geneva water jet june 2020

The effects of the COVID-19 crisis on contracts

By Eric ALVES DE SOUZA and Camille LOUP

 

Here is a reminder of the hardship doctrine. It will give you the main keys to evaluate the possible legal effects of the COVID-19 crisis on your contract.

 

General principles of Swiss contract law

The rule

Contracts are governed by the principle of good faith (Art. 2 of the Swiss Civil Code). This requires each party to a legal relationship to abide by its word faithfully, so that the other party can give credence to that word, i.e. rely on it and act accordingly.

From this general principle flows the adage "pacta sunt servanda", according to which validly concluded contracts must be performed as agreed. In other words, the parties cannot freely depart from their obligations. This binding force of conventions is a fundamental principle of both contracts and international law.

 

The exception

The principle of “contractual fidelity” has different applications and even exceptions. One of them is the theory of hardship, usually summarized by the Latin phrase "clausula rebus sic stantibus".

Where a change in the circumstances seriously disrupts the balance of interests established at the parties’ signature of the contract, the performance of the obligation may represent an intolerable burden for the debtor party. The obligation itself remains possible, i.e. the debtor may perform it, but its performance requires efforts or costs unrelated to what he had originally promised. This element is central to distinguish the theory of hardship from the theory of force majeure, which covers cases where the performance of the obligation is rendered impossible by the new circumstances.

Seldom do law or contracts anticipate serious change of circumstances and provide appropriate solutions. It is then necessary to adapt the contract. The first reaction of the debtor shall be to inform his co‑contracting party about the new situation and to renegotiate the contract.

Should the negotiations fail, and if the conditions are fulfilled (cf. infra), the court has a wide discretion to adapt the contract to the new circumstances. Several choices are open to the judge, who may pronounce or authorize the termination of the contract, with or without compensation. The judge may also maintain the contract and modify the scope of the obligations bargained for, by partially releasing one party, by extending the obligations of the other party or by reducing the duration of the contract.

This being said, the theory of hardship remains an exception which endorsement by the judge is particularly difficult to obtain. The conditions for its application must be fulfilled clearly and plainly.

It should be noted that the theory of hardship is known in international law, in particular in the Unidroit principles, Principles of European contract law (PECL) – specifically in international commercial contracts –, as well as in the United Nations Convention on Contracts for the International Sale of Goods (CISG).

 

Cumulative conditions

1) New, unavoidable and unforeseeable circumstances

Attempting to adapt the contract may abide by the principle of good faith only if the new circumstances were not reasonably foreseeable at the time of the signature. Otherwise, the debtor should have required, at the time, the insertion of a clause enabling him to rebalance it. Hardship must be linked to the understanding which the debtor had at the time of signing. Note that a change in the law cannot, in principle, be characterized as unforeseeable.

This theory often applies to contracts the performance of which is not immediate or takes place over time, such as contracts for successive deliveries, distribution or construction contracts. Since the circumstances must have changed considerably between signing and performance of the contract, long-term contracts are most often susceptible to such adaptation, without however excluding other types of contracts.

2) Excessive burden on the party liable for performance

The change of circumstances since the signature must have excessively altered the balance of the contract, so that performance of the obligation by the debtor becomes disproportionate. This runs counter to the principle of contractual fidelity, according to which the debtor bears the consequences of miscalculation and of the risks he takes in concluding a contract.

While it would be too rigid to set thresholds above which the circumstances are deemed to place an excessive burden on the debtor, the Swiss Federal Supreme Court has admitted - depending on the case - that situations of increase of costs ranging from 24% to 60% would reach the requirement (52.33% loss of revenue for the lessee of a ship's restaurant due to the war; 60% increase in the costs of a construction; 48% loss of turnover between 1931 and 1933). In contrast, a 300% increase in the price of a raw material was considered sufficiently foreseeable, since price variations on the market typically is a risk assumed by the buyer, even if it is difficult to predict the exact characteristics of said risk.

 

 

May the theory of hardship apply to the consequences of the COVID 19 crisis?

March 12, 2020, the WHO declared the outbreak of COVID-19 to be a pandemic. On March 16, 2020, the Swiss federal government described the situation as "extraordinary", within the meaning of Epidemic Act, allowing it to take urgent measures, derogating to the constitutional balance of powers.

While the conditions for applying the theory of hardship are restrictive and must be analyzed on a case-by-case basis, it is however possible that the consequences of the COVID-19 crisis would lead to new, unavoidable and unforeseeable circumstances, creating an excessive burden on the debtor of the obligation.

For example, a company may obtain an extension of the delivery period for its products because the global crisis has drastically reduced its supply channels for raw materials. Similarly, a distributor would obtain from its supplier a reduction in its annual objectives because the stores through which it usually sells its goods have been forced to close for several months.

As we see, the theory of hardship must be analyzed in the light of the contract and the particularities of the case. Its application depends on the nature of the contract, the applicable law, the presence of clauses regulating exceptional cases, the knowledge available to the parties at the time the contract was signed, as well as the factual circumstances making the performance of the contractual obligation excessive.

We would be pleased to advise you in assessing the suitability of such an adaptation to your contract.

 

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Quotation authorized with the following reference: ALVES DE SOUZA/LOUP, The effects of the COVID-19 crisis on contracts, published on June 11, 2020 by Bory & Partners, Attorneys-at-law, In Concreto News – June 2020.