China: Managing COVID-19 related Force Majeure Clauses
The ongoing COVID-19 pandemic is causing unprecedented shocks to the global economy, from both supply and demand sides. While Chinese businesses are gradually resuming operation with the support of the Chinese government, a large number of foreign governments have introduced sweeping containment measures (including lockdowns, travel restrictions, quarantines and emergency industry regulations). Indeed, the impact of COVID-19 has been felt in every stage of the supply chain, both upstream and downstream, as well as in almost every geographical region. Companies under ongoing contracts in China and around the globe are particularly concerned with the disruption to their operations, as well as associated contractual remedies available.
Particularly, many international companies who are doing business in China or with Chinese partners may have either received/issued force majeure notices (or are now expecting to do so); they are also exploring available remedies to address the existing or potential disruptions to their operations, and associated upstream and downstream value chains. In the past months, parties to a large number of contracts in China have sought to invoke force majeure relief with respect to their contractual obligations: the China Council for the Promotion of International Trade (CCPIT) and its local counterparts alone had issued more than 6400 force majeure certificates as of Mar. 25, 2020. Now, many international companies are experiencing severe disruption to their own operations and facing unprecedented decline in customer demands. This note will discuss, primarily from PRC law perspective, a few practical considerations for parties who are facing force majeure declarations from their counterparties, as well as parties who intend to seek relief on force majeure or similar grounds.
01. Triaging and assessing existing/upcoming contracts, both upstream and downstream
Due to COVID-19’s wide ranging disruptions to contract performance experienced by all industries around the globe, a joint taskforce of business and legal teams should look across their upstream/downstream value chains to identify, categorize and analyze the current and potential operational impact. This assessment should include a review of ongoing contracts and contracts under negotiation – especially where force majeure or similar clauses are included therein to evaluate the legal ramifications and the relevant action points. It is noteworthy that in many cases, performance capabilities of both Chinese and international contract parties are affected successively within a short time span, due to the rolling effects of the pandemic on different geographical regions. Furthermore, it is important to triage the contracts based on their criticality to the operation of the business, and to assess the dispute risk levels of the various contracts. The high-value/high dispute-risk contracts should receive the most attention from the business and legal teams.
02. What’s the governing law and dispute resolution forum?
While the language in the force majeure clause is the starting point of assessment, it is equally important to examine the governing law of the contract and its content, and to assess the likely interpretation of the specific contract language in the practice of the chosen dispute resolution forum. In PRC judicial practice, findings and judgments relating to force majeure depend to a great extent on specific case context. In China, the PRC General Provisions of the Civil Law (中华人民共和国民法总则) (the CL Provisions), the PRC General Principles of the Civil Law (中华人民共和国民法通则) (the CL Principles) and the PRC Contract Law (中华人民共和国合同法)(the Contract Law) all include general provisions on the definition of a force majeure event, its legal consequences/available remedies, and the associated procedural requirements. Article 180 of the CL Provisions, Article 153 of the CL Principles and Article 117 of the Contract Law define force majeure as “any objective circumstance which is unforeseeable, unavoidable and insurmountable”.
Under PRC law, the force majeure doctrine can be deemed to be incorporated into contracts by default (although the parties have significant autonomy to negotiate the details or deviate from the default contract law provisions). On the other hand, in common law jurisdictions, such as in some states of the US, the UK, Singapore and Hong Kong, there is no statutorily defined force majeure construct, and operation of a force majeure depends on the specific terms agreed between the parties; where explicit force majeure relief is not available, the doctrine of frustration may apply in certain circumstances in those jurisdictions.
03. A force majeure event (FME) as a fact to be proven by the affected party
In connection with the COVID-19 pandemic, the associated FME can be the occurrence of the outbreak itself, the government actions or decisions in response to contain the outbreak, or a combination of the two. For example, the spokesman for the Legislative Affairs Commission of the National People’s Congress Standing Committee has publicly stated that where a party is unable to perform a contract due to government prevention and control measures regarding COVID-19, such circumstance constitutes an “unforeseeable, unavoidable and insurmountable force majeure event”.
The specific language in a contract can affect the degree of burden to establish the occurrence of an FME. For example, if “pandemic”, “government action” or a similar term are explicitly listed in the force majeure clause, then the affected party has a clear path to establishing the occurrence of an FME. In the absence of such specific reference, the catch-all clause or reference to broad criteria will provide grounds for such interpretation.
Nevertheless, the mere establishment of COVID-19 as an FME by the affected party does not automatically release such party from its contractual obligations or extend its performance period. Additional factors, as illustrated below, also come into play.
04. Procedural aspects of declaring force majeure
Article 118 of the Contract Law requires that a party seeking to invoke force majeure must promptly notify the other party so as to reduce the potential losses sustained by the other party. In practice, many contracts also prescribe specific force majeure notice requirements both in terms of time and formality; often there is a specific time limit for the notification of an FME and a subsequent time period for furnishing formal supportive evidence (See Point 5 below).
Accordingly, proper and timely service of documents by the affected party is important; correspondingly, the counterparty should assess whether the affected party has provided its notice and documents pursuant to the contractual requirements. Where the counterparty is not able to receive, or fails to timely receive, the relevant FME notices/documents, this can be a factor in disputing the extent of claimed relief. While failure or delay in giving proper notices may not fully preclude the affected party from relying on the force majeure clause, it will likely make the affected party liable for any increase in losses resulted, and may also give the counterparty more room for seeking more drastic remedies.
To proactively manage the process, businesses are advised to engage in discussions with their counterparties, in order to grasp as early as possible the extent to which the disruption is likely to affect their respective operations. For example, alongside with the force majeure notice, it is advisable for an affected counterparty to produce a detailed written statement to provide as much information as possible about the specific FME claims, such as the timing and expected duration of the disruptive event, the specific scope of the impact, relevant proof and proposed mitigating measures. Correspondingly, the counterparties may request for the same type of information. The counterparty should also make sure that the affected party commit to providing timely notification of any changes to the situation.
As a caveat, counterparties to force majeure notices should be mindful about inadvertently making any goodwill gestures that may later jeopardize their contractual or legal protections which they did not intend to waive.
05. Supporting evidence and establishment of causality
Article 118 of the Contract Law provides that the party invoking force majeure must also provide evidentiary support within a reasonable time limit. Such evidence may include documents issued by government bodies or authorized institutions relating to the FME and the affected contract performance. However, such force majeure certificate only serves as a proof of objective facts such as government mandated suspension of work or restriction on movement of personnel, while the certificate itself does not have the legal effect of relieving a party from its contractual obligations or extending the contract period.
In order to successfully seek force majeure relief, the affected party also bears the burden of proof to prove the direct linkage between the FME, the impaired performance, and the relief claimed. Correspondingly, a counterparty to a force majeure notice is advised to carefully scrutinize the direct causal link between the claims and supportive evidence, so as to verify the extent to which the FME may affect the party’s contract performance and whether the relief claimed (extension of contract performance or termination of contract) is warranted by the effect of such event. Generally, factors to be considered in connection with claim of force majeure relief include the nature of the contract, the characteristics of the business in which the parties engage, the nature and duration of work disruption in the region where the party is located, and the performance period for the contractual obligation.
A party invoking the force majeure clause is generally required to take appropriate mitigating measures. Failure to do so can give the counterparty the opportunity to dispute at least part of the relief claimed, as well as to counterclaim damages resulting from such failure. Therefore, the affected party should produce and preserve records demonstrating that it has made the required effort to prevent or mitigate the effects of the FME, and the counterparty is advised to request for the above evidence.
06. Evaluate possible legal consequences
If an FME is validly established, the legal consequences are often prescribed in the related contract clauses, although the PRC contract law can fill the gap if no specific contract clause is included. These consequences mostly fall into three main categories—(1) suspension of performance; (2) consultation for modifying the affected obligations; and (3) at the extreme end, termination of the contract. In case of any gap, the CL Provisions, the CL Principles and the Contract Law provide for partial or entire relief of contract performance to the extent of the effect of the FME, and ultimately termination of the contract should the conditions for termination be fulfilled. The consequences could be layered depending on the extent of the impact and contract parties’ objectives.
For the counterparty, it is advisable to assess the specific claims and how they would impact its operations. If continued performance of the contract is preferred, it is essential to consult with the affected party in a timely manner to minimize the effect, to actively explore alternatives to the originally prescribed mode of performance, and to ensure that the affected party continues to perform the remainder of the contract. If termination of the contract is contemplated by the counterparty, it should also collect supportive evidence, as the burden of proof is borne by the party claiming termination on the ground of frustration of purpose.
It should be noted in particular that a claim seeking to terminate a contract would be subject to stricter review. In addition to evidence on the effect of the FME and the causality between the outbreak and the failure to perform the entire contract, the court will examine whether the purpose of the contract has been fundamentally frustrated. Chinese courts have been rather cautious in adjudicating a party’s claim to terminate a contract on force majeure grounds. Relevant judgments rendered on contract disputes related to the 2003 SARS outbreak may provide helpful guidance.
07. Can “change of circumstances” doctrine be applied?
A party affected by the COVID-19 pandemic (especially in situations which do not clearly fall into the category of force majeure) might also explore the so-called “change of circumstances” doctrine available under the PRC legal regime. This doctrine usually applies to situations such as an abrupt surge in the cost of raw materials, labor, logistics, financial crisis or other significant social and economic changes which make performance so onerous on the parties that it renders the contract unfair. During the 2003 SARS outbreak, judicial rules provided that relevant cases should be handled based on the principle of fairness, which is the foundational contract principle underlying the “change of circumstances” doctrine, and court judgments handed down during that time could be of some relevance.
In 2009, the Supreme People’s Court issued a judicial interpretation to the Contract Law (最高人民法院关于适用《中华人民共和国合同法》若干问题的解释(二)), Article 26 of which specifically stipulates that the court may rely on the “change of circumstances” doctrine in adjudicating a claim for modification or rescission of contract on grounds of fairness or frustration of contract purpose. In the latest draft of the Civil Code of the People’s Republic of China (中华人民共和国民法典(草案)) released by the National People’s Congress on December 28, 2019, there is a provision (Article 533) covering the situation where a material change occurred to the fundamental condition serving as the contract basis “which was unforeseeable by the parties at the time of conclusion and which is not in the category of commercial risk, and continued performance of the contract is obviously unfair to one party”; in such situation, the affected party can explore the relief of renegotiation, and where appropriate, petition for contract modification or termination. However, under current judicial practice, the court is very cautious in applying the “change of circumstance” doctrine and so far it has been rare for courts to grant relief on such grounds. When faced with such claims, counterparties should raise its vigilance level in its further communications with the claimant, as the communications between the parties could be important factors in the absence of clear contract language on force majeure.
As force majeure or “change of circumstances” cases are highly context specific, to properly manage the effects of COVID-19 on their commercial contracts and overall business operations, parties invoking or receiving force majeure or “change of circumstances” notices should seek professional advice on the legal ramifications on their contractual positions, as well as appropriate options in light of their business objectives and the evolving pandemic situations in the relevant regions. Meanwhile, companies should also carry out a risk-based review of their key supply/sales contracts (whether ongoing or under negotiation) on a priority basis.
Zhong Lun attorneys are available to assist you with these and other workplace issues. For more information, visit www.zhonglun.com.