While, the full impact of the COVID-19 coronavirus outbreak and the resulting emergency measures on international trade remains to be seen, our clients have reported substantial business and operational disruptions, including closures of workplaces and ports, disruptions to supply and distribution channels, shortage of labor and weakened regional demand.
Given the unexpected nature of the outbreak, attention has focused on the prospect that parties to affected commercial contracts may invoke force majeure provisions in those contracts in order to excuse delay or nonperformance.
However, it is equally important to take practical measures to identify and mitigate disruptions in the supply chain.
Numerous force majeure claims have already been reported in the world media and it is likely that claims with a wider ambit will follow as the ripple effects of the outbreak spread globally.
Any contract with a specific force majeure clause may be the subject of a claim. Contracts governed by a civil law framework which grants force majeure remedies, whether or not they are written into the contract, may also be the subject of the claim. This includes the PRC.
Force majeure claims are particularly relevant for contracts with a long-term or ongoing supply and in the following markets:
- Commodity contracts (including iron ore, coal and copper);
- LNG contracts;
- Ship building contracts;
- Supply contracts for textiles, foodstuffs and mechanical equipment;
- Contracts for electrical equipment and electronic components;
- Medical equipment manufacturing contracts.
The effect of the outbreak on suppliers is perhaps most obvious. With emergency measures impacting on goods, workers and logistics, many suppliers appear unable to fulfil their contracts within the prescribed time or at all. But invoking force majeure may also be of interest to buyers, either because taking delivery under the contract has been impacted or due to disruptions in downstream markets.
What is force majeure?
The concept of force majeure (FM) is widely recognized in civil law jurisdictions. It is also of wide application in common law jurisdictions and is frequently used in commercial contracts governed by such common law systems because of the limited remedies otherwise available to the parties when the contract becomes impossible, difficult or onerous to perform due to events outside the affected party’s control.
Whether the source of FM rights is legislation or the terms of the contract, FM regimes typically operate by excusing non-performance by a party of its contractual obligations where non-performance is caused by a defined FM event.
Determining whether an event is a FM event normally involves applying the objective test found in the relevant law or written in the contract. However, most FM regimes are “open” or inclusive in the sense that the event does not need to be specifically listed as a FM event, provided it meets the requirements of the objective test.
Below we consider FM under PRC law, the most likely applicable civil law jurisdiction and from the common law perspective.
PRC law perspective
FM exists as a doctrine under Article 180 of the General Rules on the Civil Law and Articles 117 and 118 of the PRC Contract Law. The regime applies automatically to commercial contracts governed by PRC law where the contract contains no FM provisions.
A FM event is an objective event or situation which is (1) unforeseeable (at the time of entering into the contract), (2) unavoidable in terms of occurrence or impact and (3) impossible to overcome.
There must be a causal link between the FM event and the affected party’s failure to perform (i.e. the affected party must establish that the FM event must have caused the non-performance). If there are too many steps between the FM event and the non-performance it will be difficult for the affected party to satisfy causation.
Requirements for claim
The affected party must notify the counterparty of the FM event promptly or in a timely manner stating their claim for an exemption of liability and providing proof of the existence of the FM event and the impact of the event on the affected party’s non-performance. There remains some uncertainty under PRC law as to whether such notice must be given before non-performance actually materializes. Accordingly, it is advisable to do this where possible.
Where such prompt or timely notice is not given the affected party may become liable for losses suffered by the counterparty which could have been avoided had such notice been given.
If the affected party fails to utilize its best efforts to overcome the impact of the FM event on its non-performance it may not invoke FM.
Under the Contract Law, FM does not apply (1) where the contract is entered into after the FM event, (2) to non-performance of monetary payment obligations; or (3) if the FM event occurs after the affected party delays performance.
FM remedies under the Contract Law are (1) the affected party is excused from civil liability, including damages, in relation to its non-performance (or delay); and (2) either party may terminate the contract where the essential purpose of the contract cannot be realized as a result of the event of FM.
While not expressed in the Contract Law, decisions of the PRC courts in the wake of the 2003 SARS outbreak demonstrate a willingness by the courts to also grant modification of the contract terms, though under a different doctrine – see alternate remedies below.
“Force Majeure” Certificates
The quasi-governmental China Council for the Promotion of International Trade (“CCPIT”) announced on 30 January that it would offer “force majeure certificates” to help companies deal with disputes with foreign trading partners arising from government control measures.
The purpose of these certificates is to facilitate the invoking of FM remedies where the contract requires the provision of such a certificate issued by a relevant government authority as a prerequisite to the bringing of the FM claim. Such certificates will not be binding on PRC courts either as to the existence of the relevant FM event or the effect of the event on the affected party’s nonperformance.
So are they of any practical use where not required by a contract? Perhaps only to add a level of authenticity when accompanying FM claims submitted to foreign counterparties. Certainly, we do not recommend relying on them alone as a virtual shield against liability as implied in several media reports.
Common law perspective
FM is a creation of the contract in common law jurisdictions. Generally, FM provisions are interpreted by focusing on the actual language used with the result that each particular case rests on its own contractual language and set of facts. Another complication is that the term “force majeure” is also sometimes used to refer to other provisions frequently applying to exceptional supervening events such as “hardship” clauses and those creating a framework for making amendments to the contract for material changes in circumstances.
What constitutes an FM event and the precise objective test depends on the specific wording of the provision. As noted above, the definition of FM is generally inclusive but some clauses are exhaustive instead. While common law systems generally take a consistent approach, variations (some subtle) persist and it is important to approach interpretation of each FM provision with regard to the corresponding case law.
Requirements for claim
FM provisions commonly contain a notification requirement, which can operate as a “condition precedent” precluding relief if the relevant notice is not given in the necessary timeframe. Such provisions are generally enforceable, and so complying fully with all notice requirements will be important for parties seeking to declare FM.
FM provisions commonly requires the claiming party to show that is has taken all reasonable endeavors to avoid or mitigate the event and its effects (a highly fact sensitive enquiry).
These are a matter of drafting and can doom an otherwise valid claim. In some markets, it is common practice to exclude changes in the relevant market or demand. This can increase the challenge for a buyer who wishes to claim FM but cannot show it was unable to accept delivery of the supply, particularly if it has taken advantage of falling prices and already sourced the supply from elsewhere.
These are a matter of drafting and need to be sufficiently certain to be enforceable. Typically, the affected party is excused from relevant non-performance while the FM event (or its effects) persist. Again, depending on the drafting, this can take effect as an extension of time or general suspension of the affected party’s obligations.
Alternate remedies to FM
Aside from the typical FM provisions outlined above, the affected party may have alternate remedies, depending on the governing law of the contract.
- For English law contracts, the affected party might claim relief under the doctrine of frustration, which permits parties to cease performing contractual obligations where it becomes impossible to do so in circumstances entirely beyond the remit of the parties.
- For PRC law contracts, the doctrine of “change of circumstances [situation]” may apply where a FM remedy is not available. While the judicial process is more complex than for a FM claim, the affected party may apply for the contract to either be terminated or modified (something not generally available for a FM claim based on the civil law).
Mitigating disruptions in the supply chain – task force units and back-up plans
Many companies report having established task force units to investigate and mitigate the effects of the coronavirus outbreak on their supply chains. The aim is to identify existing or impending supply shortages in order to develop back-up plans and find alternative suppliers if necessary.
This is particularly noticeable in the automotive industry, which is highly affected by the coronavirus. Nearly every major automaker and supplier has confirmed they are closely monitoring the situation with many saying they have created special task forces for this purpose.
The need for such task forces will continue to grow as the virus continues to spread around the world. After all, today’s alternative supplier could be affected by the coronavirus tomorrow.
Clearly if you are entering into new contracts during this period, you should consider the FM provisions with particular care.
If, whether as buyer or supplier, you have entered into commercial contracts that have or may be affected by the outbreak, we recommend the following actions:
- Review each contract carefully, with particular regard to the governing law and FM provisions, including any time bars or other procedural requirements.
- Form a preliminary view on whether any FM provision is “open” or exhaustive in relation to the list of FM events and whether the outbreak and/or resulting government crisis measures are covered/excluded.
- If you may need to invoke a claim, consider your obligation to mitigate the effect on non-performance and what steps you can take. Starting a mindful dialogue with the counterparty may be an important part of the process.
- Consider any potential flow on effects from the invoking of a claim such as termination of the contract.
Aside from the legal position, there are generally going to be several other important matters of concern:
- For a counterparty who receives a FM claim they do not think is valid, there is the issue of enforcement of the contract, particularly if it does not provide for international arbitration.
- There are the reputational risks and potential damage to long-term supply relationships with foreign buyers and suppliers. Even where there is no legal basis for FM relief, parties who receive FM claims may wish to be flexible about amending or restructuring (e.g. by postponing deliveries) the contract to accommodate the affected party.
- Declaring FM or receiving a FM claim may impact on insurance arrangements.
- Buyers who are part of a chain of supply contracts may themselves need to declare FM in response to a supplier’s declaration in order to avoid being in breach. Each contract in the chain may of course be on different terms or subject to entirely different governing laws and this can create substantial challenges for the buyer, especially where their downstream contract has less favorable (or no) FM provisions. There may also be separate time bars or other procedural requirements as above.
As practical measures, the appropriate department, whether it is a newly established task force or an existing department, should address the following five supply chain issues:
- What exactly has happened? Management needs to know what is causing problems in the supply chain. After all, the remedial actions can vary widely.
- Which suppliers are affected?
- Which material is affected? After reviewing the stock, alternatives have to be sought.
- Which of your products need this material? It has to be assessed which products can no longer be produced and how this affects sales and margins.
- Which customers are affected? Companies have to prioritize the customers and decide who gets the products, taking into account any contractual agreements. It is essential to inform each customer as early as possible whether and when they can expect delivery disruptions.
With the full impact of the coronavirus likely to play out for some months yet and the potential for the outbreak to spread into new regions, this is an issue seemingly becoming more important by the week.