Tim Parker and Abigail Liu, Barristers at Denis Chang’s Chambers, take an in-depth look at the legal ramifications of the non-performance of commercial contracts during the current coronavirus pandemic.

The rapid spread of COVID-19 has developed into a global threat. The pandemic and the laws and regulations enacted to stem its spread are causing unprecedented disruption to businesses.

This article addresses the way in which the coronavirus pandemic will affect the continuing validity of contractual obligations. We set out the legal principles governing the circumstances in which contracting parties may be released from their obligations by:

1. the operation of a force majeure clause, or
2. invoking the common law doctrines of frustration and impossibility.

The discussion inevitably addresses the general principles only, and as always, specific legal advice should be sought about the application of these principles to any particular contract.

1. The operation of a force majeure clause

A force majeure clause is a type of contractual term that is triggered by an exceptional event beyond the parties’ control, and usually operates to excuse non-performance by parties of their obligations under the contract where the event has prevented or hindered their fulfilling their end of the bargain.

This will only apply if the contract includes such a term. Whether or not COVID-19 will amount to such an event turns entirely on the wording of the clause in the contract in question. Where a contract contains a force majeure clause, the party seeking to invoke it will need to show that:

• COVID-19, and/or the governmental measures adopted in response to it, constitute events of force majeure within the meaning of the contract
• performance of the relevant obligation was prevented, hindered or delayed (depending on the wording) by COVID-19/the governmental measures, and/or
• in many cases, it will also be necessary for the party seeking to rely on the clause to show that they took reasonable steps to mitigate any losses arising out of their non-performance.

We expand on each of these elements below.

Is COVID-19 an event of force majeure?

In analysing whether or not a given event constitutes a force majeure, one can begin by looking at the specific wording of the clause. Many force majeure clauses contain a list of force majeure events. Common examples include war, revolution or acts of terrorism.

If the clause in question includes wording such as ‘pandemic’, ‘epidemic’ or ‘disease’, it is likely that COVID-19 will qualify. Depending on the context, a reference to ‘plague’ may potentially also cover COVID-19.

Some clauses may contain a general category, for example: ‘all events outside the reasonable control of the parties’. As COVID-19 is an event beyond the parties’ control, it is likely to fall within a widely drafted clause like this. It is also an event that is of the type that would likely have been within the contemplation of reasonable parties agreeing to a general clause of this nature.

Another commonly used term is ‘acts of god’. An act of god refers to the operation of natural forces (as opposed to acts of man) not reasonably possible to foresee and guard against. Whether COVID-19 will be caught by this phrase is debatable. While the emergence of a disease itself may be an unforeseeable natural disaster, it may be argued that its spread between humans involves human agency and is not per se an act of god. It might also be contended that any disturbance caused to businesses by regulatory government measures adopted in response to the outbreak of COVID-19 is not caused by an act of god, even if the disease itself meets the definition.

Governmental acts in response to COVID-19

Many force majeure clauses will be triggered where performance is inhibited by ‘government orders’, ‘government action’ or ‘government acts or priorities’. Such terms are likely to be relevant in the context of COVID-19, given the highly restrictive governmental measures adopted in response to it.

The HKSAR Government has promulgated regulations which, among other things, severely restrict public gatherings, require places of entertainment to cease business, and limit capacity at restaurants (see Cap 599F and Cap 599G). These have been followed up by further measures ordering the closure of pubs and bars. Such regulations are likely to constitute ‘government orders’ or ‘government acts’, or other similar phrases used in force majeure clauses. As are the government-imposed quarantine of incoming travellers, infected persons and their close contacts.

Required impact of the force majeure event on performance

The fact that an event of force majeure has arisen does not of itself excuse performance of a contract. There must be a causal relationship between the force majeure event and the non-performance of the contract. Precisely what is required by way of causation turns on the wording of the contract.

The contract may require, for example, that the force majeure event has ‘prevented’ performance, or ‘rendered [the party] unable’ to carry out its obligations. In such case, the party seeking to rely on the force majeure clause must show that performance has become physically or legally impossible – as opposed to merely more difficult, more expensive or less profitable.

If the force majeure clause provides relief where performance is ‘hindered’ or ‘delayed’, this is a significantly less stringent standard. The benefit of the clause may be available when the event of force majeure renders performance substantially more difficult and financially burdensome. Where the words ‘materially hindered’ were used, parties are not required to prove that completion had been prevented or become impossible (see Goldlion Properties Ltd and Others v Regent National Enterprises Ltd (2009) 12 HKCFAR 512).

As a matter of legal policy, the courts will not lightly conclude that non-performance is excused by an event of force majeure. The mere fact that the market or economic situation attendant on a force majeure event has made performance of the contract more onerous or difficult, or less profitable, will not excuse a party from fulfilling it. Parties are taken to contract on the basis that, within reasonably foreseeable limits, the risk that more resources may have to be allocated to perform the bargain than those originally contemplated – and thus diminishing one party’s profits is part and parcel of doing business.

Duty to mitigate

There is no general duty to mitigate the effects of a force majeure event. In practice, however, many force majeure clauses impose such a requirement.

Where the term does require mitigation, it will be incumbent on the non-performing party to try to avoid as far as possible the adverse consequences of the event of force majeure and minimise the losses it causes, and in the present case, to minimise the impact of COVID-19 on the performance of the relevant obligation(s) and the damage that will do. The failure to do so may mean that the force majeure clause cannot be relied upon.

Relief conferred by a force majeure clause

Where a party is able to rely on a force majeure clause, the relief that flows depends entirely on what has been specified in the contract. Common formulations include the following:

• that certain obligations under the agreement will be suspended for a given period of time – usually until the relevant event ceases to prevent or hinder performance
• that one or both parties is entitled to terminate the contract, and/or
• that the contract is suspended for a period of time, after which it can be formally terminated.

A force majeure clause will almost invariably provide a defence for the non-performing party in the event they are sued for a breach which has been precipitated by the event of force majeure.

Points to note before invoking force majeure clauses

Apart from mitigation (see above), care must also be taken to comply with any procedural requirements detailed in the contract prior to halting performance, for example, to give formal notice within a time limit, or exhaust a specified disputes procedure prior to any termination.

Depending on the wording of the relevant clause, such procedural requirements may be interpreted to be preconditions to a valid exercise of the right, and if not complied with, the right to invoke the force majeure clause may be lost.

Accordingly, any procedural requirements should be strictly complied with in form and substance. Moreover, parties wishing to terminate should generally do so promptly to avoid any suggestion that they have sat on or waived their rights.

2. Grounds for termination at common law – frustration and impossibility

Frustration and impossibility (which for convenience we refer to collectively as frustration) apply where events outside the control of the parties render performance of the contract legally, physically or commercially impossible, or transform the obligations under it into something radically different from what was contracted for (see Li Ching Wing v Xuan Yi Xiong [2004] 1 HKLRD 754). This is a high threshold: it is necessary to show more than mere inconvenience, hardship or reduced profitability.

Frustration will apply where performance of the whole contract has become illegal. This is likely to be highly relevant in the context of COVID-19, given the regulations introduced by the HKSAR Government mentioned above, which restrict many activities previously taken for granted. For example, a contract with a concert venue to hold a large concert will, while the regulations banning gatherings remain in force, likely be held frustrated by supervening illegality. If performance becomes unlawful only in part, it is a question of fact and degree whether the whole contract should be treated as frustrated.

Relationship between force majeure and frustration

The presence of a force majeure clause in a given contract may preclude the operation of the doctrine of frustration. The logic is this: the doctrine of frustration is concerned with supervening events unforeseen at the time of the entry of the contract. If the contract contains express provisions that cater for the event in question, for example a force majeure clause that covers the outbreak of COVID-19, the doctrine of frustration would not be lightly invoked as an event of that nature has been foreseen and the risks allocated.

Whether a given force majeure clause excludes the possibility of relying on frustration entirely turns on the specific wording of the clause and the implicit assumptions of the parties about the allocation and assumption of risk under the terms of the contract.

Consequences of invoking the doctrine of frustration

Frustration brings an end to the contract automatically and all parties will be released from their obligations. At common law, the court has no power to allow the contract to continue or to modify its terms.

The courts have various powers under Section 16 of the Law Amendment and Reform (Consolidation) Ordinance (Cap 23) to give relief where a contract is discharged for frustration. For example, the court may order that the purchase price be returned, or that a party be compensated for expenses incurred before the contract was frustrated. 

Deciding to terminate a contract – and considering alternatives

An unanticipated, catastrophic event such as the coronavirus outbreak will inevitably lead to the termination of many commercial contracts and great care should be taken when deciding to terminate. Serving a notice of termination in circumstances where grounds for termination are not objectively made out may, in certain circumstances, be treated by the other party as a repudiatory breach of contract – entitling them to terminate and claim damages.

Other options should always be considered – renegotiation or terminating the agreement by mutual consent can reduce or eliminate the risks of wrongful termination.

The application of principles relating to force majeure and frustration is highly fact-sensitive and requires careful analysis. If in doubt, it is wise to approach your legal advisers early in the process.

Tim Parker and Abigail Liu, Barristers

Denis Chang’s Chambers

Copyright: Denis Chang’s Chambers