The possibility of a pandemic caused by the swine flu virus (H1N1) has received considerable media attention over recent weeks. Although the virus does not appear to be as deadly as initially feared, it would be dangerous to assume we are out of the woods. The number of victims continues to climb steadily across the world on a daily basis increasing the risk of the virus mutating into a more virulent form. While the human toll of such an event could be devastating, the effect of such an outbreak on businesses and commerce should not be underestimated or ignored. The measures taken by governments across the world recently to try to contain the disease, including the quarantining of nearly 300 people in the Metropark Hotel in Hong Kong for seven days and the five day shut down in Mexico, demonstrate the enormous disruption that can be caused not only to personal lives but to business operations.
As pandemics may not, generally speaking, be insured, the costs will largely be retained by businesses and hence robust business continuity plans are essential. A review of the impact of a pandemic on the ability to perform ongoing contractual obligations should form part of all business continuity plans. This update looks at ways businesses can manage their risks of non-performance of contractual obligations in the event of a pandemic.
Risks To Businesses Resulting From A Pandemic
In the event of a prolonged pandemic, businesses may face difficulties in performing contractual obligations as a result of the following:
- Closure of premises and workplaces
- Travel restrictions and quarantining
- Shortage of labour/high absenteeism
- Disruption to supply and distribution channels
- Communication and decision-making difficulties
As a general rule, if the performance of a contract becomes more difficult or even impossible, the party which fails to perform its obligations is in breach of contract and is liable in damages to the other party. If there are no specific provisions in the contract dealing with the supervening event which has caused the difficulties in performing the contract (such as a force majeure clause), and no agreement can be reached between the parties on how to deal with it, the defaulting party may seek to have the contract discharged on some other grounds, such as frustration.
Under Hong Kong law, the doctrine of frustration allows the contract to be automatically discharged when a frustrating event occurs so that the parties are no longer bound to perform the obligations in it.
A frustrating event is an event which:
- takes place after the contract has been formed;
- is so fundamental as to be regarded by law as striking at the root of the contract and entirely beyond what was in the contemplation of the parties at the time they entered into the contract;
- is not the fault of either party to the contract;
- is not contemplated or provided for in the contract;
- renders further performance of the contract impossible, illegal or makes it radically different from that in the contemplation of the parties at the time the contract was made.
Some examples of events of frustration include:
- destruction or unavailability of the subject matter of the contract
- personal incapacity in a personal services contract
A contract would not be frustrated if:
- express provision has been made in the contract for the consequences of an event which has in fact occurred (for example, a force majeure clause covers the situation)
- the contract is merely more expensive to perform
- an alternative method of performance is possible
- the event was foreseeable (given the media attention to a pandemic caused by the swine flu virus, it is arguable that such an event is foreseeable and therefore would not be covered by this doctrine)
If a contract is frustrated, the contract is automatically terminated and the parties are discharged from their further obligations. The courts are not at liberty to amend the terms of the contract to deal with the effect of the supervening event. No party can claim damages for non-performance because no party is at fault. Generally, all sums paid in respect of the contract before it was discharged are recoverable, although the court has discretion to allow a party to retain some or all of the payments if expenses have been incurred or the other party has received a valuable benefit before the contract was discharged (Sections 16 to 18 of the Law Amendment and Reform (Consolidation) Ordinance).
The English and Hong Kong courts generally consider the doctrine to be of limited application and that it should not be invoked lightly. Furthermore, where the contract is governed by the law of another jurisdiction, the doctrine of frustration may not exist or its application and effect may differ.
Force Majeure Clauses
Because of the uncertainty of the application and effect of frustration, force majeure clauses are playing an increasingly important role in contracts in response to new threats such as terrorism and pandemics as they can provide greater security and assurance.
The underlying principle of a force majeure clause is that no party to an agreement should be required to perform its obligations under a contract to the extent that such performance is prevented by events outside that party's control (such as natural disasters, strikes, wars, government acts and terrorism).
The role of force majeure clauses is, therefore, to allocate risk between the parties should performance be disrupted at any stage. Provisions such as the right to terminate the contract or the provision of additional time to recommence operations are all intended to fairly allocate, between the parties, any damage caused by an event. How this risk is allocated will often depend on the parties' willingness to accept the risks, the bargaining position of the parties, market practice and/or the parties' ability to pass the risk on through insurance.
Four main issues need to be considered in relation to force majeure clauses:
1. Does the definition of force majeure in the contract cover the particular event?
Careful consideration of the definition of force majeure is required to ascertain whether it includes a pandemic. When drafting new contracts, it is advisable to specifically include pandemics and other widespread outbreaks of infectious diseases as events of force majeure to avoid uncertainty.
2. Was the event outside the control of either party?
The force majeure clause normally requires the event to be beyond the reasonable control of the parties. An event which is caused by a party's negligence or wilful default will not constitute force majeure since it is within the reasonable control of the party.
3. Did the event cause the non performance of the obligations in the contract?
The mere occurrence of a force majeure event does not automatically excuse the parties from performance of their contractual obligations. A party must show a causal connection between its inability to perform its obligations and the event of force majeure it is relying on. The particular wording of the clause will be of importance in determining whether the conditions necessary to invoke the protection of the clause have been satisfied. For example, a clause requiring a party to be prevented from performing obligations will have different implications to a clause requiring a party to be hindered from performing obligations, the latter wording usually offers wider scope. The use of the word 'prevented' requires the party to show that performance is legally or physically impossible.
4. What is the effect of the force majeure clause?
The effect of the force majeure clause will depend on its particular wording. Performance of the obligations may be excused or suspended for a particular period of time, or the contract may be terminated if the event continues beyond a specific period of time.
Material Adverse Change Clauses
Other contractual provisions that may be affected by a pandemic are "material adverse change clauses". A material adverse change clause gives a party the right to withdraw from an agreement/transaction before completion if certain detrimental events occur. Businesses which are involved in acquisitions, and listed companies proposing to raise finance or involved a takeover, should consider the effect of a pandemic upon any material adverse change clause in the relevant documentation.
In view of the uncertainties in the application and effect of frustration, it is advisable to plan for the legal risks posed by a pandemic now. It will certainly be more difficult to communicate and take decisions in the midst of a crisis. Furthermore, companies listed on the Hong Kong Stock Exchange have a duty to maintain "sound and effective internal controls to safeguard the shareholders' investment and the issuer's assets" (Principle C2 of the Code on Corporate Governance Practices (the "Code")). The Code recommends that the board's annual review considers changes since the last review in the nature and extent of significant risks and the company's ability to respond to changes in its business and external environment, as well as the scope and quality of management's ongoing monitoring of risks and the systems of internal controls.
We recommend the following action:
(a) Analyse the potential risks to the business a result of a pandemic (on a worst case scenario basis) and their likely effect on the ability to perform contracts that contain future or ongoing performance obligations.
(b) Where the ability to perform contractual obligations will likely be affected by a pandemic, consider whether the contract adequately provides for what would happen in that situation and that the provisions are enforceable. Businesses should also check the governing law (and any dispute resolution procedures) in their contracts as different jurisdictions have different rules governing contractual liability.
(c) If the contract does not deal with, or adequately provide for, what would happen in the event of performance issues resulting from a pandemic, a strategy should be devised and contingency plans made to deal with the risks, particularly where the risk and effect of non-performance is high. For example, collaborate with suppliers in relation to their plans and renegotiate important contracts (such as agreeing a grace period to perform the obligations).
(d) Ensure that all new contracts contain specific provisions to deal with emergencies such as pandemics. Remember that a force majeure clause needs to be carefully worded and tailored to the specific circumstances of the particular contract. One size does not fit all. The parties should formulate an agreement to address their unique course of dealings and industry idiosyncrasies. In cases of doubt, consult a lawyer.
(e) Monitor the latest pandemic information and review risk assessment and business continuity plans on a regular basis and adjust strategies as necessary.