risk management through commercial contracts

RISK MANAGEMENT THROUGH COMMERCIAL CONTRACTS

- By Ramya Hariharan

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Overview of Contracts: Offer and Acceptance Section 2 of the Indian Contract Act, 1872 provides for the definition of the terms,

‘proposal’ and ‘acceptance’.

When one person signifies to another his willingness to do or to abstain from doing anything, with a view to obtaining the assent of that other to such act or abstinence, he

is said to make a proposal.

When a person to whom the proposal is made, signifies his assent thereto, the proposal is said to be

accepted. A proposal, when accepted, becomes a promise.

OFFER ACCEPTANCE

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Features of a Valid Offer There must be two parties

Terms must be clear and definite

Creates a legal relationship

Offer must be communicated

It may be specific or general


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Features of a Valid Acceptance

Absolute and unqualified

Must be communicated

Must be in the prescribed mode

Must be given in reasonable time

Implied Acceptance


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Consideration Section 2(d) of the Indian Contract Act, 1872 provides that, when, at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration for the promise.

Should not be immoral, or against

the public policy of the state

Need not be adequate but should

be real

Should not be something which the promisor is already bound to do Can be past, present or future

Features of Consideration


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Parties Competent to Contract

Who is of the age of majority according to the law to which he is subject

Who is of sound mind

Who is not disqualified from contracting by any law to which he is subject

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Drafting of Contract : SMART While drafting a contract, one must ensure that the same is drafted along the following lines:

•  Specific

•  Measurable

•  Attributable

•  Realistic

•  Timebound

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Drafting of Contract : Specific

Section 29 of the Indian Contract Act, 1872 provides that, agreements, the meaning of which is not certain, or capable of being made certain, are void. Thus, a contract must clearly specify the intention of the parties entering into the contract and every clause of the contract must be certain and precise.

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Drafting of Contract : Measurable

A c o n t r a c t m u s t b e measurable. The contract must clearly and sufficiently set out the subject matter of the agreement. The subject matter shall not be illegal or for an illegal p u r p o s e . F u r t h e r, t h e contract must be objective and not subjective.

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Drafting of Contract : Attributable The contract should clearly identify the rights and duties of each party. Where fulfilment of any obligation by a party is contingent on satisfaction of any condition by the other party, the same should be clearly stipulated. The liabilities of the parties to the contract should also be clearly attributed so as to establish rights of each party in case of breach of contract.

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Drafting of Contract : Realistic and Timebound


The scope of work and purpose of the contract should be realistic. A contract must be timebound and the parties must be given a specific timeline to perform their duties and obligations. A clause can also be inserted to provide that, in relation to certain events, time is of the essence. This means that time periods and limitations must be strictly observed or else the contract is terminated.

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TYPES OF RISKS

CONTRACTUAL

FINANCIAL


LEGAL

•  Non-performance

•  Disputes between

parties •  Insolvency and Bankruptcy

•  Currency Fluctuation

•  Change of Law

•  Declaration of Emergency

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TYPES OF RISKS

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FORCE MAJEURE POLITICAL

•  Flood, cyclone, earthquake, volcano, epidemic, pandemic

•  Tidal waves, fire, floods, hurricane, explosion, wars

•  Act of God

•  Government Sanctions

•  Riots or terrorist attacks

•  Embargos & blockages

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ALLOCATION OF RISKS

•  Party which is best placed to control the risk, should be allocated the risk.

•  Risk allocation should be based on the following:

•  Which party can best control the events which may lead to the occurrence of the risk;

•  Which party can best control the risk;

•  Which party should bear the risk if it cannot be controlled; and

•  What effect the transfer of risk to a party will have on the other parties


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RISK MANAGEMENT

Damages – Liquidated & Unliquidated

Indemnity

Guarantees

Representations and Warranties

“Manage the risks you know and sell the rest”


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Damages – Liquidated and Unliquidated Damages

LIQUIDATED DAMAGES - are the damages which the parties to the contract may

agree to pay on the breach of contract.

UNLIQUIDATED DAMAGES – are the damages awarded by the court on the basis and assessment of actual loss or injury caused to

the party suffering breach of contract.

•  Damages refer to a form of compensation due to breach, loss or injury.

•  ‘Damage’ v. ‘Damages’


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Difference – Liquidated and Unliquidated Damages

Body Liquidated Damages Unliquidated Damages •  Section 74 of the ICA, 1872 •  Section 73 of the ICA, 1872

•  Is a sum stipulated in the contract as damages payable for breach of contract.

•  Contract does not have any sum stipulated.

•  Only reasonable compensation is awarded - the amount stipulated is only the outer limit

•  Only reasonable compensation is awarded.


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Principles Of Liquidated Damages Only reasonable compensation is awarded & any amount stipulated is just the upper limit

•  Aggrieved party can receive such liquidated amount only if it is a genuine pre-estimate of damages fixed by both parties and found to be such by the Court.

Reasonable compensation based on well known principles found in Section 73

•  Losses naturally arose in usual course of things from such breach.

•  Losses which the parties knew would result from such breach

•  Compensation is not provided for indirect or remote loss or damage

•  General principle - Injured party is put in the same position as that he would have been if he had not sustained the wrong.


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Occurrence of damage or loss caused is sine qua non for applicability of section 74

•  "whether or not actual damage or loss is proved to have been caused thereby"

•  Occurrence of damage or loss is required to be proved, wherever possible.

•  If difficult or impossible to prove then the the amount named in the contract if being a genuine pre-estimation of damage or loss, the same can be awarded.

•  Estimation of damages/compensation should not be unreasonable or by way of penalty.

•  Kailash Nath Associates v. Delhi Development Authority & ONGC v. Saw Pipes Ltd.

Principles Of Liquidated Damages


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Liquidated Damages does not constitute a debt

•  Amount stipulated as liquidated damages in the contract does not give rise to any automatic pecuniary liability.

•  The court has to determine entitlement to damages and exact quantum of damages, prior to which no liability arises on the defendant.

Principles Of Liquidated Damages


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Penalty vs. Damages •  A clause is penal if amount stipulated for payment is in terrrorem, to force the

offending party to perform the contract.

•  If, on the other hand, the clause is an attempt to estimate in advance the loss which will result from the breach, it is a liquidated damages clause.

•  The question whether a clause is penal or pre-estimate of damages depends on its construction and on the surrounding circumstances at the time of entering into the contract.

•  The fact that a sum of money is payable on breach of contract is described by the contract as "penalty" or "liquidated damages" is relevant but not decisive as to categorization.


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Mitigation of Risk through Liquidated Damages •  Wherever the loss or damage may be difficult or impossible to prove, the contract

should contain a liquidated damages clause.

•  Parties should use clear and unambiguous terms.

•  Contract should state the amount stipulated is genuine and reasonable pre estimation.

•  Parties also should provide that they unconditionally and irrevocably waive their right to challenge the quantum.

•  Different amounts should be specified for different categories of breaches.

•  Pre-estimation should be made carefully to ensure that the affected party is fully compensated.


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Indemnity •  Section 124 of the ICA

“A contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person, is called a "contract of indemnity”

•  ‘Indemnity’ in English law means a promise to save a person harmless from the

consequence of an act or an omission.

•  Promise can be express or implied.


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Scope of Indemnity vs. Damages •  Claim for indemnity is much wider than claim for Damages.

Direct

losses or losses in

natural and usual course

of things

All kind of losses including direct, indirect, remote, consequential and third-

party losses.

Scope of Indemnity

Scope of Damages

Claim for indemnity arises even prior to the indemnified having suffered actual loss.


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Mitigation of Risk through Indemnity Clause •  The scope and extent of the indemnity clause should be well defined.

•  The Indemnifying Party may consider to safeguard itself:

Ø  by capping the indemnity clause; Ø making provision for de minimis (threshold limit to trigger the indemnity liability); Ø  providing a limitation of time beyond which the obligation to indemnify ceases.

•  Requirement of mitigation of loss is not a pre –requisite to claim indemnity.

•  Claim for indemnity can cover consequential, remote, direct, indirect and even third-party losses.

•  Further it can be made even prior to the indemnified party has suffered actual loss.


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Guarantees

•  Section 126 of the ICA

“A ‘contract of guarantee’ is a contract to perform the promise, or discharge the liability,

of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the

‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’”


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Principles of Guarantees


party losses.

•  A contract of guarantee is a tripartite contract. The contract between the principal debtor and creditor forms the consideration for the guarantee.

•  The liability of a guarantor is co-extensive with that of a principal debtor.

•  Unless otherwise stated Guarantors enjoy the right of subrogation


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Mitigation of Risk through provisions of Guarantees •  Provision for bank guarantees can be an effective tool for risk mitigation.

•  A bank guarantee is an independent contract and not qualified by the underlying transaction and validity of the primary contract between the beneficiary and the person at whose instance the guarantee is being given.

•  Bank guarantees are usually unconditional and impose an absolute obligation on the

bank to pay without demur.

•  The interference of courts in enforcing bank guarantee is minimal. Only in cases of fraud or to prevent irretrievable injustice that the courts can prevent enforcement of bank guarantees.

•  Determination of quantum of loss is not a pre-requisite for invocation of bank guarantees provided to secure such loss.


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Mitigation of Risk through provisions of Warranties •  Warranties provide a shield against the fundamental principle of caveat emptor i.e.

buyer beware.

•  The key considerations that is required to be kept in mind while drafting a warranty clause is:

Ø Determination of exact scope of warranty;

Ø  Exclusion of warranty should be adequately carved out;

Ø Warranties to be backed by indemnities.


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General Principles of Force Majeure / Frustration Force Majeure and Frustration- Applicable Law

•  Force majeure is a French term which means ‘superior force’. It is not defined under

Indian Laws. Force majeure clause is a creature of a contract.

•  The principles of force majeure is embodied in section 32 of the Indian Contract Act, 1872 (“ICA”) and the doctrine of frustration is embodied in section 56 of the ICA.


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Threshold of impossibility


The grounds to be satisfied for applicability of the doctrine of frustration are as follows: •  A supervening event which was not contemplated by the parties arises subsequent to

the execution of the contract;

•  The event could not be prevented despite due diligence; •  The event is required to be of a catastrophic character that strikes the very root of the

whole object and purpose for which the parties had entered into the bargain in question or to have rendered the contract impracticable or impossible of performance;

•  An element of permanence needs to be established; and

•  Availability of alternative modes of performance.

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party losses.

Impossibility / Frustration •  A contract cannot be frustrated merely because the circumstances in which it was

made are altered. Satyabrata Ghose v. Mugneeram Bangur & Co. (1954 SCR 310) and The Naihati Jute Mills Limited v. Khyaliram Jagannath (AIR 1968 SC 522).

•  There is no general liberty reserved to the courts to absolve a party from liability to

perform his part of the contract, merely because on account of an uncontemplated turn of events, the performance of the contract may become onerous. It was held that abnormal rise in price, onerous conditions or change in circumstances do not lead to frustration of contract. Alopi Parshad and Sons Ltd. v. Union of India (AIR 1960 SC 588).

•  The test of "radically different" is important: 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. Energy Watchdog and Ors v. Central Electricity Regulatory Commission and Ors (2017) 14 SCC 80


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Force Majeure Force majeure is defined to mean:

•  Event or circumstance or combination of events and circumstances that wholly or partly prevents or delays an Affected Party in the performance of its obligations;

•  Events or circumstances are not within the reasonable control, of the Affected Party Could not have been avoided if the Affected Party had taken reasonable care or complied with prudent utility practices.


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Force majeure clauses are split into three broad heads: •  Non-Political Events-which is natural force majeure

events like Act of God, epidemics, etc.

•  Indirect Political Event-industry wide strikes, lock-out, act or war, etc.

•  Political Event- Government action-expropriation or compulsory acquisition of project assets, failure to grant consents without fault of the aggrieved party.

Force Majeure

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Force Majeure – Impact on Commercial Contract

Contract not having Force Majeure Clause •  In the absence of a specific Force Majeure clause, parties may seek the benefit

embedded under Section 56 of ICA.As already stated the threshold to be satisfied is very high.

Contract to contain force majeure clause

•  In order to claim force majeure, the contract should have aforce majeure clause •  Adequate care to be taken while drafting force majeure clause as force majeure

clauses are interpreted narrowly.

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Consequence of Force Majeure


Consequence of force majeure •  Suspension of performance

•  Extension of time •  Reimbursement of Cost •  Termination in the event of prolonged

force majeure

Responsibility of Affected Party •  Duty to report

•  Duty to mitigate loss

•  Duty resume performance

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Key considerations for affording a party Force Majeure Relief

•  Burden of proof.

•  Scope and interpretation.

•  Causation/Causal link.

•  Notice for invocation.


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Thank You!

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risk management through commercial contracts

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