High Court finds alleged frustration of contract due to COVID-19 pandemic is not sufficiently arguable to grant injunction restraining demand under letter of credit  

The High Court has dismissed an application for an injunction to prevent an airline group from making demands under bank-confirmed standby letters of credit (SBLCs), securing aircraft leases granted to the claimant (a budget passenger airline), on the basis that it was not sufficiently arguable that the leases were frustrated due to the effects of the COVID-19 pandemic: Salam Air SAOC v Latam Airlines Group SA [2020] EWHC 2414 (Comm).

The court’s decision confirms the established position on the law of frustration, which requires a multi-factorial approach as per Edwinton Commercial Corporation v Tsavliris Russ (Worldwide Salvage and Towage) Ltd (The Sea Angel) [2007] 1 CLC 876. The decision highlights the importance that the nature of the contract and its terms may play when applying the multi-factorial approach. Here, the claimant had agreed to provide the SBLCs as an alternative to paying a cash deposit for the aircraft, and the SBLCs were commercially and legally intended to be equivalent to cash. The terms of the leases also expressly placed on the claimant the full risk of any disruption whatsoever to their airline business; they had been drafted to make it clear that the claimant’s obligation to pay continued in almost any conceivable circumstances. Taking these factors into account, the court found that the claimant’s frustration case was “far too weak” to justify the step of interfering with the operation of the SBLCs.

It is a noteworthy decision for financial institutions because of the obvious increased risk of frustration arguments relating to the ongoing COVID-19 pandemic. There have been relatively few decisions on frustration in recent years, most notably: Canary Wharf (BP4) T1 Ltd & Ors v European Medicines Agency [2019] EWHC 335 (Ch) (see our litigation blog post). While decisions applying the doctrine will depend on their precise facts, it is helpful to see recent authority confirming the established principles, in particular when considering the specific context of the COVID-19 pandemic. For further legal analysis and insights in relation to COVID-19, and how we expect the crisis to operate as a catalyst for change, please visit our Catalyst Hub. Please also see our COVID-19 Contract Disputes Guide.

In addition, the decision will be a reassuring one for financial institutions as credit-providers under letters of credit and other similar instruments, providing certainty and clarity as to the high bar for any interference with their operation. In particular, it confirms that the enhanced merits standard for obtaining interim relief against the credit-provider applies equally to any injunction applications seeking to restrain the beneficiary from making a demand, i.e. that in either scenario, the claimant must establish that the case is “seriously arguable”.

Background

In 2017, the claimant budget passenger airline entered into three aircraft leases with the defendant airline group. The claimant leased the aircrafts with a view to operating domestic flights within Oman initially. The leases included an obligation on the claimant to: (a) pay rent and make other payments, which was “absolute and unconditional irrespective of any contingency whatsoever”; and (b) as an alternative to paying a deposit of three months’ rent, provide irrevocable and bank-confirmed SBLCs, under which the defendant would be entitled to withdraw all or part of the amount of the SBLCs and apply this in the same way as it would apply the deposit.

In March 2020, in response to the COVID-19 pandemic, the Oman Civil Aviation Authority introduced strict travel restrictions, notably the prohibition of all flights to or from Oman airports (with few exceptions such as cargo flights). The claimant stopped paying rent under the leases in March 2020, redelivered the aircrafts to the defendant in June 2020 and subsequently gave notice to terminate the leases.

The claimant made a without notice application to the court for an injunction to restrain the defendant from making a demand under the SBLCs, on the basis that the purpose of the leases was frustrated by the effects of the COVID-19 pandemic, in particular the strict travel restrictions introduced by the Omani authorities.

Decision

The court said that the application raised two threshold issues:

  • Whether it would be appropriate for the court to interfere with the operation of the SBLCs by injuncting the defendant (the beneficiary of the SBLCs) from making a demand under them.
  • If so, whether the claimant could demonstrate a sufficiently arguable case that the leases were frustrated by the effects of the COVID-19 pandemic.

The court found that the claimant failed to satisfy either of the threshold issues with the result that it was not entitled to the injunction it sought. The two issues are considered in further detail below.

Issue 1: Injunction against the credit-provider or beneficiary

The court considered whether it would be appropriate to interfere with the operation of the SBLC via injunctive relief, noting that the court will only intervene by injunctive relief in the operation of irrevocable letters of credit and similar instruments in “exceptional circumstances” because they are intended to be “the equivalent of cash”.

The court noted that for these reasons, the circumstances in which an applicant can obtain an injunction restraining the credit-provider from paying out under the instrument are limited to where the instrument itself is invalid or where the bank knows the demand for payment is fraudulent. The strength of case which the applicant is required to establish for the purpose of an injunction is an enhanced one (as per Alternative Power Solution Ltd v Central Electricity Board [2015] 1 WLR 697). The case must be “seriously arguable” and the American Cyanamid Co v Ethicon Ltd [1975] AC 396 principles on the granting of interim injunctions do not apply.

The claimant did not challenge the validity of the SBLCs, or suggest that any demand made by the defendant under them would be fraudulent. Rather, it alleged that the substantive and evidential obstacles which apply to an application for an injunction restraining a credit-provider (as set out above) do not apply to an applicant seeking an injunction restraining a beneficiary from making a demand (as in the present case).

The court accepted that it was bound by the decision in Themehelpe v West [1996] WB 84, in which the court found that in some circumstances an injunction to prevent the beneficiary from making a demand under an irrevocable letter of credit (and similar instruments) can be obtained even though the applicant is unable to satisfy the requirements of the fraud exception. However, given the criticism of that case in subsequent authorities and legal commentary, the court was not willing to give the decision any broader application than it strictly required. In the court’s view, that involved at least the following limitations:

  1. The applicant’s underlying claim against the beneficiary must include an allegation of fraud;
  2. The injunction must be sought “well before” the right to call on the instrument has arisen (although the court noted some hesitation in respect of this limitation); and
  3. The enhanced merits standard for obtaining interim relief against the credit-provider apply equally to any injunctions to restrain the beneficiary from making a demand.

Considering these limitations, the court repeated that the claimant did not contend that there was any fraud by the defendant in relation to the aircraft leases (nor did it argue that any term of the aircraft leases meant that the defendant was not permitted to make a demand). Further, the court stated that this was not a case in which the claimant sought an injunction “well before” the right to claim under the SBLCs arose.

Accordingly, the court concluded that the claimant was not entitled to the injunction sought.

Issue 2: Frustration

Notwithstanding its conclusions on the first issue, the court proceeded to consider whether the claimant was able to make out its frustration case to the requisite degree of arguability. As noted above, this required the claimant to establish a strong rather than merely arguable case. The court found that the claimant’s frustration case was “far too weak” and not sufficiently arguable to justify the step of interfering with the operation of the SBLCs.

Test for frustration

The court noted that the authorities on frustration had recently been reviewed in detail in Canary Wharf v EMA and pointed to the formulation of the test for frustration set out in National Carriers v Panalpina [1981] AC 675:

“Would outstanding performance in accordance with the literal terms of the contract differ so significantly from what the parties reasonably contemplated at the time of execution that it would be unjust to insist on compliance with those literal terms.”

On the application of that test, the court cited the leading authority of The Sea Angel, which confirms that the doctrine of frustration requires a multi-factorial approach, with the factors to be considered being:

“…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 the 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.”

The Sea Angel also confirms that the doctrine is not to be lightly invoked (mere expense, delay or a more onerous obligation are not sufficient) and the purpose of the doctrine is to do justice (and so considerations of justice are important factors to bear in mind). Part of that calculation is the consideration that the frustration of a contract may well mean that the contractual allocation of risk is reversed.

The parties agreed that the question for the court to consider was whether there had been “frustration of purpose” (i.e. that the frustrating event had transformed performance of the contract into something so radically different from the intended purpose that it would be unfair to hold the parties to their obligation), as opposed to the event of frustration making the contract physically or commercially impossible or illegal to perform.

Application of the test for frustration

In considering whether there was, in fact, frustration of the purpose of the contract, the court considered the nature of the contract and its terms, making the following observations:

  • Shared purpose. The court noted that the “frustration of purpose” doctrine had seldom been applied since it first emerged in the Coronation cases at the start of the last century, and in particular in Krell v Henry [1903] 2 KB 740. The Court of Appeal in that case emphasised that viewing the coronation procession was a “state of things assumed by both contracting parties as the foundation of the contract”, in finding that a contract to hire a flat in Pall Mall was frustrated when the coronation was postponed. In contrast, on the facts of the present case, there was nothing in the leases to suggest that the claimant’s use of the aircrafts was a shared purpose of both parties to the leases as opposed to a matter with which the claimant was alone concerned.
  • Allocation of risk. The leases expressly placed on the claimant the full risk of any disruption whatsoever to their business. The leases were drafted to make it clear that the claimant’s obligation to pay rent continued in almost any conceivable circumstances (i.e. a “hell or highwater” basis as per Bitumen Invest AS v Richmond Mercantile Ltd FZC [2016] EWHC 2957). The obligation to pay rent was expressed to be “absolute and unconditional irrespective of any contingency whatsoever”. In the court’s view, such clauses were fundamentally inconsistent with any suggestion that the existing Omani travel restrictions (for so long as they remained in force) or any other long-term suppression of air travel preventing the claimant from using the aircrafts to earn revenue through passenger flights with an Omani terminus had the effect of terminating the leases and freeing the claimant of its obligation to pay rent.
  • Right to terminate. The claimant had the option of terminating the leases on six months’ notice from a date on or after 4 years of the delivery date of the aircrafts if it ceased to carry on the business of air transport. But in the court’s view there was nothing on the facts to suggest that this contingency had arisen. The leases still had 3 years left to run on them at the time that it was alleged the inability to operate passenger flights frustrated them.

For these reasons, the court refused the claimant’s application.

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Supreme Court hands down judgment in FCA’s Covid-19 Business Interruption Test Case

The Supreme Court has today handed down judgment in the Covid-19 Business Interruption insurance test case of The Financial Conduct Authority v Arch and Others. Herbert Smith Freehills acted for the FCA who advanced the claim for policyholders.

The Supreme Court unanimously dismissed Insurers’ appeals and allowed all four of the FCA’s appeals (in two cases on a qualified basis), bringing positive news to policyholders across the country that have suffered business interruption losses as a result of the Covid-19 pandemic.

At first instance the FCA had been successful on many of the issues, and now the Supreme Court has substantially allowed the FCA’s appeal on the issues it chose to appeal. The practical effect is that all of the insuring clauses which were in issue on the appeal will provide cover for the business interruption caused by Covid-19.

For more information, please see this post on our Insurance Notes blog.

Commercial Court considers impact of force majeure clause on repayment obligation in sale of goods contract

In a decision earlier this year, the Commercial Court considered the impact of a force majeure clause on a repayment obligation in a contract for the sale of goods: Totsa Total Oil Trading SA v New Stream Trading AG [2020] EWHC 855 (Comm). (The judgment was given in March 2020 but the transcript has only recently become available.)

While the force majeure event in this case was unrelated to COVID-19, the decision will be of interest to financial institutions considering the ongoing impact of the pandemic. Although, under English law, force majeure is entirely a creature of contract, it is helpful to see further examples of the court’s interpretation of such clauses. Whether force majeure can be relied on, and the effect of such reliance, will depend on the proper construction of the contract and the particular circumstances of the case.

In this case, the court granted summary judgment on a buyer’s claim for repayment of an advance payment, in circumstances where (on facts assumed for the purposes of the summary judgment application) the seller had been prevented from delivering product due to a force majeure event, and the buyer had given notice terminating the contract. The court found that, on the proper construction of the contract, the repayment obligation kicked in if product was not delivered in accordance with the contract (and any agreed extension) for any reason whatsoever, including force majeure. However, where the failure to deliver was due to force majeure and that triggered an extension to the delivery timeframe, it could not be said that product had not been delivered “in accordance with the contract and any agreed extension” until the contract was actually terminated in accordance with its terms.

This decision illustrates that a valid claim to force majeure will not necessarily relieve a party of all of its obligations under the contract, such as obligations to repay advance payments for deliveries that are prevented due to force majeure. Parties negotiating force majeure provisions will wish to consider the extent to which any relevant obligations are to be affected by force majeure, and ensure the drafting is clear.

For a more detailed discussion of the decision, please see our litigation blog post.

For further legal analysis and insights in relation to COVID-19, and how we expect the crisis to operate as a catalyst for change, please visit our Catalyst Hub.

Judgment handed down in FCA’s COVID-19 business interruption insurance test case

The High Court has today handed down judgment in the COVID-19 Business Interruption insurance test case of The Financial Conduct Authority v Arch and Others. Herbert Smith Freehills represented the FCA (who was advancing the claim for policyholders) in the case, which considered 21 lead sample wordings from eight insurers. Following expedited proceedings, the judgment brings highly-anticipated guidance on the proper operation of cover under certain non-damage business interruption insurance extensions.

While different conclusions were reached in respect of each wording, the court found in favour of the FCA on the majority of the key issues, in particular in respect of coverage triggers under most disease and ‘hybrid’ clauses, certain denial of access/public authority clauses, as well as causation and ‘trends’ clauses. The judgment should therefore bring welcome news for a significant number of the thousands of policyholders impacted by COVID-related business interruption losses.

For more information see this post on our Insurance Notes blog.

Our new publication: COVID-19 Contract Disputes Guide

The economic disruption caused by the COVID-19 pandemic inevitably exposes businesses to heightened legal risk. In particular, counterparties may seek to delay, avoid performance and/or terminate agreements. This may be either because COVID-19 has legitimately prevented them from performing their contractual obligations, or because they are seeking to use the pandemic as an excuse to extricate themselves from a bad deal.

We have published a guide which provides a general overview of the common bases for avoiding contractual obligations in commercial contracts, including a comparison of the key rights and remedies. Click here to access the guide.

The banking litigation team has also prepared a more detailed COVID-19 disputes “handbook” for in house legal teams at banks, specifically considering the key clauses engaged in standard financial market documentation and sharing our market insight as to the types of litigation risks our clients are already seeing in each asset class. If you would like to receive a copy of the handbook, please get in touch with your usual HSF contact.