May 25,2020 | 14 min read

Legal Impact On Contracts Due To Supply Chain Disruption

Author - Nirupama Kar

COVID-19 epidemic has negatively impacted the global economy and so it has on the Indian Economy. Such a negative impact has at its heart affected the domestic business chain. The immediate consequences were supply-chain disturbances, 'unintentional' and imminent delays in production and fulfilment of 'contractual' obligations. The number of contracts that are likely to be impacted by the spread of COVID-19 is certainly humongous, from manufacturing and supply agreements to building contracts to production and procurement agreements and more. Counterparties, including suppliers and service providers, may attempt to avoid immediate performance by claiming delays or failures or even terminate contracts, resulting from an unforeseen event like the government enforced lockdowns for prevention of the spread of Novel Corona Virus and further resulting in disruption of the supply chain or impossibility of performance of an obligation under the contract.

In this unfortunate state of affairs, the parties to commercial contracts and legal experts, both nationally and globally, are continually updating and analysing their contractual clauses to pursue appropriate rights and remedies, in particular under the distinct “Force Majeure” clause.

Force Majeure

'Force majeure' is a contractual clause allocating the risk of loss if the output is impossible or impracticable, primarily because of an occurrence of such event that the parties could not have expected or managed.' It includes an act of God or a natural disaster or a war or similar situations, an epidemic or a pandemic, etc., essentially an event on which the parties to the contract had no control and which prevented a party to perform its obligation under the Contract. Although force majeure was neither specified nor explicitly dealt within any of the statutes in India, some reference can be found in Section 32 and Section 56 of the Indian Contract Act, 1872, the former provides that if a contract is contingent on the occurrence of an event that is unlikely, then the contract is void and the later provides that an agreement to do an act impossible in itself is void.

From a contractual viewpoint, a force majeure provision provides a Party with immediate relief from performing its obligations under a contract when a force majeure arises. However, there are quite a few factors that could determine whether a contractual obligation can be avoided under the Force majeure clause, which includes:

  1. Wordings and language of the clause – eg., express use of term ‘pandemic’ or ‘epidemic’ or use of generic language like ‘extraordinary event or circumstance beyond the control of the parties’; 
  2. Steps taken by parties before invoking Force majeure clause – whether the party has taken reasonable steps to mitigate the negative effect of the event, whether the event is a cause of the contractual breach;
  3. Notice of the event before invoking force majeure;
  4. The burden of proof for establishing a Force majeure event will be on the party seeking to invoke the same.

Though there is a catena of seminal judgments of the Hon’ble Supreme Court of India on the subject matter, including Satyabrata Ghose vs Mugneeram Bangur & Co. (AIR 1954 SC 44) and the more recent case of Energy Watchdog vs CERC (2017) 14 SCC 80.

To ascertain as to whether the extent of the COVID-19 pandemic will qualify as an impossibility in relation to the performance of a contract, it is essential to consider the observation of the Hon’ble Apex Court in the landmark case of Satyabrata Ghose v. Mugneeram, where the Supreme Court held that:

“The performance of an act may not be literally ‘impossible’, but maybe impracticable and useless from the point of view of the object and purpose which the parties had in mind…the performance of a contract can be said to have become impossible if an untoward event or change of circumstances beyond the contemplation and control of the parties upsets the very foundation upon which the parties rested their bargain.”

However, Hon’ble Supreme Court in the more recent judgment of Energy Watchdog v. Central Electricity Regulatory Commission has held that parties can invoke the doctrine of frustration and seek exemption from the performance if they can validate, that performance of doing such an act will be impracticable and hopeless, keeping in consideration the object and purpose sought and intended to be achieved at the time parties signed the contract.

Highlighting objectively the impossibility in performance, the Supreme Court in the said judgment of Energy Watchdog v. Central Electricity Regulatory Commission clearly laid down that the only those events, which are explicitly included in the contract, can excuse a party from performance, which clearly suggests that a force majeure clause, at all times, will be strictly interpreted.

 

Besides Force Majeure, parties may invoke various other clauses of the contract like clauses regarding price adjustments, exclusion clause, limitation or exclusion of liability. Apart from this liquidated damages clause shall take effect in the event of non-performance under the contractual terms.       

Impact on Companies

Wide-spread quarantines, factory closures and logistical disruptions including migration of labour to their home states have severely affected main industrial areas. In an attempt to reduce the costs of the supply chain, several businesses were drawn to these manufacturing centres, however, the present extraordinary situation of extended lockdowns in these key red-zone cities, like Mumbai, Delhi, Chennai, Ahmedabad, Indore, etc have further compounded the logistical supply chain issues. At the same time, the introduction of a 'just-in-time' approach for distribution and logistics has led several companies to hold limited inventory stock.

Short term impacts

Companies will need to take immediate action in the near term to minimize the impacts on their company. That may include:

  • consider alternate supply sources; 
  • increase the lead times for customer deliveries; 
  • cancel or limit new customer orders; and 
  • renegotiate customer contracts.

Many businesses would try to implement disaster recovery plans; however, these plans may be of little benefit if they do not include geographically diverse manufacturing and logistics sources.

Long term impacts

The COVID-19 outbreak will affect the long-term thinking around the design of the supply chain and the preparation of risks. This would also push companies to strive for greater geographical diversification of their supply chain, critical onshore functions, develop and use automated technologies such as robotics to reduce the risk of production and transportation epidemics, and implement more pragmatic approaches to 'lean' supply chains and 'just-in-time' inventory management.

PANDEMIC & FORCE MAJEURE

The government has taken note of the impact that this pandemic has on India's economy and across different industrial sectors, and has given numerous alerts and advisories to help stabilize the market. As regards force majeure, other government agencies have also explained their respective roles on the same.

The Finance Ministry released a Notification dated February 19, 2020. It was explained that Force Majeure would be applicable in this pandemic under the 2017 Manual of Procurement of Goods due to disruption of supply chains. It was also stated that it should be considered a natural disaster and that the Force Majeure clause should be invoked after the correct procedure. The Ministry of New & Renewable Energy has announced that parties will invoke the Force Majeure clause to escape financial penalties if they fail to fulfil contractual obligations due to COVID-19. Likewise, other ministries have given notices of triggering the Force Majeure clause, respectively. Nevertheless, due to the wide-spread impact on the economy caused by the pandemic, it is imperative to address the effect of the Force Majeure clause and the doctrine of dissatisfaction on those sectors whose exposure under the prevailing circumstances is more profound than others.

It is interesting to note the recent order dated 8 April 2020 of the Hon’ble Bombay High Court where the Bombay High Court viewed this situation differently when it dismissed reliance on Section 56 of the Indian Contract Act, 1872 in the matter of Standard Retail Pvt. Ltd. v. M/s. G. S. Global Corp & Ors. While dismissing the Commercial Arbitration petition, it has held that the “lockdown cannot come to the rescue of the Petitioners so as to resile from their contractual obligations.” In other words, a lockdown in these unprecedented times is not a legal basis for termination or repudiation of a contract.

Further, the Court has held that in any event, “The lockdown was temporary and only for a limited period, making it a bad excuse for the Petitioners so as to resile from their contractual obligations with Respondent No.1 of making payments for their supply.” It clarifies that mere hardship in performance of an obligation in view of the COVID-19 pandemic is not a valid objection which can be used against a seller.

SAFEGUARDS IN COMMERCIAL CONTRACTS

Despite this new pandemic in mind, there are few safeguards to be found in commercial contracts: -

  1. Re-evaluate and review the contract under which the force majeure provision resides, and consider the necessary factors and events to implement the 'rule of excuse'.
  2. Ensure the notification protocol 'all' or 'any' as specified by the contract terms and conditions - strict adherence to the traditional 'notice' formalities.
  3. Analyse the effect of the COVID-19 outbreak on the contract and its results collectively (together with the other parties to the contract).
  4. Initiate an opportunity to conduct the contract in a possible alternative way; a failure would comfortably rule out a future 'security' against an alternative output process.
  5. In the current situation, the pandemic, gather evidence to grant non-performance of the duty to the single force majeure case.
  6. Keep a clear record of the various state and administrative notices and orders. The same can be proven during the stage of litigation/arbitrage.
  7. All documents relating to inevitable additional spending must be kept.

Conclusion

Any party to a contract can, under section 56 of the Indian Contract Act, invoke either the Force Majeure clause or the Doctrine of Anger. However, in cases where the same cannot be achieved, and a duty to be fulfilled can be suspended by mutual consent of the parties.

Section 3 of the Epidemic Disease Act, 1897 states that any person who disobeys any regulation made under it will be liable under the Indian Penal Code, 1860 and Section 4 of the same, also specified that no complaint or legal action could be brought against any person for anything that they have done under the Epidemic Disease Act. Furthermore, Article 73 of the Disaster Management Act, 2005 states that no proceedings may be opened against any person who acts in good faith under regulations laid down therein.

However, in the wake of the mass exodus of migrant labourers from the key cities and industrial hubs, the effect of which is causing an already deep supply chain crisis to worsen,  shall need some serious steps to be taken by the local and central Government as also the industries to ensure the revival of trade. Government’s focus on ‘Law’ as one of the key areas in the recent announcements by the Hon’ble Finance Minister, suggesting consolidation of labour laws, for instance, can potentially become a game-changer.        


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ABOUT THE AUTHOR


Nirupama Kar

Experienced Legal professional, Founder of Interjuris, a full-service law firm based in Mumbai and having network of Associates across major cities in India, engaged in providing legal services to Corporate Enterprises, Banks, Corporations and other Indian and transnational clients. Company law, Banking law, Insolvency and bankruptcy code and Arbitrations

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