COVID-19; Legal Impact On Commercial Contracts

The outbreak of COVID-19 sometime in November,2019 in the Wuhan province of China and its expansion across global jurisdictions have stimulated a different kind of response from the governments across the globe. However, there exist certain similarities between them, a significant one being, a legally enforced Lockdown. The unforeseeability of the Pandemic that is COVID-19 is undisputed, and among all jurisdictions including India, in order to break the chain from further expansion, the imposition of nationwide Lockdown has come into play. In India, especially while issuing the lockdown guidelines, the Government Ministries have resorted to invocation and application of specific acts such as the Epidemic Diseases Act, 1897 and the Disaster Management Act,2005.

From a legal perspective, the unforeseen event which could not be reasonably contemplated by a prudent person at the time of entering into a commercial contract gives rise of 4 kinds of situations under the law namely- Frustration of the Contract, Material Adverse Effect, Force Majeure and Change in Law.

For the purpose of discussion and by way of this article, we will be focusing on the provisions of Force Majeure and Change in law.

As we know a Force Majeure clause under a Commercial Contract primarily excuses the parties from performance of their obligations under the contract meaning thereby that non-performance due to force majeure will not attract the breach of the agreement. However, in India, the Ministry of Finance on 19.02.2020 issued a notification specifically recognizing the COVID-19 as a pandemic and a constituent of Force Majeure. A Force Majeure provision does not in itself take care of the cost implication or the effect on the cost perspective of the commercial contract. We are aware that prudent businessmen enter a commercial contract to accrue certain benefits out of it, and such contract may involve a high degree of predictable performance. It is neither disputed nor denied that in a commercial contract it is the objective of all the Contractors to gain some profit from the Contract.

We also know that any extension of time or any elongation of the time for the performance of the contract is inversely proportional to the net present value (NPV) or the profitability of the business. The question here arises that how by the mere excuse of performance under Force Majeure, a Contractor could be entitled to any benefits out of the commercial contract as it is the Contractor that stands to lose revenue in the form of loss of business opportunity and overhead expenses that are subsisting on the site and head office both. Therefore, if we look at recent large Commercial Contracts, we will find separate clauses with respect to Force Majeure and Change in Law.

Interestingly, a Change in Law provision in Public Private Partnership (PPP) contracts usually defines what constitutes a Change in Law by agreeing to what is the law (often termed "applicable law") and what would constitute a change in that applicable law. The definition of Change in Law usually incorporates legislation, regulations, interpretations of courts etc. The wording of the particular clauses in the context of the particular contract is crucial. In many PPP contracts, the definition includes the modification of the law, its interpretation and modifications of applicable law by local courts.

Notably PPP Contracts have different risk allocation approaches to Change in law, in some cases, the Contracting Authority has to bear all forms of change in law risk, while in others the risk relating to change in law is allocated between the Private Party and the Contracting Authority by setting a threshold of losses, generally on a yearly basis, below which the Private Partner will not be compensated. Meaning, the Private Party will only be entitled to compensation to the extent that it is able to demonstrate that the aggregate costs incurred as a result of a change in law exceed the agreed threshold during a specified period in time, e .g . per accounting year. However, in our opinion, if a change in law occurs, then the private party must take all reasonable steps to mitigate any such losses that have been accrued owing to such change in law. At this juncture, it is also important to mention that World Bank Report- Guidance on PPP Contractual Provisions, 2019 EDITION, states that a more developed approach to sharing change in law risk has also been developed and also includes Discriminatory Changes in Law, Specific Changes in Law, Discriminatory and Specific Change in Law, General Changes in Law and Any Other Changes in Law.

In order to assess the compensation accrued to the Private Party as a result of such Change in law, the threshold inquiry is "whether the change in law" in fact, operated as a substantial impairment of a contractual relationship and if the answer to the same is in the affirmative, then the private contractor is entitled to what extent?

The exercise is essentially a valuation of loss of a commercial opportunity. There is a detailed methodology for the same. Valuing loss is done without hindsight; however, the task of assessing the loss; on the other hand, is often done with the benefit of hindsight. The issue of the timing of loss or loss recognition is critical. The valuation of loss is ultimately a legal question; however, it is necessarily informed by financial valuation theory. Financial valuation theory offers a coherent set of normative models which ascribe monetary values to assets at a particular point in time (generally the present time, but hypothetically from any point in time at which some asset value remains).

The key for such exercise is necessarily a time value relationship, and that's why most of the Change in Law clauses provide for the protection of NPV. Loss of NPV can easily be ascertained based on the Financial Model submitted at the time of Financial Closure. Furthermore, such Financial Model is a document that has been accepted by both parties, therefore, placing reliance on the same would be a great start for assessing the losses accrued to the Contractor. There can also be a direct and indirect effect of Change of law, and the same should be computed as per the terms of the agreement.

Therefore, in PPP contracts invoking a "change of law" provision for COVID-19 restrictions would yield more benefits than the invocation of Force Majeure Clause.

Conclusion

As discussed previously, Change in law is differently worded in different agreements. By and large, in most of the agreements, to determine what is included in change in law, the definitions of "applicable laws/laws" are also important. For example, in many agreements, Applicable laws definition also includes not only all laws but also rules, regulations and notifications made thereunder.

For example in Concession Agreements relating to mines, in addition to the above, applicable law also included orders, ordinances, protocols, codes, guidelines, policies, notices, directions, official directive of any governmental authority or court or other law, rule or regulation approval from the relevant governmental authority, government resolution.

As a result, Change in Law in such agreements is not restricted to only new law but can be interpreted widely to include new order, guidelines, etc., issued by Government instrumentalities, and it also includes adoption and invocation of laws as per the power provided under respective Acts.

The above proposition is also supported by the judgment of Hon'ble Supreme Court of India in the case of Energy Watchdog and Ors. Vs. CERC & Ors., (MANU/SC/0408/2017) wherein the Hon'ble Court held a statutory document issued under an Act and having the force of law is covered under the expression change in law, and the consequential benefits of change in law can be claimed thereupon.

The fundamental thumb rule difference between Force Majeure and Change in Law is that in the case of Force Majeure parties have to bear their own cost (subject to respective agreements) however in Change in Law events, subject to the respective agreement, the NPV of the project is protected.

It may also be appreciated that most Force Majeure clauses recognize the political event and non-political events. Political Events entitle the contractor or concessionaire to be compensated for certain things subject to the same not being claimed by the contractor/concessionaire under change in law.

Generally, Force Majeure and Change in Law are treated separately and have different consequences, but since a Force Majeure clause is a contractual creation, it has to be read harmoniously with the other provisions of the Contract. Hence, even though the Force Majeure clause might itself provide that neither party may be entitled to make a claim, the same cause of action may also fit within the ambit of another clause which is Change in Law and in such a scenario, the two clauses would have to be harmoniously construed. By doing so, it may be possible for a party to make a claim and to be compensated for all losses accrued to it.

The article was authored by Ms. Gunita Pahwa, Joint Managing Partner, Singh & Associates and assisted by Mr. Anmol Kumar, Senior Associate, Singh & Associates.Views are personal.