The recent terrorist attacks in Mumbai have not only raised national security and geopolitical issues, but they have also brought into the fore the crucial issue of Force Majeure especially in M&A and PE/VC funding contracts.
Force Majeure is a clause in contracts that allows both parties to walk out of the contract when an extraordinary event or circumstance beyond the control of the parties happen. During events such as terrorist attacks, business may be disrupted. Does such disruption allow parties to a contract to relieve themselves from their contractual obligations? Can the parties invoke the doctrine of Force Majeure after a terrorist attack in order to extricate themselves from a transaction?
Force Majeure
“An act of God or force majeure clause ... generally operates to discharge a contracting party when a supervening, sometimes supernatural, event, beyond the control of either party, makes performance impossible. The common thread is that of the unexpected, something beyond reasonable human foresight and skill†held Justice Dickson of the Supreme Court of Canada in Atlantic Paper Stock Ltd vs St Anne-Nackawic Pulp and Paper Co, ([1976] 1 SCR 580).
Force Majeure clauses envisage eventualities beyond the control of contracting parties. Such clauses are of two types: open and close ended. Close-ended clauses specify the exact events that constitute Force Majeure. However, in an open-ended clause, the parties simply narrate what generally constitute Force Majeure situations and add “and such other acts or events that are beyond the control of partiesâ€. In the absence of clear agreement to the contrary, the parties to a contract are excused from the performance of their respective obligations on occurrence of such extraordinary acts.
The concept of Force Majeure is often incorporated as clause in contracts which serves to release both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as a war, strike, riot, crime, or act of God (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract.
However, Force Majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.
The elements of Force Majeure are:
a) It must proceed from a cause not brought about by the defaulting party’s default;
b) The cause must be inevitable and unforeseeable; and
c) The cause must make execution of the contract wholly impossible.
Frustration of Contract:
If a contract is silent as to Force Majeure events, it may be possible for the parties to argue that there has been a frustration of contract. Under section 56 of the Indian Contract Act, 1872, the doctrine of “frustration of contract†has been defined as to the impossibility of performance. However, such impossibility must be physical, ie. inability to perform rather than commercial. Physical impossibility means absolute inability to perform, though the parties themselves may not be at fault and it does not include commercial hardship, which might be unwillingness to perform rather than inability to perform.
In Hamara Radio and General Industries Ltd. Co. vs State of Rajasthan, (AIR 1964 Raj 205) it was held that frustration of contract comprises “the impossibility, or, rather, the impracticability in law or fact of the performance of a contract brought about by an unforeseen or unforeseeable sweeping change in the circumstances intervening after the contract was madeâ€. In such a case, while the contract was properly entered into in the context of the circumstances which existed at the time at which the contract was entered, the situation has subsequently fundamentally changed such that due to frustration of contract, the parties are excused from or relieved of the responsibility of performing the contract.
Acts of God and Acts of War:
In Saraswati Parabhai and Another v. Grid Corporation of Orissa and Others, (2001 ACJ 1874, AIR 2000 Ori 13), the court defined an “Act of God†as “the operation of natural force free from human interventionâ€, ie. an act of nature, so extraordinary that it could not be foreseen, or if foreseen could not be guarded against, for example, an extraordinary high tide or flood.
Force Majeure, however, may involve both acts of nature (eg., floods and hurricanes) and acts of people (eg., riots, strikes, and wars). In Lebeaupin vs Crispin [(1920) 2 KB 714] it was held that wars, floods, epidemics and strikes all may be included in Force Majeure. However, other force majeure events included in contracts are often negotiated between the contracting parties and may be specific to the type of contract and the type of services being provided by and to the parties.
Acts of war are often included in Force Majeure clauses. Although the terrorist attacks have been deemed by some as an “Act of War†and the subsequent response as the “War on Terrorâ€, neither the US nor India was at war during the 9/11 or 26/11 attacks. War is commonly construed as occurring between sovereign entities and not by terrorist groups, although there a further issue of state supported terrorism and whether this may bring a terrorist attack closer to the definition of an Act of War.
Material Adverse Effect:
Force Majeure is also similar to material adverse effect, where a Force Majeure event radically alters the transaction. Material Adverse Effect (“MAEâ€) or Material Adverse Change (“MACâ€) in a contract is typically defined as an event, condition or change which materially and adversely affects or could reasonably be expected to materially and adversely affect the assets, liabilities, financial results of operations, financial conditions, business or prospects of the company.
A MAC clause serves to allocate the risks presented by adverse business or economic developments occurring between the signing and the closing of a merger or acquisition agreement. A MAC clause in an agreement may provide a party with the ability to terminate the agreement if events occur which are detrimental to the other party.
For example, USA Networks, Inc. had agreed in July 2001 to merge with National Leisure Group, Inc. After the 9/11 terrorist attacks, USA Networks claimed material adverse change in an attempt to void a proposed merger with National Leisure by arguing that the 9/11 terrorist attacks, as well as National Leisure’s loss of a large client, had triggered the material adverse change clause contained in their merger agreement.
Protection of Force Majeure Clause - When Not Available:
The party seeking protection of the Force Majeure clause in a contract must prove that he is entitled to be absolved of the contract obligations because of a supervening event and that he could not have foreseen the event with due diligence and that despite all care and caution could not have control over it. However, there are certain situations where a party may not be extended protection of a Force Majeure clause.
In a French case, builders agreed to carry out works at certain docks. Shortly after the contract was made, a collective agreement resulted in increased wages being paid to workmen. The builders sought to recover the extra wages from the employer, on the ground that the rise in rates amounted to Force Majeure. It was held, by the French court that there was no Force Majeure. The rise in rates simply rendered the work more onerous, but not impossible.
Insurance Issues:
The insurance industry faces potentially large exposure due to terrorist attacks and “terrorism†may be defined differently by different insurance companies in their insurance policies. Generally “civil disorder,†“riots†and “acts of war†are not considered terrorism, excluding them from cover. In the case of Swiss Re vs World Trade Center, the Silverstein Group (“Silversteinâ€) sought $7 billion from insurer Swiss Re to rebuild the World Trade Center (“WTCâ€). Silverstein claimed that the attacks on the WTC were two separate terrorist attacks caused by two different airplane crashes and therefore should be considered as two separate events and not as one isolated incident that amounted to one single insurable event.
The New York Court of Appeal in 2006 ended a long legal battle by upholding that the destruction of the WTC in the 9/11 terrorist attacks was a single event and not two events as claimed by Silverstein. The court upheld the original jury verdict of 2004 in favour of Swiss Re and set aside Silverstein’s plea of two occurrences, claiming $7 billion from Swiss Re as the insurance money. The jury ruled that Swiss Re’s payment obligation could not exceed Swiss Re's 25 percent share of the $3.5 billion loss limit coverage that Silverstein had purchased.
The New Reality:
As described above in the elements of Force Majeure, the “cause of Force Majeure must be inevitable and unforeseeableâ€. The unfortunate new reality post 9/11 and 26/11 is that terrorism is a very real threat and may unfortunately no longer be considered as an unforeseen possibility, thereby making it more difficult for parties to claim Force Majeure. This needs to be considered by parties entering into agreements.
Thus, contracting parties may now consider amending standard force majeure provisions by including "acts of terrorism" as an enumerated Force Majeure event. The phrase "acts of terrorism" may be further qualified by adding the language "whether actual or threatened". In light of the recent attacks, parties may well reconsider their contract language by expanding the scope of Force Majeure as without such protection, contracting parties may be forced to perform their contractual obligations when the business world has been disrupted by terrorist acts.
(Shantanu Surpure is Managing Attorney at Sand Hill Counsel, a law firm with offices in Mumbai and Silicon Valley. He focuses on venture capital and private equity transactions. Shantanu holds a BA from Brown University/London School of Economics, an MA Juris from Oxford University and a Juris Doctor from Columbia Law School and is admitted to practice law in India, California, New York and England and Wales. He can be reached at ssurpure@sandhillcounsel.com.)
Shantanu was assisted by Nisha Mallik of Sand Hill Counsel.
This column is meant for public discussion and informational purposes only and is not to be construed as legal advice.