Wednesday, May 24, 2017

A Proposal for Dealing With Force Majeure Clauses Under Contract Law

[Post by Siddharth Bajpai, who is a 4th year student at the National Law School of India University, Bangalore.

Other posts related to this topic are available here and here.]

Introduction

In 2013, Adani Enterprises entered into a power purchase agreement (PPA) with Gujarat Electricity Regulatory Commission and Haryana State Regulatory Commission. Under the terms of the arrangement, Adani was bound to procure coal. The coal was imported from Indonesia. However, a change in the Indonesian law led to a substantial rise in the price of coal. In light of this, Adani sought to dissolve the contract on the grounds of frustration due to sudden escalation in prices.

At the outset, it must be highlighted that Adani incorporated a broadly worded force majeure clause (FMC) and chose the cost plus method for pricing of coal in the PPA. This implied that the coal charges would be fixed and not escalable. This was an aggressive and competitive factor which gave Adani an edge in the bidding process it won.[1] In this post, the author has two objectives: first, to analyse the correctness of the judgement regarding the frustration of the contract and second, to discuss the usage of FMC in commercial practice.

Judgement 

In the above matter, the Supreme Court of India (SC) held in its judgment that the contract was not frustrated, and it did so by relying on the interpretation of section 56 of the Indian Contract Act, 1872 (the Act). It relied on precedents and the terms of the contract to draw two conclusions regarding the FMC. First, the escalation in price of coal had only made the performance onerous and not impossible. Second, mere escalation of price could not be construed as a hindrance to prevent performance under the contract, and Adani could not be discharged from performance of the contract. 

Analysis

In India, section 32 of the Act is applicable if the terms of a contract expressly state that, upon happening of certain contingencies, it would stand discharged. Therefore, FMCs have to be interpreted in accordance with section 32 of the Act and the doctrine of proper construction will be applicable.[2] It entails the construction of the FMC with the events which preceded or followed it. Due regard must be given to the nature and general terms of the contract.[3] The rule of ejusdem generis also acts as an external aid in the interpretation in a manner so as to include only the happening and eventualities of a similar standard.[4] This is the legal position on the FMC in India.

In the present case, the Court extensively relied on cases in which the agreement in contention did not contemplate an FMC and an application of section 56 was sought. The Court came to the conclusion that economic downturns did not alter the fundamental basis of the contract. It must be highlighted that the application of this doctrine of fundamental basis is limited to the cases under section 56 where an external event that has not been contemplated by the parties radically changes the object of the agreement.[5]

The author is of the opinion that the judgement is sound in concluding that economic downturns cannot be considered as a factor for frustration of a contract. However, the SC has deviated from the crux of reasoning adopted by it. The author sets forth two main arguments regarding the analysis in this judgement. First, there was a pre-existing FMC and the application of section 56 was erroneous. Second, the interpretation of the hindrance was redundant because there was a specific exclusion in the agreement.

Regarding the first submission, section 32 of the Act should have been relied upon to enforce the agreement terms. The SC was bound to apply the doctrine of proper construction to the agreement. This doctrine has two main limbs: first, the court must evaluate the allocation of the risks in the agreement and second, the ejusdem generis rule must be employed to interpret the terms of the contract.[6] With regard to the first limb, the court must identify whether any party has expressly assumed the risk of the events which have occurred. In the present case, construction of risk allocation manifests in the fact that Adani expressly undertook the risk by choosing the cost plus method for pricing while being aware of the volatile prices in the coal market.[7] Although the SC has made an oblique reference to this fact in its judgement, it failed to discuss this issue in greater detail. As per the second limb, the rule of ejusdem generis should have been employed to determine if the economic downturns were within the ambit of the FMC. The two relevant considerations that the Court should have taken into account are: first, that the events mentioned in the FMC belong to the class of an act of God, war or unlawfulness; second, clause 12.4 of the PPA made a specific exclusion regarding the cost of fuel not being within the ambit of the FMC. With respect to the first consideration, the SC failed to rely on those precedents where facts were in pari materia with the present case. In such precedents, it had been held that the court would not interpret the FMC broadly to construe economic downturns within its ambit.[8]

The Court has skirted the issue of protecting the sanctity of the contract by relying on unrelated precedents and not construing the contract itself. This opens a Pandora’s Box where the court will be free to apply the principles of section 56 to the cases of contingent contracts, which should otherwise fall under section 32. The author submits that in a similar factual matrix, the terms of the agreement may provide for economic downturns as a force majeure event. In such cases, these precedents will not be directly applicable. Instead, the burden will fall on the courts to apply the doctrine of proper construction to ascertain the intention of the parties in that specific agreement.

Proposals 

Assuming that these clauses are not drafted in a broad, inclusive manner, the author would like to argue in favour of disbanding the practice of drafting such FMCs. Professor Berman’s “enumerative” principle laid down this practice.[9] As per this practice, parties list a number of discharging contingencies, intending that all the risks will be borne by the promisor. However, there are number of significant drawbacks to this approach. First, it is extremely onerous on the obligor. Assuming but not conceding that nothing is unforeseeable, it is unjust to hold the promisor liable for the risk of events that are not specifically mentioned.[10] Second, a logical corollary of this principle could suggest that the promisor can minimize his liability by specifically listing all the imaginable events. Third, due to the high drafting costs involved, it is a reality only in high value contracts. Hence, the author would like to suggest an alternative approach.

The fundamental purpose of the contract is to maximize its economic efficiency by fulfilling its purpose. The fact that the performance is to extend into the future introduces uncertainty, which in turn creates risks. Therefore, another incidental fundamental purpose is to allocate these risks between the parties to the exchange. At this juncture, the author submits that parties should not bargain with the future events because they cannot be anticipated. The courts in such cases should bear the duty of the allocation of risks after considering the implied or express terms of the contract. A two-step test should be applied. First, it should be determined whether the obligor is the superior risk bearer in the particular contract. This here is to be understood as the party which can bear the risk more efficiently.[11] Discharge from performance would be unjust and inefficient in cases where the obligor could have prevented the risk from materialising at a cost lower than the expected cost of the risky event. Cases may also arise where although the obligor was the superior risk bearer, he could not have prevented the risk from materialising.[12] In such cases, the court should proceed to the second step, i.e., evaluate which party could have insured itself at a lower cost. The author submits that insurance is a method of reducing the costs associated with the risk that performance of a contract may be costlier than anticipated. The author would also like to provide an illustration for this model.

Consider A, a printing machinery manufacturer, contracts with B, to install a customised and a totally unique model for printing. Since it is customised, its value to any other printer will be marginal. Just before its installation, a fire destroys B’s premises and puts B out of business. Since the machine has no value in the market, A accordingly sues B for the full price. B’s defence is that since the fire was not caused due to its negligence, it should be discharged from the performance. Applying the two-step test, it is clear that since the fire occurred in B’s premises, it had the superior ability to prevent the fire. However, considering the fact that it was not due to B’s negligence, B could not have prevented the incident. Therefore, the court should proceed to the second step in the test. Which of the parties could have obtained an insurance protection at a lower cost? Here, although B would be able to determine the probability that a fire would occur, A is in a better position to determine the actual loss. A is better aware than B of the stages of production of the machine and the salvage value at each stage. A could have easily known the contingencies and the magnitude of loss since the machine was highly unique. In such contracts, A could have charged a premium from customers like B. On the other hand, the cost of B’s insurance would be higher, i.e., not only against loss caused by the fire but also against its contractual liability to A. Thus, B should be discharged from performance.

Conclusion 

The Indian Contract Act is an exhaustive and lucid statute. The principles under every section are codified and the mode of their application has been provided in the illustrations. The Act solemnly protects the sanctity of contracts by also delimiting the jurisdiction of the court. However, in cases like Adani, the court has encroached upon this sanctity of contracts. Adani manifests that the courts often overlook the correct principled justification by finding an easy way out. Further, such precedents open the Pandora’s Box for further abuse of courts’ discretion. Added to this, considering the drawbacks of drafting the FMCs, the author has argued for their disbanding. Instead, a two-step test has been suggested for the courts to allocate the risk among the parties.

- Siddharth Bajpai






[1] Adani Power Limited v. UHBVN Ltd, Order in Petition No.155/MP/2012(I).

[2] Ganga Singh and Ors v. Santosh Kumar and Ors, AIR 1963 All 201.

[3] Mahadeo Prosad Shaw v. Calcutta Dyeing and Cleaning Co, AIR 1961 SC 70.

[4] Dhanrajamal Gobindram v. Shamji Kalidas and Co, (1961) 3 SCR 1020.

[5] Satyabrata Ghose v. Mugneeram Bangur & Co., 1954 SCR 310.

[6] Md. Serajuddin v. State of Orissa, 1969 SCC Online Ori 4. Davis Contractors Ltd v. Fareham Urban District Council, [1956] 2 All ER 145.

[7] Adani Power Limited v. UHBVN Ltd, Order in Petition No.155/MP/2012(I).

[8] British Machinery Supplies Company v. Union of India, 1993 Supp (2) SCC 76. Madras Society Ltd v. O. Ramalingam, (1976) 1 MLJ 136. Pioneer Shipping Ltd v. BTP Tioxide Ltd, [1981] 2 All ER 1030.

[9] See Michael G. Rapsomanikas, Frustration of Contract in Commercial Practice, 18 Duquesne Law Review 551, 562 (1979).

[10] Rapsomanikas, at 563.

[11] Richard A. Posner, Impossibility and Related Doctrines in Contract law: An Economic Analysis, 6(1) The Journal of Legal Studies 83, 99 (1977).

[12] Posner, at 105.

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