majeure

Force majeure is derived from Roman law and is an operative doctrine in many legal systems, such as in the French system. However, the common law generally does not recognise a doctrine of force majeure as a standalone legal concept[7], rather it is the product of commercial agreement between contracting parties[8].  

Many contracts, and most international trade contracts, contain a force majeure clause.  However, these clauses are not ubiquitous.

The usual intent of a force majeure clause is to excuse contracting parties from contractual obligations and liabilities while they are prevented from performance (either completely or sometimes partially) by defined events or circumstances.

In some instances, a force majeure clause may also provide a contractual termination right, most often if the force majeure event subsists for a defined period. In these instances, the clauses may specify which party is to retain the benefit of monies paid or work done under the contract upon termination. Normally, the defined events that are required to occur are matters that are beyond the reasonable control of either party.

Because force majeure clauses are the product of commercial agreement, the scope and effect of a force majeure clause is determined on a case-by-case basis, by reference to the wording of the clause and the relevant facts. That said, there is a range of jurisprudence on force majeure clauses that is relevant and important (particularly in the context of a pandemic situation), including:

• The party that relies upon the force majeure event generally has the burden of proof of the event itself[9]. Similarly, these clauses will be subject to the contra proferentem rule and, as such, the force majeure clause will be construed strictly. In the event of ambiguity, it will interpreted against the interests of the party that relies upon it.[10]
• It will usually be an express term that the force majeure event is an event beyond the reasonable control of either party. However, if it is not, the term may be implied[11].
• A seller of generic goods is not usually relieved, even by a force majeure clause, from a duty to appropriate such goods simply because a particular source of supply becomes unavailable or there is a shortage of materials, especially if it can be overcome at a cost[12];
• US Courts have held that a force majeure event cannot retroactively alter unfulfilled contractual obligations as to which complete performance was due prior to the force majeure event. The courts have held that the parties could not have reasonably meant to excuse past, uncured breaches of contract by an unexpected future event.[13]

The application of COVID-19 and its consequences in the force majeure context will be interesting. Many contracts contain clauses that make the issue simple to resolve, for example, because they contain clauses that stipulate specific events such as epidemics, quarantine, biological contamination or entry and exit restrictions. However, other clauses include generic phrases such as ‘natural disaster’. It is certainly arguable that COVID-19 could fall under this definition.

Further, COVID-19 does not need to be the direct cause of a force majeure event to be relevant. It is entirely possible that a force majeure event may be triggered tangentially or as a second order consequence.

For example, it is conceivable that a serious outbreak of COVID-19 may result in ports being closed to certain ships. This may make delivery of essential component parts impossible, thereby triggering a force majeure.

Obviously, if parties are in current contract negotiations, they should certainly consider including a force majeure regime that will protect them from the consequences of being unable to perform their contracts because of COVID-19 (and its knock on effects).  

Similarly, contracting parties should carefully consider the consequences of a force majeure event occurring and the impacts that this would have on ongoing operations if contractual obligations (say of critical suppliers) were suspended for months on end (as these sort of time scales are entirely possible).

Notably, the China Council for The Promotion of International Trade, accredited with China’s Ministry of Commerce, announced on 30 January 2020 that Chinese entities may apply for force majeure certificates for disputes with foreign trading partners arising from COVID-19 control measures.  

Whether a contracting party may rely on such a certificate (as proof of a force majeure) would remain dependent on an analysis of the relevant facts and wording of the force majeure clause and also whether the certification is recognised by the counterparty to the contract (and the jurisdiction in which the contract is formed).

Where a contract does not contain a force majeure clause, or where a force majeure clause does not cover the relevant circumstance, parties may wish to consider whether the doctrine of frustration applies.

Frustration

Unlike force majeure, frustration is a concept recognised by the common law (and in many states in Australia by statute). Frustration operates to bring a contract to an end in circumstances where an intervening, post-contract event, has occurred through no fault of the parties, which:

• makes a contractual obligation impossible to perform; or
• transforms a contractual obligation into a fundamentally different obligation.

Frustration is typically not easy to establish and has a narrow scope.  

Examples of situations where frustration has arisen include:

• A change in the law rendering performance illegal[14]. For example, where a regulator declares a pre-exiting chemical (existing on a construction site for example) as a new contaminant, making performance as anticipated under the contract (for example removal and re-use at another site), illegal.
• Physical destruction of the subject matter of the contract[15].
• Restraint by injunction.[16] Codelfa Construction is one of the leading cases in Australia related to frustration and is essential reading for any lawyers considering frustration.  

A contract will generally not be frustrated if:

• it has an operative force majeure clause that can deal with the relevant issue;
• the impossibility of performance is the fault of either of the parties;
• performance has only become more onerous or expensive[17]. The intervening event should lead to serious consequences, and not a mere change in circumstances for performance;[18]
• the change is only temporary or transient.[19] One Hong Kong case arising from the SARS epidemic illustrates this issue. In Li Ching Wing v. Xuan Yi Xiong[20], a tenant the subject of a 10-day isolation order due to SARS, who was 13 months into a 24-month lease, sought to invoke frustration to discharge a lease to which he was a party. The court rejected the tenant’s argument on the basis that the isolation order was only of a short duration in the context of the entire lease.

Unlike force majeure, where frustration does apply, the contract is automatically terminated by operation of law upon the occurrence of the frustrating event. In that event the common law provides that losses lie where they fall. No party can claim damages for non-performance because no party is at fault.  Under the common law (which operates in Tasmania, Queensland, Northern Territory, ACT and Western Australia), where a contract is frustrated all obligations from the point of frustration cease for both sides, including payment obligations. This may result in harsh economic and financial outcomes and parties may seek recovery in restitution. The other three jurisdictions have legislation that regulates (and ameliorates) how frustration operates:

• New South Wales (Frustrated Contracts Act 1978),
• South Australia (Frustrated Contracts Act 1988), and
• Victoria (Australian Consumer Law and Fair Trading Act 2012).

Each State’s regime is different, however, the legislation attempts in each case to provide a fair result to the parties.

A simple example of how COVID-19 may result in frustration is if the contract in question was a personal services contract (say an artistic performance on a particular date). If a person was subject to a period of enforced isolation (for example under a public health order made under the Public Health and Wellbeing Act 2008 (Vic)) and as a result was not able to provide services on a particular day / time, it would appear plain that the contract had been frustrated.

If COVID-19 caused significant labour force issues (due to absenteeism and/or quarantine etc), it is probably unlikely that this alone will amount to a frustration, unless for example time is of the essence in respect of the issue or items that is impacted by the delay.

Conclusion

COVID-19’s global trajectory is currently uncertain. That said, there are obvious and apparent risks that the virus may – if it has not already - move to pandemic levels and have very significant economic and contractual impacts.  

Businesses should be carefully assessing their existing contractual arrangements now to understand the risks (and opportunities) that may be presented if contractual obligations are severely impacted.  Similarly, in respect of future negotiations and contracting, businesses should prepare for a likely change in the normal and pre-existing assumptions underlying and surrounding risk allocations in a range of contracting structures, the operation of supply chains and in terms of the ability to easily access markets and materials.

Both frustration and force majeure relief can have profound impacts, so the exercise of these rights should be carefully assessed.  

This article is part of our insight series COVID-19: Navigating the implications for business in Australia and beyond. Subscribe to get notified by email when new COVID-19 insights are released.