May 6, 2022

Rising Costs and Fixed-Price Contracts

Guest post by Pallavi Mohan

The 2-year long global COVID-19 pandemic, the Russia-Ukraine conflict and the recent spate of lockdowns in China have left the MSME (Micro, Small and Medium Enterprises) sector in India in dire straits. Those who have entered fixed-price contracts are feeling the pinch of the rising cost of raw materials and the increased fuel prices, making it difficult for them to perform their obligations under these contracts. Fixed price contracts are agreements with a pre-determined value that doesn’t change, irrespective of the time spent, cost of materials or labour involved. For example a contract to manufacture 2000 leather handbags over a period of 1 year at a fixed cost of 10,000 per bag. The manufacturer will have to make bags at the cost of Rs 10,000, even if the cost of leather increases 10 times.

What is the legal principle that applies to such situations?

The legal principle that applies in such situations is called the “Doctrine of Frustration”. It is a common law principle which allows for the discharge (or non-performance) of a contract because of a change or interruption to the normal course of events that has made the performance of the contract impossible or illegal. In India, this doctrine is enshrined in Section 56 of the Contract Act, 1956. It is often used where there is no specific clause in the contract that provides for the frustration of contracts such as a Force majeure clause.

What is a Force majeure clause in a commercial contract?

Many commercial contracts these days have a ‘Force Majeure’ clause. Its importance became universally apparent after the first COVID wave. This clause allows parties to not perform their obligations under the contract in case of an unforeseeable event that makes it impossible for them to perform the contract. The term ‘Force majeure’ literally means “Act of God”. It includes events such as war, terrorism, natural disasters, explosions, fires, plagues and epidemics. Most contracts include a definition of the events that are covered under the term for the purposes of that contract. Any party invoking the Force majeure clause must show that:

  • the event was unforeseeable,
  • beyond its control,
  • that it has taken all possible steps to mitigate the effect of the event, and
  • despite its efforts, the party finds it impossible to perform its obligations under the contract.

Can the doctrine of frustration or a Force majeure clause help MSMEs in the current economic climate?

Indian Courts have taken the view that economic hardship is not enough to invoke a ‘Force Majeure clause or the doctrine of frustration, since it makes performing a contract merely difficult

but not impossible. The Supreme Court has consistently taken this view. It is reiterated strongly in the case of  Energy Watchdog v. CERC, where electricity generating companies were not allowed to take recourse to the Force majeure Clause on account of an increase in the price of coal.

So, MSMEs cannot invoke the Force majeure Clause or the doctrine of frustration to claim that increased fuel prices or increases in the cost of raw materials have made it impossible for them to perform their obligations under the contract.

How can MSMEs protect themselves in the future from economic hardship caused by unforeseeable events such as a pandemic or the economic impact of wars or other geopolitical conflicts?

A simple Force majeure clause in a contract cannot benefit the parties in the event of an unforeseeable event that only causes economic hardship. It is important to include clauses in the contract that protect the parties from price variation/escalation. A price variation/escalation clause allows a party to seek a change in the original contract price or the scope of work on account of variation in the cost of raw materials or cost of labour, or if supply restrictions are imposed, as with the lockdown during Covid-19. These clauses are especially useful in fixed-price contracts and MSMEs should consider including them when they enter contracts.