Frustration of contract: the cumulative conditions section 18 requires

Service page: Commercial contracts lawyer: drafting, review and enforcement.

When something big happens (a lockdown, a war, a supply chain disruption), the first argument raised in negotiations is “this is frustration”. In most cases it is not accurate, and not because the event was not serious, but because section 18 is built differently from what people tend to think.

Two misunderstandings keep coming back: that frustration cancels the contract, and that it is enough that the event was unusual. Both are wrong.

What the section actually says

Contracts (Remedies for Breach of Contract) Law, section 18(a) (unofficial translation)

Where the breach of contract resulted from circumstances which the party in breach, at the time the contract was made, did not know of and did not have to know of, or did not foresee and did not have to foresee, and could not prevent, and performing the contract in those circumstances is impossible or fundamentally different from what was agreed between the parties, the breach shall not be grounds for enforcing the breached contract or for damages.

Note what the section does: it does not cancel the contract, does not extinguish obligations, and does not create a cause of action for the party that relies on it. It takes only two remedies, enforcement and damages, away from the injured party. It is a defense, and like any defense, the burden of proving it is on the party that raises it.

The practical effect becomes clearer when you read it alongside section 2 of the same Law, which lists the injured party’s remedies: enforcement, cancellation and damages. Section 18 takes away two of the three. Cancellation remains. An injured party whose contract was frustrated may still cancel it under the provisions of the Law, so a successful frustration claim does not preserve the deal; it only protects the party in breach from a money award and from enforcement.

Four elements: the first two are alternatives, and the rest are cumulative

• Lack of knowledge: the party in breach, at the time the contract was made, did not know of the circumstances and did not have to know of them. The test is twofold: subjective and objective together.
• Unforeseeability: alternatively, it did not foresee them and did not have to foresee them. Here too, “did not have to” is an objective test, not a question of what the party actually thought.
• Inability to prevent: it could not prevent them. An event that could have been worked around by reasonable means, for example an alternative supplier, does not meet the condition.
• Impossibility or fundamental change: performing the contract in those circumstances is impossible, or fundamentally different from what was agreed. A rise in costs, even a significant one, is not necessarily a “fundamental change”: it makes performance more expensive, not different in its nature.

The word “and” between the conditions is what makes the claim difficult. It is enough that one of the cumulative conditions is not met, for example that the party in breach could have prevented the result by reasonable preparation, for the whole section not to apply. Because frustration is almost never established in practice, the real protection is a well-drafted force majeure clause, and this is the purpose of reviewing an agreement before signing.

The most common failure is actually in the foreseeability condition, and it is tested as of the time the contract was made, not as of the time of the breach. An event that was already part of public discussion at the time of signing, even as a possibility, makes it very hard to argue that the party “did not have to foresee it”.

What the court may do anyway

Section 18(b) is the section that turns frustration from an all-or-nothing barrier into a flexible mechanism:

Contracts (Remedies for Breach of Contract) Law, section 18(b) (unofficial translation)

In the cases described in subsection (a), the court may, whether or not the contract has been canceled, order each party to return to the other party what it received under the contract or, at the choice described in section 9, to pay it its value, and order the party in breach to indemnify the injured party for the reasonable expenses it incurred and for the undertakings it reasonably assumed in order to perform the contract, all if it appears to the court just to do so in the circumstances of the case and to the extent it sees fit.

Four points worth noting. First, the power applies whether or not the contract has been canceled: restitution does not depend on cancellation. Second, restitution can be ordered in kind or by payment of its value. Third, the party in breach may have to pay, not damages for breach, but an indemnity for reasonable expenses the injured party incurred and for undertakings it reasonably assumed in order to perform the contract. And fourth, all this is at the court’s discretion: “if it appears to the court just to do so in the circumstances of the case and to the extent it sees fit”.

The commercial meaning: a successful frustration claim is not necessarily a clean exit. It removes the exposure to damages for breach and to enforcement, but leaves a possible exposure to restitution and indemnity, to the extent the court sees fit.

Why a force majeure clause in the contract changes the picture

Section 18 is built around what the parties knew or should have foreseen at the time the contract was made. This leads to a drafting point that is easy to miss: a contract that expressly lists a particular event (a pandemic, closure of ports, a reserve call-up, a stop in supply from a particular supplier) records that the parties had the possibility in mind. This directly affects the first and second conditions.

So a good force majeure clause is not one that lists a long list of disasters, but one that sets what happens when an event occurs: who bears the costs already incurred, when obligations are suspended and for how long, which event justifies cancellation, and what the notice mechanism is. An agreed contractual mechanism makes it unnecessary to rely on section 18, and also removes the broad discretion that section 18(b) gives the court.

A question worth asking in every draft: if the event happens, do we prefer an outcome we set in advance, or an outcome the court will set according to what seems just to it? In most commercial deals the answer is clear.

What to do when the event has already happened

• Read the contract first. If it has a force majeure clause, that clause, not section 18, is the starting point. Section 18 is a default rule where there is no contractual arrangement.
• Document the time the contract was made and what was known then. The foreseeability test in section 18(a) is applied as of the time the contract was made, so material from that period is worth more than any analysis after the fact.
• Document the attempts to prevent and to mitigate. The condition “could not prevent them” is tested by what was actually done, and an alternative supplier that was considered and rejected for a documented reason is evidence.
• Notify the other party in writing and in real time. Even when the contract does not require notice, advance notice affects how much the other party will go on spending, and the indemnity under section 18(b).
• Collect the expenses of both parties. Section 18(b) deals with mutual restitution and indemnity, so the full picture of the expenses, not only yours, is what the court weighs.
• Do not assume the contract is void. Section 18 does not cancel it; cancellation, if needed, is done under the provisions of the Law and by notice.

Frequently asked questions

Does frustration cancel the contract?

No. Section 18(a) takes away only two remedies, enforcement and damages, and does not cancel the contract. Cancellation is done under the provisions of the Law, and section 18(b) empowers the court to order restitution and indemnity whether or not the contract has been canceled.

Which conditions must you prove to claim frustration?

The conditions are cumulative: that the party in breach did not know of and did not have to know of the circumstances at the time the contract was made, or did not foresee and did not have to foresee them; that it could not prevent them; and that performing the contract in those circumstances is impossible or fundamentally different from what was agreed. If one of them is not met, the section does not apply.

What may the court award when the contract was frustrated?

Under section 18(b), the court may order each party to return to the other party what it received under the contract or to pay its value, and order the party in breach to indemnify the injured party for the reasonable expenses it incurred and for the undertakings it reasonably assumed in order to perform the contract, all if it appears to the court just to do so in the circumstances of the case and to the extent it sees fit.

Does a significant increase in costs count as frustration?

Section 18(a) requires that performing the contract be impossible or fundamentally different from what was agreed. A rise in costs makes performance more expensive, but not necessarily different in its nature, so in itself it does not meet the condition.