10 February 2020

Impact Of The Novel Coronavirus Outbreak On Chinese Commodity Sale Contracts

Impact of the novel coronavirus outbreak on Chinese commodity sale contracts

The novel coronavirus outbreak in China has attracted significant attention worldwide with the World Health Organization recently declaring it a “public health emergency of international concern”. Reportedly, there is a rising number of infection and mortality cases resulting from the outbreak, with the majority of those cases still being found in mainland China. In response, the Chinese government has taken various significant measures to contain the widening spread of the new disease, resulting in a knock-on effect on industrial and commercial activity within the country. As one of the largest consumers of commodity products globally, the impact of the novel coronavirus outbreak on international commodity contracts with Chinese buyers raises challenging and important questions of whether it constitutes ground for buyers to be relieved from their performance (and if so the extent of such relief), the procedure for claiming such relief and also the consequences on the overall contractual relationship. Obviously, these are equally important questions for commodity sellers on the other end of the equation.  At a high-level and as part of a brief note, we consider some key issues arising and endeavor to provide certain practical suggestions how might parties address the issues in a manner best to safeguard their interests.

For a start, the majority of international commodity contracts (e.g. crude oil, LNG, coal, etc.) are governed by a common law legal system such as English law.  Under a common law legal system, the two main grounds for claiming relief due to circumstances beyond the control of a party (i.e. not due to breach) are typically founded in either (i) force majeure (“FM”) or (ii) frustration.  Under common law, force majeure is a creation of contract, which means that the parties’ contract must have a FM clause for either party to make a claim on this basis. These clauses are typically worded so as to define FM as a circumstance beyond the reasonable control of the party claiming relief and preventing that party from performing the obligation in question.  On the other hand, the concept of frustration under common law is a principle of general law and there is no need for the contract to specifically provide for it.  Essentially, a claim for frustration is made out where an event occurs which is beyond the control of the parties rendering it impossible to perform the contract or transforming the relevant obligation into a radically different obligation from that undertaken at the time of contracting. It is worth noting that the courts tend to apply this concept very narrowly and there is a relatively high bar to prove frustration. As a result, where its contract allows it to so do, a party will typically try to claim FM first, rather than trying to make out a claim for frustration. 

In contrast to the common law understanding of the above concepts, FM under PRC law is codified as a matter of statue, being defined “an objective event or circumstance which is unforeseeable, unavoidable and insurmountable[1] and therefore applying regardless of whether it is specifically provided for under the contract. Similarly, the consequences of FM under PRC law are set out in legislation. Among other things, the legislation provides for relief from affected obligations[2], a requirement to provide notice of FM[3], and obligations to mitigate the effect of FM[4].

Given it is relatively uncommon for PRC law to govern international commodity agreements, the remainder of this article focuses largely on the common law perspective and particularly  on FM claims (which, as noted, are far more prevalent than frustration claims). 

Before turning to our more detailed analysis, it is worth noting that the situation is not without relatively recent precedent.  Many similar claims of FM were made in the face of the SARS outbreak in the early 2000s.  In that context, as is very often the case with FM claims (more on this below), many of the claims were resolved commercially and not by formal dispute resolution. However, a number of PRC court judgements were made on the issue. Generally speaking, these cases were in respect of PRC law-governed arrangements (and therefore do not offer definitive guidance in terms of common law-governed matters).  Nevertheless, the decisions (which varied, depending on the court’s view as to whether the party claiming relief was actually prevented from meeting its contractual obligations) confirm that, when it comes to FM claims, it is not a case of “one size fits all”.  Each case needs to be assessed on its own merits and particular circumstances to properly determine whether there is a valid basis for relief.

In the face of the coronavirus outbreak and associated events, a party claiming relief from its obligations on the grounds of FM (or the party being faced with such a claim) should consider the following key issues:

  1. Trigger for FM claim

The first issue for a party claiming FM is to identify the circumstance or events, whether singly or cumulatively, that would be basis for founding such claim.  It is typical for FM clauses to contain a list of specific events which might constitute FM (the list might either be an exhaustive (i.e. an event cannot give rise to FM if it is not listed) or non-exhaustive list of examples).  In any case, any specific events which are listed will invariably be subject to fulfilling the overriding principle that the event is outside of the reasonable control of the affected party and causing it to be unable to perform its contractual obligation(s).

One common example of FM is an “epidemic”. In the context of the coronavirus outbreak, there is a question of whether such outbreak rises to the level of an epidemic given the geographical and population size of China. This is ultimately a question of fact, which may be supported by expert opinion e.g. opinions of national or international health organizations. 

An alternative ground to establish an FM claim in the present circumstances might be “government action” (which, again, is a common example of FM).  For instance, a party could claim that various Chinese government regulations or policies put into effect to contain the outbreak (e.g. extension of holidays, restriction of people movement, health inspections, isolation periods, etc.) constitute relevant events of government action or inaction. Obviously, there are various ways to characterise the coronavirus outbreak and its flow-on impacts. However, what is important is that the interaction with other clauses in the contract is carefully considered, and also to bear in mind that the occurrence of a relevant event is not sufficient in and of itself but must also be said to prevent the contractual obligation in question (more on this further below).

It should be noted that the FM clause in commodity contracts also often excludes certain circumstances from qualifying as FM events (for instance, insufficient demand for a product). For instance, due to the broader economic effects of the coronavirus outbreak, we are certainly seeing a dampening of demand for certain commodities, thus affecting the ability of a Chinese buyer to profitably on-sell commodities to end users. However, if such a buyer was to claim FM on the grounds of insufficient demand and the exclusion mentioned above were to apply, then it may be an uphill task to establish FM on the face of the contractual terms.  

  1. Evidence of performance being prevented

As noted above, the key to claiming FM is the ability to prove that performance of the relevant obligation has actually been prevented because of the event in question. In other words, the party alleging FM must establish the causal connection and it is normally not enough to show that performance has merely been made more difficult or onerous, whilst otherwise still being possible to carry out.  For instance, it may be more challenging for a Chinese buyer to secure berthing slots at a terminal due to reduced operating efficiencies (such as lack of manpower as a result of quarantine and other containment measures) but, strictly speaking, the buyer must show that, as a matter of fact, it was actually prevented from taking the relevant cargo according to the contractually agreed schedule. Proving the causal connection between the event and the inability to perform is not always a straightforward exercise and it may be subject to many variables, including whether alternative measures could reasonably have been taken by buyer to avoid the issue.  

On the subject of evidence, it appears that the China Council for the Promotion of International Trade (CCPIT) is offering “force majeure certificates” to companies based in China, subject to the fulfillment of certain conditions[5]. The effect of these certificates in any particular case will depend on the particular terms of the contract in question and the factual circumstances.  However, as a general matter, it is reasonably likely that there would be potential legal arguments as to why such a certificate should not (in and of itself) be binding on the parties or treated as conclusive evidence unless that is expressly provided for under the relevant contract.

  1. Procedure for claiming FM

In a commodity sale contract, the FM clause will often set out an express procedure for claiming FM. Often, the party seeking relief is required to notify the other party of the FM event and the relevant details as soon as possible. There is   a question though as to what the consequences are if a party fails to comply with all or some of the FM notification obligations.  In this respect, certain commodity sale contracts may provide expressly that the relief from FM takes effect from the date that the FM occurs and not when notice is provided or when all such notification obligations are fulfilled. However, even in such a situation, there may still be adverse effects on a party’s ability to claim FM arising from a failure to comply with procedural obligations.  For instance, a court or tribunal may draw adverse inferences from a lack of notification (e.g. the failure to provide prompt and full notice could be taken as evidence of failing to take sufficient steps to try and mitigate the issue (more on this below)).

  1. Relief from obligations

If the claim for FM is established, then the party claiming FM will be relieved from the relevant obligation to the extent it is prevented from performance. One important question is whether the obligation to take a cargo is merely delayed or otherwise cancelled. For instance, even if a Chinese buyer can successfully argue that the coronavirus outbreak is a FM event preventing it from taking delivery of a cargo, the seller may argue its obligation to take a cargo is only deferred to a latter date, but not cancelled. Certain commodity sale contracts may expressly provide that FM delay beyond a certain time (e.g. seven days past the scheduled delivery date) results in the cancellation of the affected cargo but other contracts may be silent on the point and fail to offer a clear answer.

If the FM in question is prolonged, then the commodity sale contract may provide that one party or the other (or either of them) can elect to terminate the contract. For instance, a long-term commodity sale agreement may provide that such a termination right arises if the FM event extends beyond a certain period (e.g. 1 year) and affects more than a specified volume (e.g. half the annual contract quantity). Of course, the coronavirus outbreak is still in its early days and it may be premature for parties to consider exercising termination rights (in respect of the whole contract) at the current stage.

  1. Mitigation

The affected party will normally have an obligation to use reasonable efforts to mitigate the effects of the FM. For instance, this may involve working with terminal owners or port operators to permit expeditious delivery of cargoes to Chinese terminals or ports, notwithstanding the impact of anti-epidemic measures.  There is also a question of whether an affected Chinese buyer, as part of its mitigation obligation, would be required to cooperate with its seller to divert the cargo away from China to another destination. Whether in fact this is an obligation of the buyer will, again, depend on the wording of the contractual agreement. It should also be borne in mind that the FM affected party is typically required only to use reasonable efforts to mitigate which does not extend to incurring unreasonable cost or extraordinary hardship.

For parties facing an FM claim or preparing to raise such claim based on the coronavirus outbreak, there are a few practical points to bear in mind.

  • First, FM claims are often highly fact sensitive and, especially in the initial stages, it may be difficult to provide compelling evidence of an event and its impact on contractual performance (or, conversely but for the same reasons, to rebut a claim of FM raised by a counterparty). There can be considerable ambiguity and uncertainty in actually making out a FM claim.  It is worth noting in this context that the requirement for notice under most commodity contracts is not so much as to establish or prove the existence of an FM in and of itself but, rather, to notify a claim of such an event (and impact) and to provide such details as are reasonably available at the time.
  • Second, apart from an FM claim itself, the parties should consider the broader contractual picture. For instance, the relevant commodity contract (e.g. a long LNG sale and purchase agreement) may contain certain hardship clauses or price review clauses entitling parties to commence a renegotiation or price review under certain circumstances. Regardless of whether the coronavirus outbreak constitutes FM under a contract, it may nevertheless be grounds to trigger a renegotiation or price review, depending on the specific provisions.
  • Third, the FM clause only represents a default position if the parties do not otherwise agree on alternative consequences. In other words, quite apart from what the FM clause may or may not provide, if the parties agree on another means of addressing the adverse effects of the coronavirus outbreak (e.g. delaying cargo deliveries but subject to price adjustments), then that agreement will prevail over the express contract provisions. As noted above, claims of FM are very often uncertain (as to the event, its impact, and/or application of contractual terms to the facts). These factors very often drive a commercial response. While being careful to preserve and optimise their legal position, parties will often benefit from a parallel consideration of opportunities to seek a mutually satisfactory negotiated outcome.

The novel coronavirus outbreak in China is new and worrisome situation for many reasons, and certainly one watched with some anxiety by (not least) participants in the international commodity market. However, claims for FM under commodity contracts are certainly not new, whether in terms of Chinese counterparties or otherwise. While, as noted, every FM claim should be addressed on its own facts and prevailing contractual terms, the preceding analysis may provide a useful generic framework for parties to adopt in their consideration of actual or potential FM claims and their broader commercial strategy in the face of what is an ongoing and evolving situation of considerable complexity and concern.

Given that there is no clarity yet as to when the coronavirus outbreak will be contained, parties to commodity contracts for delivery into the Chinese market would be well-advised to take careful note of the changing circumstances and also to prepare themselves (from both a legal and commercial perspective) for the not so remote possibility that their relevant contractual obligations may be affected by claims for FM (whether advanced by themselves or their counterparties).  

If you would like further advice on the potential impact of the novel coronavirus outbreak on your contracts and the steps to address potential or existing claims arising from such situation, please get in touch with one of our experts from the International Projects, Energy and Resources practice of King & Wood Mallesons.

 

[1] See Article 180 of the “General Provisions of the Civil Law of the People’s Republic of China(中华人民共和国民法总则)”,  Article 107 and 153 of the “General Principles of The Civil Law of The People’s Republic of China (中华人民共和国民法通则)” and Article 117 of the “Contract Law of The People’s Republic of China”.

[2] Article 117 of the “Contract Law of The People’s Republic of China”

[3] Article 118 and Article 119 of the “Contract Law of The People’s Republic of China”

[4] Article 119 of the “Contract Law of The People’s Republic of China”

[5] http://www.ccpit.org/Contents/Channel_4256/2020/0130/1238885/content_1238885.htm

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