Frustrating Finances?

Mark Jones looks at the impact of the financial crisis on the shipping industry and long-running contracts. Mark considers the use of the English legal doctrine of 'frustration' and the operation of force majeure clauses as potential methods for parties to escape contracts.

This is the full length version of an article originally published in abridged form under the auspices of The Britannia Steam Ship Insurance Association.

The recent worldwide financial crisis has hit the shipping industry hard. Unsurprisingly, many involved in long-running projects agreed before the financial downturn, or at least before the sheer scale of that downturn had become apparent, found themselves in the unenviable position of being bound into contracts that became commercially unviable. Some found themselves simply unable to pay, others able to pay but facing significant losses.

As a result, there has been an ongoing swathe of litigation and arbitrations arising out of parties' attempts to escape from contracts (in particular, contracts for the purchase of tonnage new and old, and long term time charters). Many of the arguments raised are familiar ones. However, the scale and relatively sudden impact of the financial crisis has prompted a number of paying parties to say that the unforeseen and unpredictable change in circumstances has meant that the nature of their contractual obligation to pay has in fact changed dramatically. This is not what I expected when I entered into this contract, they say. It is then that they turn to their English legal advisers and ask about the English legal doctrine of 'frustration' and the operation of force majeure clauses.

The modern doctrine of frustration was encapsulated by Lord Simon of Glaisdale in the case of National Carriers Ltd v Panalpina (Northern) Ltd^[i], where he said:

"Frustration of a contract takes place when there supervenes an event (without default of either party and for which the contract makes no sufficient provision) which so significantly changes the nature (not merely the expense or onerousness) of the outstanding contractual rights and/or obligations from what the parties could reasonably have contemplated at the time of its execution that it would be unjust to hold them to the literal sense of its stipulations in the new circumstances; in such case the law declares both parties to be discharged from further performance."

In another leading case, it was said that the change of circumstances must make what the party was bound to do "a thing radically different from that which was undertaken by the contract", such that he could fairly argue: "Non haec in foedera veni: It was not this that I promised to do."^[ii]

While fairly easily stated, the doctrine can be difficult to apply in any particular case. In the recent case of The Sea Angel,^[iii] the Court of Appeal gave useful guidance that is likely to be much referred to in future cases. The leading judgment was given Lord Justice Rix, whose succinct description of how the doctrine should be applied is difficult to dispute:

"[111] In my judgment, the application of the doctrine of frustration requires a multi-factorial approach. Among the factors which have to be considered are the terms of the contract itself, its matrix or context, the parties' knowledge, expectations, assumptions and contemplations, in particular as to risk, as at the time of contract, at any rate so far as these can be ascribed mutually and objectively, and then the nature of the supervening event, and the parties' reasonable and objectively ascertainable calculations as to the possibilities of future performance in the new circumstances. Since the subject matter of the doctrine of frustration is contract, and contracts are about the allocation of risk, and since the allocation and assumption of risk is not simply a matter of express or implied provision but may also depend on less easily defined matters such as "the contemplation of the parties", the application of the doctrine can often be a difficult one. In such circumstances, the test of "radically different" is important: it tells us that the doctrine is not to be lightly invoked; that mere incidence of expense or delay or onerousness is not sufficient; and that there has to be as it were a break in identity between the contract as provided for and contemplated and its performance in the new circumstances."

[112]   What the "radically different" test, however, does not in itself tell us is that the doctrine is one of justice, as has been repeatedly affirmed on the highest authority. Ultimately the application of the test cannot safely be performed without the consequences of the decision, one way or the other, being measured against the demands of justice. Part of that calculation is the consideration that the frustration of a contract may well mean that the contractual allocation of risk is reversed.... If the provisions of a contract in their literal sense are to make way for the absolving effect of frustration, then that must, in my judgment, be in the interests of justice and not against those interests. Since the purpose of the doctrine is to do justice, then its application cannot be divorced from considerations of justice. Those considerations are among the most important of the factors which a tribunal has to bear in mind."

As is no doubt obvious from the passages quoted above, it is very difficult to establish frustration in any case. The doctrine is in essence a long-stop, imposed by law only where justice truly demands it.

In the normal case of an obligation to pay, say, a US dollar sum, it is almost inconceivable that the financial crisis, of itself, would be seen as rendering that obligation to pay something "radically different" from the obligation to pay originally envisaged under the contract. The Courts have repeatedly stated that the mere fact that a contract has become more onerous or expensive to perform does not bring into play the doctrine of frustration - indeed it has been said that "rarely, if ever, is it a ground for inferring frustration of an adventure that the contract has turned out to be a loss or even a commercial disaster for somebody."^[iv] The financial crisis does not mean that there is no money out there. Indeed, to suggest that would be absurd. The real problem is the banks' unwillingness to supply that money on commercially viable terms - i.e. the 'price' of the money has gone up dramatically or the terms on which the money is available have become much more 'onerous'. That problem is not a frustrating event.

In theory, it might be easier to argue that a contract has been frustrated where the parties had expressly agreed (or at the very least contemplated) that the paying party would procure payment of a particular type from a particular source, and the financial crisis has made it impossible to obtain such funds from that source. In such a scenario, the paying party might seek to draw an analogy with a line of cases concerning the sale of commodities from a particular country, in which a supervening event then made it impossible to procure the shipment or export of the commodity from that country. The analogy would have to be based on seeing 'money from X' as the 'commodity' in question. Quite aside from the problem that drawing analogies with other cases can be a fruitless exercise when it comes to such a fact-specific doctrine as frustration, it is doubtful whether a true analogy could be drawn in any event in the great majority of cases.^[v] Not only that, but the underlying premise of this scenario is in practice improbable: most charters, for example, impose a simple obligation to pay the owner in cash in US dollars.

In United International Pictures v Cine Bes Filmcheck VE Yapimcilik AS,^[vi] the defendant argued that an unforeseen supervening event impacting severely on a party's ability to obtain finance facilities (in this case letters of credit in US dollars) amounted to the frustration of that party's obligations to pay under the relevant contract. At the time that the relevant agreement was entered into, the Turkish Government had in place an exchange rate mechanism tying the Turkish-lire to a basket of currencies including the US Dollar. After the agreement had been concluded, a serious financial crisis in Turkey led the Government to abandon the exchange rate mechanism and to allow the lire to float freely on the currency markets. This had a devastating effect on the value of the lire. The defendant argued that this had the immediate effect that it became impossible for Turkish companies (such as it) to obtain facilities for the letters of credit in US dollars that were required under the agreement. The argument was held not even to have a real prospect of succeeding. The Court refused to accept that it had in fact become impossible for any Turkish company to obtain letters of credit in dollars, and pointed out various ways in which a prudent Turkish company could have acted (e.g. holding accounts in US dollars or by hedging its exposure by forward foreign exchange contracts or currency options) which would have enabled the defendant to maintain or open a letter of credit in dollars. In essence, the Court considered that the risks of it becoming much harder to perform the payment obligation, or of events occurring against which the paying party could have protected itself rendering payment in the anticipated fashion nigh on impossible, were risks undertaken by the paying party when it gave an absolute and unqualified promise to pay (or in that case open and maintain letters of credit). In the writer's opinion, the hard line adopted in that case is indicative of the line that would probably be taken were a charterer to seek to run a similar argument.

Of course, it will always be possible to come up with hypothetical scenarios in which a frustration argument might be available to a paying party, but the more rarefied those scenarios become, the less likely it is that they would ever arise in reality. There is no getting away from the fact that the English Courts, when faced with real scenarios, have shown a sustained and deep-rooted reluctance to find a contract to have been frustrated on the basis that it has become much harder, or supposedly impossible, for the paying party to perform its simple, and usually unqualified, obligation to pay.

In practice, commercial parties frequently legislate for the occurrence of unforeseen events out of their control by including force majeure clauses in their contracts. Where they have done so, there is only limited room for the doctrine of frustration to operate and one must instead look to the force majeure clause in question.

The range of different wordings used in such clauses is in practice very wide and in theory unlimited. However, a common theme is that they enable one or both parties to cancel the contract (or suspend performance, etc.) upon the happening of a specified event or events beyond its control. In principle, such clauses fall to be interpreted like any other; however, some general rules of thumb can be gleaned from the case law. Thus, the party seeking to rely on a force majeure clause will usually have to show that its non-performance was due to circumstances beyond its control and that there were no reasonable steps that it could have taken to avoid or mitigate the event or its consequences.^[vii] The phrase 'force majeure' is not a term of art, and so it is possible that a particular clause could be drafted so as to cover expressly the consequences of an event such as the recent financial crisis. It seems rather doubtful that such a clause would ever be agreed in practice (and this writer has never seen one), although it is not uncommon to see clauses in long term contracts that provide for variations to the sums payable in line with, for example, fluctuations in interest or exchange rates, which might lessen the impact of a financial crisis.

An attempt to rely on a force majeure clause as an excuse for a failure to pay in the context of the financial crisis recently came before the English Commercial Court in Tandrin Aviation Holdings Ltd v Aero Toy Store LLC.^[viii] In that case, the claimant had agreed to sell to the defendant an executive jet aircraft for US$31.75 million. When the time came to do so, the defendant refused to pay for the aircraft and, among other things, argued that it could rely on the force majeure clause in the agreement because of the "unanticipated, unforeseeable and cataclysmic downward spiral of the world's financial markets". In giving the claimant summary judgment, the judge said that defendant had not managed to convince him as a matter of principle that extreme economic circumstances could even arguably give rise to force majeure in the context of a clause such as the one in that case (which was in unexceptional terms).

In reaching his conclusion, the judge observed that "it is well established under English law that a change in economic / market circumstances, affecting the profitability of a contract or the ease with which the parties' obligations can be performed, is not regarded as being a force majeure event. Thus a failure of performance due to the provision of insufficient financial resources has been held not to amount to force majeure ... and likewise a rise in cost or expense..."

He also cited two judgments disapproving the notion that economic circumstances can generally found a claim for force majeure or frustration: the first and more recent being the case of Thames Valley Power Ltd. v. Total Gas & Power Ltd.,^[ix] where the judge said:

"...It does not at all follow that the supplier is entitled to rely upon an increase in the market price in comparison to the contract price as a force majeure circumstance...This conclusion is consistent with a line of cases, both on force majeure clauses and on frustration...to the effect that the fact that a contract has become expensive to perform, even dramatically more expensive, is not a ground to relieve a party on the grounds of force majeure or frustration...", and the second being the case of Tennants (Lancashire) Ltd v CS Wilson & Co Ltd, a force majeure case in which it was said: "By "hindering" delivery is meant interposing obstacles which it would be really difficult to overcome. I do not consider that even a great rise of price hinders delivery. If that had been intended different language would have been used, and I cannot regard shortage of cash or inability to buy at a remunerative price as a contingency beyond the sellers' control. The argument that a man can be excused from performance of his contract when it becomes "commercially impossible" seems to me to be a dangerous contention which ought not to be admitted unless the parties plainly contracted to that effect."^[x]

Drawing the threads together, it is fair to say that - in theory - it is possible to envisage scenarios in which the recent financial crisis could justify an argument that a contract has been frustrated or that non-payment could be justified under the terms of an appropriately worded force majeure clause. But the reality is likely to be altogether different from the theory. Perhaps the best indicator of that is the simple fact that, as far as this writer is aware, there is not a single reported case in which such an argument has succeeded (and there have been numerous financial crises of one sort or another in the past). That is not surprising and reflects the fact that the doctrine of frustration is one of last resort, and in the current context at least is often the last gasp argument of the desperate.

Mark Jones has a broad commercial practice, including shipping (dry and wet), sale and carriage of goods (international and domestic), insurance and re-insurance (and brokers), banking and general commercial litigation. Mark is recommended in the Legal 500 as a leading barrister for shipping, where he is noted for his expertise in shipbuilding and ship purchasing disputes.

^[i] [1981] AC 675 at page 700

^[ii] Davis Contractors Ltd V Fareham Urban District Council [1956] AC 696 at page 729 per Lord Radcliffe

^[iii] [2007] 2 Lloyd's Rep 517

^[iv] Larrinaga v Societe Franco-Americaine des Phosphates (1923) 14 Ll.L.Rep. 457 at page 464 per Lord Sumner

^[v] See Chitty on Contracts (30^th ed., 2008) Volume 1, paragraph 23-047 and CTI Group Inc v Transclear SA, The "Mary Nour" [2008] EWCA Civ 856 (CA), [2008] 1 Lloyd's Rep 250

^[vi] [2003] EWHC 798 (Comm) - The case was the subject of an appeal, but the Court of Appeal did not address the issue of frustration.

^[vii] Chitty on Contracts (30^th ed., 2008), Volume 1, paragraph 14-140

^[viii] [2010] EWHC 40 (Comm)

^[ix] [2006] 1 Lloyd's Rep. 441

^[x] [1917] AC 495 at page 510 per Lord Loreburn