Frustration stations: SMEs targeted for post-pandemic contract claims

By Susanna Beard, below, Senior Associate, King & Spalding International LLP

During the COVID-19 pandemic, SMEs were placed under huge financial and operational pressure due to lockdown restrictions that savaged their income and severely disrupted business continuity. Businesses had to evaluate the options available to them to terminate expensive contractual arrangements or to otherwise enable them to avoid or delay contractual performance and protect themselves from financial disaster.

A number of court cases arising from the impact of the recent pandemic have considered the availability of the decades-old legal remedy of contractual frustration. For the most part, these cases involved SMEs seeking to employ the remedy to help extract themselves from tricky financial situations in B2B arrangements. Few were successful. But recently, as the after-effects of the pandemic continue to impact our lives, consumers have been successful in seeking the remedy of frustration of customer contracts held with SMEs.

The recent spate of cases has intensified SMEs need to pay careful consideration to commercial risks when there is a major disruption to business continuity, whether lockdowns, protests, a weather event, natural disaster, military action, civil unrest or political reforms. Crucial is how SMEs can protect themselves from costly legal proceedings in such events.

Impact of a Crisis on Contractual Performance

During a crisis event, such as a civil emergency or unrest, a business may be affected in a number of ways. It may find itself unable to perform its own contractual obligations or may find that its suppliers or customers are in default for non-performance or non-payment which in turn can jeopardise the business’ ability to meet its own obligations and liabilities.  Where a supervening event prevents proper performance of a contract, an SME should be aware of the options it has (and its counterparties have) at its disposal to mitigate or remediate non-performance.

Contractual Remedies

The first port of call an SME should consider in a situation where it is unable to perform a particular contractual obligation is the relevant contract itself.  What does it say? Does it anticipate this particular scenario either specifically or generally and, if so, what is the contractual remedy provided for? Typically remedies for the impact of crisis events included in a contract are seen as “force majeure clauses”. A force majeure clause sets out a procedure for excusing one or both parties from contractual performance for so long as that party is affected by an “Act of God” or other crisis event, thereby avoiding a trip to court for resolution. But if the contract is silent, or doesn’t anticipate the specific crisis that has occurred (many force majeure clause didn’t anticipate the pandemic lockdowns), the parties may be forced to seek resolution through the courts (or other applicable dispute resolution process of the contract).

A Claim in Damages

Most businesses will be familiar with the presumption of the UK courts that damages are the appropriate remedy for an aggrieved party where a contract has been breached (including by non-performance). The non-defaulting party is compensated financially for its loss caused, or in consequence of, the failure in performance of the other party.  This is known as the doctrine of absolute contracts. These losses are subject to determination in accordance with the relevant contract (as to scope of recoverable loss, which may expressly exclude, loss of profits, for example) and to common law rules on remoteness of damage (the loss must be reasonably foreseeable to be recoverable). But what if, as a result of some crisis event, like the COVID-19 pandemic, Russian invasion of Ukraine or the recent earthquakes in southern Turkey, performance of a contract, or part of it, is rendered impossible, through no fault of the contracting parties? Then (but only then) the UK courts may apply the doctrine of frustration.

A Claim for Frustration

The doctrine of frustration is an exception to the doctrine of absolute contracts. Where a frustrating event occurs, the parties to a contract will no longer be bound to perform their respective obligations under that contract. Because the intervening event is outside of the control, and often foreseeability, of the parties, frustration is considered by the court to be an appropriate remedy since neither party is responsible for the loss suffered and cannot therefore be held responsible for it, either financially or practically. Application of the doctrine of frustration will typically be sought as a defence to a claim for contractual breach but may also be used to obtain relief from performance.

Utilising the legal concept of contractual frustration to manage business continuity risk

What is legal frustration?

The legal concept of frustration is settled law and was described by Lord Radcliffe in the 1956 case of  Davis Contractors Ltd v Fareham UDC [1956] AC 696 as occurring “whenever the law recognizes that without default of either party a contractual obligation has become incapable of being performed because the circumstances in which performance is called for would render it a thing radically different from that which was undertaken by the contract.

The courts may apply the doctrine of frustration where a contract has become (almost) impossible to perform. It is a remedy only very rarely granted by the courts in circumstances where a crisis event has changed performance of the contract so significantly and, through no fault of the parties, that they should (or one of them at least) should rightly be relieved of the obligation to perform as a result.

Establishing frustration

If a SME business considers that it cannot make good on a contractual obligation due to a significant change in circumstances outside of its control, it can seek a ruling from the court that the contract has been “frustrated”. The courts are reluctant to find that frustration has occurred – and will not do so merely because the contract is more difficult or more expensive to perform, or even where a third party’s failure to perform an obligation in favour of the SME have prevented it from meeting its own contractual obligations (e.g. supply chain risk).  The high threshold for establishing that a contract has been “frustrated” means that a business should never rely on its availability and the use of contractual force majeure clauses provides much more certainty for performance relief in specified emergency circumstances.

Frustration terminates the contract

If a SME is successful in arguing that its contractual obligations are frustrated by the supervening event, the contract is terminated and discharged. There is no concept of temporary frustration.  A frustrating event brings the contractual relationship to an end and relieves both parties of any further performance obligations. SMEs should therefore consider whether it wishes to lose its contractual relationship entirely by seeking the remedy of frustration, or if there is potential to negotiate a settlement, waiver or delay in performance in the absence of an effective force majeure clause to provide relief.

Frustration of business contracts

During the COVID-19 pandemic many SMEs were focussed on relieving themselves of contractual obligations – a number of frustration claims were brought in the landlord and tenant arena as businesses sought to alleviate the costs of leasing properties they couldn’t operate from during lockdowns.  Few were successful, demonstrating the narrow approach of the courts to applying frustration as a remedy, and reinforcing the no temporary frustration principle. The cases involved long commercial leases that even a 2-year long pandemic was not going to permanently frustrate.

Frustration of consumer contracts

SMEs are seeing a rise in consumer claims indirectly resulting from actions taken during the pandemic. Recently consumers have been successful in bringing frustration claims not to alleviate performance but to recover money spent with businesses for which goods or services cannot not be received in lieu in accordance with the original transaction between the business and consumer.

Particularly in the travel sector, businesses responded to the pandemic restrictions by issuing vouchers in exchange for tickets that could not be used at the time. Most consumers were reasonably happy with this policy on the assumption that they could then use the voucher for travel at a later date, when restrictions eased. For the businesses themselves this approach protected revenue and working capital when it most need to.  However, as restrictions across the world eased through 2022, many consumers found that their travel vouchers could not, in fact, be used as intended as airlines had cut back certain routes and some destinations remained closed to foreign visitors.

Earlier this year a British Airways customer was successful in a frustration claim against the airline when it ceased to operate a route previously flown during the pandemic, for which she had a voucher. The grant of the frustration remedy by the magistrates’ court brought the contract with BA to an end, entitling the customer to a cash refund.

A number of other airline passengers have successfully brought claims against airlines that have cancelled flights or dropped routes as they struggle to recover from the effect of the pandemic.

Mitigation of business continuity risk

Whilst we can’t predict when, where or how then next crisis event will strike, SMEs can take steps to protect themselves from the business continuity risk it may pose:

Contractual Protection: Carefully consider and provide for any foreseeable risks (however remote) within written contracts and in general terms and conditions with suppliers and customers.  Provide for temporary alleviation of performance obligations using force majeure clauses drafted to mitigate the impact of the specific geographic, political and industry risks posed to business operations together with general “Act of God” business continuity protection. In consumer contracts, particular care should be taken to avoid an unfairly one-sided force majeure clause falling foul of the Unfair Contract Terms Act 1978, which can set aside contractual provisions that are unreasonable or unfair for a consumer counter party. In business-to-business contracts, SMEs have wider discretion to obtain the terms they are able to negotiate.

Mitigation: In the event of a crisis event occurring, quickly evaluate the available options for meeting or postponing contractual operations, and the potential for any possible frustration claim. Whilst a SME may want to be able to claim frustration of its supplier contracts, it will want to be able to defend customer claims of frustration by offering suitable alternatives to performance that do not render the contract so significantly different that it can be terminated by frustration.