The outbreak of COVID-19 has a great impact on all aspects of social life and its impact on the performance of the contract seems prominent. The interruption of traffic, the closure of public places and the delay of resuming operation of enterprises required by the government inevitably impact the performance of contracts and may even cause the performance impossible. Under normal circumstances, the non-performing party should bear the corresponding liability for breach of contract. However, should the non-performing party be exempted from the default liability under current circumstances? Furthermore, should the contracts continue to be performed, changed or terminated? These are the most fundamental problems brought by Covid-19 to the performance of contracts.
The General Principles of the Civil Law of China (「General Principles」) and the Contract Law of China (「Contract Law」) stipulate the general principles applicable to this kind of circumstances, i.e., force majeure (「Force Majeure」) and change of circumstances (「Change of Circumstances」). By adopting these two principles, the parties to a contract may be able to limit the economic damages incurred by them.
The principle of Force Majeure would relieve the non-performing party from the liability for breach of contract caused by epidemic situations. While the principle of Change of Circumstances focuses more on the subsequence of the failure of performance, i.e., whether the contract can be changed or terminated.
This article addresses how Chinese laws regulate on non-performance of contracts caused by COVID-19 under Force Majeure and Change of Circumstances principles. In addition, to mirror the similar circumstances, how Chinese courts viewed Force Majeure and Change of Circumstances in certain commercial contracts during the SARS breakout in 2003. Lastly, this article further uses two types of contracts to illustrate the application of Force Majeure and Change of Circumstances in contract disputes.
Does COVID-19 outbreak constitute Force Majeure event under Chinese law?
The application of Force Majeure must be analyzed on a case by case basis in accordance with the basic elements of Force Majeure and specific contracts. Therefore, no standardized answer as to whether COVID-19 constitutes a Force Majeure event or not. According to Article 180 of the General Principles and Article 117 of the Contract Law, Force Majeure is characterized as "unforeseeable, unavoidable and insurmountable objective circumstances". In this regard, any situation satisfies these three elements at the same time shall be regarded as a Force Majeure event.
"Unforeseeable" means that the parties cannot foresee the objective circumstances at the time of signing the contract. In principle, after an outbreak (especially a large-scale outbreak) has begun for a while, the epidemic is no longer an "unforeseeable" matter. In addition, as for whether a specific contract, which is signed right before and on the very beginning of the outbreak and last for a period during or after the outbreak of an epidemic, constitutes "unforeseeable", it need to be analyzed on a case by case basis.
In order to determine 「unavoidable」 and 「insurmountable」,generally speaking, the stage of outbreak, the place where the contract is performed, the administrative measures taken by relevant government authorities and the causal relationship between the above factors and the event of default should be taken into consideration.
What are the legal consequences of Force Majeure?
"Force Majeure" is a legal exemption for defaultliability under Chinese law. In case of failure to perform the contract due to Force Majeure event, the default liability may be exempted in part or in whole inlight of the impacts of Force Majeure events, unless otherwise provided by law. It is necessary to note that: firstly, there must be a causal relationship between the event of Force Majeure and the event of default; secondly, the exemption shall closely relate to the impact of Force Majeure event. The Contract Law also requires the non-performing party affected by the Force Majeure to take necessary measures to mitigate the losses and damages. If the losses and damages increase in an uncontrollable way due to the lack of mitigation measures, the non-performing party will not be exempted for the expanded losses and damages.
In addition, Force Majeure is also one ofthe legal bases to terminate a contract, provided that the Force Majeure renders "the purpose of the contract unachievable".
Does the COVID-19 outbreak constitute Change of Circumstances under Chinese law?
According to the Interpretation of the Supreme Court on Certain Issues Concerning the Application of the PRC Contract Law (II), there are three essential elements that are taken into consideration whether the Change of Circumstances is triggered:
(1) After the conclusion of a contract, the objective situation has changed fundamentally, which is unforeseeable at the time of signing the contract;(2) After the occurrence of any material change of circumstance, the continuous performance of a contract is obviously unfair to one party or the purpose of the contract cannot be realized;(3) The occurrence of any material change of circumstance is not caused by Force Majeure and not a commercial risk as well.With respect to Element (2), there is no unified standard to determine whether「obviously unfair to one party」 or 「unable to achieve the purpose of the contract」 is satisfied. Generally speaking, if the change ofobjective situation only causes the difficulty of performance under certain conditions or the increase of performance costs and the decrease of profits, it is still far from triggering the criteria of 「obviously unfair to one party」 or 「unable to achieve the purpose of the contract」.
What are the legal consequences of Change of Circumstances?
Change of Circumstances entitles the parties to request for altering or terminating acontract. However, without such a request from either party, the courts may actively adopt the Change of Circumstances principle. In essence, the courts』 goal to adopt such principle is to cause the parties share the losses caused by the Change of Circumstances in a fair way.
Injudicial practice, for the purpose of maintaining the normal order of transactions and the stability of social life, the courts are very cautious in adopting or accepting the Change of Circumstances claims. Specifically, the courts will take following aspects into account: (i) respecting the requests of the parties, and (ii) avoiding active intervention in allocating the rights and obligations of the parties and keen to use consultation and mediation methods to encourage the parties to reach a settlement.
How Chinese courts viewed Force Majeure and Change of Circumstances principles in certain commercial contracts during the SARS outbreak in 2003?
In Year 2003, in order to guide the trials of contract disputes caused by the SARS epidemic, the Supreme People's Court issued a Notice on Well Conducting the Relevant Trials and Enforcement Work of the People's Court in accordance with the Law During the Period of Prevention and Treatment of SARS (「SARS Notice」). The SARS Notice set forth the following two principles for courts in ruling contract disputes related to failure of performance during the SARS outbreak:
(1) As aresult of the SARS epidemic, if the rights and interests of one party to the contract is severely impacted by performing the contract, courts may adopt theprinciple of fairness to those disputes; and(2) Disputes arising from the failure of performance directly caused by the administrative measures taken by the government authorities to prevent and control the SARS epidemic or caused by the impact of the SARS epidemic shall be handled in accordance with Article 117 and Article 118 of the Contract Law (which are related to Force Majeure).The Notice also provides that if the affected contract still can be performed, it shall be handled according to the principle of Change of Circumstances; if not,the disputes shall be ruled according to the Force Majeure principle.
Examplesfor the application of Force Majeure and Change of Circumstances in contract disputes.
Example: Company A signed an electronic equipment sales contract with Company B with the date of delivery on February 5th, 2020. However, due to the lockdown of transportation and production facilities required by local government, Company B is unable to deliver the electronic equipment to Company A on time; while the sales contract does not expressly provide breakout of an disease isone of the Force Majeure events. What should Company B do?
Company Bshall inform Company A with the exist of the COVID-19 breakout and its impact on Company B’s ability to perform, then may argue for delaying the performance or terminating the contract under Force Majeure principle without bearing defaultliability. First of all, though it was notexpressly provided in the contract, lockdown satisfies the three elements of Force Majeure (i.e., unforeseeable, unavoidable and insurmountable) at the same time and can be regarded as the event of Force Majeure. Secondly, there is acausal relationship between the lockdown and the event of default. Thirdly, the exemption of default liability closely relates to the impact of lockdown. Therefore, as the non-performing party affected by the Force Majeure event, Company B’s liability for breach of contract shall be exempted. However, Company B may not be exempted for the expanded losses and damages, if it does not take necessary measures to mitigate the losses and damages.
Example: Company A runs an exhibition hall. It signed exhibition contracts with several exhibitors before the outbreak of COVID-19 and agreed to hold the exhibition in Guangzhou, China in the middle of February 2020. Due to the impact of the outbreak, the local government issued administrative notice (「Government Notice」) which required all exhibitions be suspended until further notice. What measures should Company A take?
Company A shall inform the exhibitors regarding the Government Notice in writing as soon as possible. If the exhibition can be rescheduled, Company A shall consult with the organizer regarding rescheduling and inform the exhibitors. If the exhibition is determined to be canceled, it shall consult with the exhibitors regarding the termination of the exhibition contracts.
COVID-19 outbreak, as discussed in the case example above, is an unforeseeable, unavoidable and insurmountable objective circumstance. Since the Government Notice directly results in the suspension of the exhibition, it has direct causal relationship with Company A’s failure to perform the exhibition contracts. Therefore, Company A may ask for extending the timing for performance or terminating the exhibition contracts (as the case may be) under Force Majeure.
COVID-19 is a huge challenge faced by the whole world. China has been through a tough time. The entire economy has been shutting down for almost two months in China and a lot of transactions and contracts have been impacted by the outbreak. Now, China’s productions and business activities are resuming gradually. Due to the wide spread of the virus, the whole world is experiencing a slowing down oreven shutting down of business activities. More and more contract disputes may occur. We will keep on tracking new developments and updates in legal field in China.
Partner Jenny Wang
Practice Areas：M&A, Banking and Financing
139 1089 6736
yanyan.wang@meritsandtree.com
Amy Zhang
Practice Areas：Entertainment law, PE/VC, M&A
135 5211 1728
yuxin.zhang@meritsandtree.com