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As the economic ravages of Covid-19 continue, the question of who should bear the costs in contractual relationships where neither party can reasonably be held at fault for the damages resulting from Covid-19 business disruptions is arising on a daily basis.

The answer to that question might depend on the legal doctrine of “frustration”.  Frustration is often characterised as an impossibility to do what was contracted.  Courts cannot give effect to the contract by compelling a party to do the impossible.  A contract appears to be capable of being frustrated on the basis that the obligations created by a contractual term cannot be performed.  It applies where,

“… a situation has arisen for which the parties made no provision in the contract and the performance of the contract becomes a thing radically different from that which was undertaken by the contract.” [Naylor Group Inc. v. Ellis-Don Construction Ltd., 2001 SCC 58, at para. 53.]

The Test for Frustration

While there is some inconsistency in the caselaw, a party typically needs to establish the following in order to succeed in arguing that a contract has been frustrated:

1. The alleged frustrating event was unforeseen by the parties with the obvious corollary that no provision was made in the contract prescribing what is to be done in case of such an event;
2. the event made performance of the contract either impossible or “radically different” from what was undertaken in the contract (the fact that the obligations become more expensive, more time consuming, delayed or more difficult are unlikely to suffice unless they are so extreme as to amount to something “radically different”); and,
3. it stands to reason that, much like the rules in respect of implying terms into contracts, the undertaking alleged to have been frustrated was a common purpose of the parties to the contract and not simply the expectations of one party.

Many legal authors have speculated about whether Covid-19 is capable of triggering the doctrine of frustration.  However that question is determined on a case by case basis, rather than any a priori rule that Covid-19 restrictions do or do not generally trigger the doctrine of frustration.

Based on the current state of the law, the commercial circumstances where a contract could be frustrated by the commercial restrictions flowing from Covid-19 are limited, but conceivable.

What is the Effect of a Finding of Frustration?

If a court finds that a contract has been frustrated, the result is that all remaining obligations of the parties are discharged and the contract is terminated.  The relief potentially available to the parties was previously limited at common law, but has been expanded by legislation in many common law jurisdictions (including Ontario by the Frustrated Contracts Act, R.S.O. 1990, c. F.34).  Where applicable, it provides (among other things) that:

1. sums paid before the parties were discharged are recoverable by the payor;
2. any sums payable cease to be payable; and,
3. there is a broad discretion to order the recovery of expenses incurred as a result of the frustrated contract.

Comparison with a “Force Majeure” Contractual Term

A “force majeure” clause is not a legal doctrine, but a contractual term which the parties to a contract may decide to include which enumerates how intervening events (e.g. acts of God, war, terrorist attacks, acts of government, etc.) are to affect the contract.  This allows the parties to assign risk and either bear it or insure against it.  The extent to which Covid-19 falls within a force majeure clause, and the effect it has upon the contract, depends on the rules of contractual interpretation and varies from contract to contract.

The applicability of a given force majeure clause to Covid-19 interruptions is outside of the scope of this article.  Whether or not the doctrine of frustration is capable of applying in the face of a force majeure clause is likely to depend upon whether, on a true construction of the contract, “the parties made no provision in the contract” for the alleged frustrating event – having regards to the specific terms of the given force majeure clause.

For a summary of a recent Quebec case considering a force majeure clause in the context of commercial leases and insolvent tenants during Covid-19, see my colleague’s recent article, Quebec Court Finds Tenants Obligated to Pay Rent During Pandemic Lockdown by Puya Fesharaki, accessible here.

Frustration Caselaw – Relevant to Covid?

Of potential relevance to Covid-19 impact is the case of Victoria Wood Development Corp. v. Ondrey (1977), 14 O.R. (2d) 723 (H.C.).  In that case the plaintiff contracted to purchase 90 acres of land with a closing date of October 31, 1973.  The plaintiff’s purpose was to develop the land into a subdivision.  Legislation was passed shortly thereafter that effectively precluded the development.  The plaintiff sought a declaration that the contract was frustrated and that the deposit ought to be returned.  The court refused to make a finding that the purchaser’s anticipated use of the property as a subdivision was the “very foundation of the agreement”.  The risk was held to be that of the purchaser as there was no promise by the seller that the property would be suitable for the purchaser’s intended use.  Osler J. reasoned that,

“… a developer in purchasing land is always conscious of the risk that zoning or similar changes may make the carrying out of his intentions impossible, or may delay it.  He may attempt to guard against such risk by insertion of the proper conditions in the contract and thereby persuade the vendor to assume the risk.  In the present case he has not done so and, indeed, there is no evidence that he has attempted to do so.  “The very foundation of the agreement” is not affected and there is no room for the application of the doctrine of frustration.”

Victoria Wood distinguished the case of Capital Quality Homes Ltd. v. Colwyn Construction Ltd. (1975), 9 O.R. (2d) 617.  In that case the parties agreed to the conveyance of 26 lots by separate deeds for each lot.  The purchaser’s purpose of buying the lots was to subsequently re-convey them to separate home buyers.  Legislation intervened which prevented the conveyance of the individual lots without the consent of the relevant committee of adjustment.  It was held that the intervening legislation did frustrate the contract.  Of note is that the relevant legislation in Capital Quality Homes had a potential effect upon both the ultimate purpose of the purchaser and (more importantly) the terms of the contact between the parties – to convey the 26 lots separately as opposed to conveyed in one deed.  In Victoria Wood it was only the former (the purchaser’s intention) that the legislation frustrated.  Conveyance of 26 separate lots to the purchaser was not merely the intention of the purchaser in Capital Quality Homes, it was the common purpose of the parties.

In the more recent Supreme Court of Canada case of Naylor Group Inc. v. Ellis-Don Constrution Ltd. [2001] 2 SCR 943, the court rejected couching the doctrine of frustration on an “implied term” theory.  In other words, the court ought not to ask the hypothetical question of whether, had the parties contemplated the supervening event at the time of contracting they would have agreed that the contract should be put to an end.

The above is not to say that a term cannot be implied into a contract, providing it meets the relevant legal hurdles.  That term could create contractual obligations that go to the root of the contract.  Those obligations could be made impossible to perform (or “radically different”) by an unforeseen event for which there is no provision in the contract, and the doctrine of frustration might well apply.  We have yet to see many examples of this line of argument being raised in the context of Covid-19 restrictions.

How Could This Apply to Covid-19 Scenarios?

By analogy if a restauranteur or retailer had a specific purpose for leased property, but that purpose was not evidenced in the agreement with the landlord, Victoria Wood suggests that frustration might not apply if that purpose was rendered impossible by unforeseen events (like Covid-19 restrictions).  The common purpose of the parties might simply be to lease property, a purpose that Covid-19 restrictions are unlikely to directly frustrate, even though the tenant’s obvious purpose for the lease (to use as a store, restaurant, etc.) might well be frustrated.  Unless the fitness for the purpose is a term of the contract (express or implied) there is no obligation to be frustrated.  In that scenario, the relevant economic relationship being frustrated by Covid-19 restrictions is more likely that of the tenants and their customers (shoppers and diners), even though that might impact the tenant’s inability to pay. 

It seems unlikely that a commercial contract would be held to be frustrated simply because the goods or services no longer serve the purpose of one contractual party where that purpose is not a term of contract or where such a term cannot be implied by the facts.

While the court has moved away from an analysis of the doctrine of frustration by analogy to the law with respect of implied terms, such terms need to be considered in determining the terms of the contract and the presumed intention of the parties.  To answer the question, “what was contracted?” one often has to look beyond the four corners of a written agreement. 

The recent case of FSC (Annex) Limited Partnership v. ADI 64 Prince Arthur L.P. (2020) ONSC 5055 affirms the established principle that an inability to pay is rarely capable of grounding an argument that a contract has been frustrated and considers such an argument in the specific context of Covid-19.  Referring to the Covid-19 pandemic, Justice Koehnen stated as follows:

“I also take a different view of the, “never before in human history” approach to the issue.  While it may be that we have not experienced a pandemic of this proportion in our lifetimes, restrictions on the availability of credit are not uncommon.  They occur regularly as part of the ebb and flow of economic cycles…  Even if there were a general freezing of liquidity, that would also not constitute frustration because restrictive lending practices are not unforeseen and are a common feature of economic downturns.  Moreover, it is also a risk against which a purchaser can protect itself by making the purchase conditional upon financing.” (para. 25)

The Judge went on to conclude the following:

“The potential for an economic downturn is an inherent risk in any purchase decision and is not one from which a purchaser should be protected by the doctrine of frustration.

If it were otherwise, purchasers would have the option to resile from contracts if economic circumstances took a turn for the worse between the date of the agreement of the date of closing.  There are of common contractual provisions to cover that eventuality such as financing conditions, material adverse change clauses and material adverse event clauses.” (paras. 27-28)

Covid-19 restrictions might well cause a party’s inability to pay, but it seems one step too removed to suggest that any such restrictions prevent payment itself.  For example, some form of cyber terrorism targeting the banking sector could well frustrate a party’s possibility of making a payment.  But impossibility of payment is substantively different from an inability to make a payment due to economic circumstances caused by Covid-19 and its restrictions.  The inability of a creditor to make a payment because of solvency is the subject of a different area of law – the law of bankruptcy and insolvency.

The recent decision of the B.C. Supreme Court in New City/ Safety Mortgage Fund Inc. v. Pacific Point Holdings Ltd. et. al. BCSC 1792 (2020) is consistent with the above principles.  In that case, a petitioner applied for a declaration that certain mortgages were in default.  Three separate defences were raised on the basis of the doctrine of frustration.

First, the defendants argued that the closure of law firms frustrated the time sensitive refinancing of the mortgage.  That argument was rejected in the following terms:

“Many law firms adapted to the outbreak of COVID-19, and began processing transactions remotely. Time may have been of the essence in this refinancing, but there is no evidence it was rendered impossible because of any medical or legal restriction relating to COVID-19.” (para. 41)

Further, the court reasoned that:

“More to the point, even assuming the outbreak of COVID-19 caused PPH’s refinancing effort to collapse, neither that turn of events, nor the Province’s declaration of a state of emergency under the Emergency Program Act frustrated the mortgages or the general security agreements between New City, PPH, 103 and Mr. Gardner.” (para. 41)

            …

“While the outbreak of COVID-19 may have been an unforeseen event for which there was no provision in the security agreements, it did not fundamentally alter the nature of the parties’ contractual obligations.” (para. 41)

Second, one of the defendants also argued that the plaintiff had waived its rights under the mortgage and had agreed not to proceed with the default provisions, but to instead be paid out of the refinancing.  It was that collateral agreement (the defendant argued) that was also frustrated as a result of Covid-19 restrictions.  That argument was rejected on a finding that there was no such agreement.

Third, two of the defendants argued that they were uniquely prejudiced by the outbreak because the value of the property declined as a result.  That was also rejected in the following terms:

“There is no admissible evidence on this application that the value of the Angus Drive property declined since the refinancing collapsed, or that the COVID-19 pandemic caused any such decline in value. Even assuming the value of the Angus Drive property did decline as a result of COVID-19, however, it could not have frustrated the mortgage or the general security agreement. A decline in the value of the security may expose the guarantors to increased risk; but difficulty of performance, or even hardship, does not frustrate a contract. A more onerous obligation than the parties anticipated will not frustrate a contract unless it undermines the very foundation of the agreement” (para. 53)

The doctrine of frustration as a result of Covid-19 was considered even more recently by the Ontario Superior Court of Justice in the decision of Sub-Prime Mortgage Corporation v. Kaweesa et. al., 2021 ONSC 739.  The defendants argued that they were unable to make a payment owing under a settlement agreement by the deadline to do so, as a result of Covid-19.

The defendants’ first argument appeared to be that the pandemic itself was a frustrating event.  That was rejected on the basis that the existence of the pandemic was known to the parties at the time that they entered the settlement agreement.  As such, frustration could not apply: the parties chose not to provide for Covid-19 contingencies.

The defendants argued, in the alternative, that the lockdown measures imposed by the Government of Ontario (rather than the pandemic itself) had the effect of frustrating the defendants’ attempts at refinancing in order to meet their obligation to pay pursuant to the settlement.  That argument was rejected on a factual basis as follows:

“The limitations imposed by that measure were not of a nature that would preclude them [the defendants] from refinancing, in my view.” (para. 25)

The court ultimately concluded as follows:

“The question to pose, therefore, is this: Did the ongoing COVID-19 pandemic and the most recent lockdown measures alter the settlement agreement to such an extent that to compel performance would cause the defendants to do something that is “radically different” than what they parties had agreed to do? The answer is “No”. The obligation of the defendants was to pay a specified sum on a specified date, in exchange for specified actions (discharges/assignments of mortgages) by the plaintiffs.  The pandemic and the lockdowns did not alter those obligations.” (para. 28)

Potential Application to Covid-19

Based on the above, there are scenarios where the Covid-19 restrictions could lead to successful arguments that contracts have been frustrated, although those scenarios are narrow.  The relevant questions to ask include:

1. what are the terms of the contract, having regard to express terms (written and oral) and any potentially implied terms;
2. do those terms go to the root of the contract or are they terms that, if breached, are capable of being otherwise performed or remedied without producing a result that is “radically different” from what was contemplated;
3. is performance of the obligation(s) truly frustrated in the sense that it cannot be performed or performance would look “radically different” from what was contemplated, or is the party unable to perform the obligation as an indirect effect of Covid-19 restrictions;
4. were any provisions made in the contract that could conceivably address Covid-19 impacts and how risks ought to be allocated in that regard; and,
5. was the contract entered into at a time when the risks of Covid-19 were known, such that silence as to how such risks ought to be allocated could suggest that damages ought to be borne where they lie and contractual obligations ought not to be discharged.

Situations where performance is simply delayed (and time is not truly of the essence) or that make performance more onerous or expensive are unlikely to meet the test for frustration.  There may be circumstances caused by the Covid-19 pandemic that constitute frustration, but they are likely to be unusual.