Arbitration of Long-Term Contracts Impacted by Supervening Events

Arbitrators’ power and authority to adapt or modify contracts

With the outbreak of COVID-19 and consequent imposition of restrictive public health measures, the number of contractual disputes, including arbitrations, grew exponentially in Brazil. In particular, parties to long-term contracts started to seek restoration of an allegedly lost contractual balance, caused by so-called unforeseen events. Along with many other controversial questions, this situation raised new debates as to whether arbitrators (and judicial courts) have the power and authority to adapt or modify contracts regardless of the parties’ will. This article will address the question, showing that judges and arbitrators have the power to review contracts governed by Brazilian law, provided that certain legal requirements are met.

Contractual interventions: legal framework

Under Brazilian law, the principle of pacta sunt servanda is of utmost relevance. This means that in a private contractual relationship, obligations freely undertaken by each party should prevail and may be enforced by the other party.

Nevertheless, the rule is not absolute. Changing of circumstances, amongst a few other restricted conditions, may justify judicial intervention in contracts, provided that the modification of obligations is minimal and exceptional, pursuant to Article 421, sole paragraph of the Brazilian Civil Code (BCC). Further, alteration of contracts must be guided by the principles of good faith, the social role of the contract and material equivalence, as reckoned by scholars and jurisprudence.

Perhaps one of the best known and intuitive cases in which parties are exempted from their obligations is set forth in Article 393 of the BCC, which states: “the debtor is not liable for damages resulting from a fortuitous event or force majeure, if they are not expressly responsible for them”. The sole paragraph of Article 393 provides a definition of a fortuitous event or force majeure as the “necessary fact, whose effects were not possible to avoid or prevent”.

Justification for an even more substantial intervention in the content of a contract is provided for in Article 317 of the same law, which is the legal ground for the unpredictability doctrine (teoria da imprevisão):

“When, for reasons that could not be foreseen, the value of the obligation owed and its value when it performed become manifestly disproportionate, the judge may correct it, at the request of a party, in such a way as to ensure, as far as possible, the real value of the obligation.”

The unpredictability doctrine arises from the principle of conservation of contracts, according to which termination should be the last remedy of a party. The principle is rigorously observed by the Brazilian legal system and is grounded on the notion that conserving a contract is more advantageous to parties and society, especially in times of crisis. Based on this premise, the unpredictability doctrine aims to re-establish a contractual balance lost due to unforeseeable events, which were disregarded by the parties when they entered the agreement.

In order to be granted, the remedy provided by Article 317 of the BCC depends on the observance of the following requirements:

• a long-lasting contract;
• an unforeseeable supervening event (or a foreseeable event with unpredictable results);
• an objective imbalance in the obligations undertaken by the parties due to such event; and
• that the unforeseeable event was not caused by the party benefiting from the imbalance.

In addition, some scholars argue that Article 317 of the BCC would only be applicable to monetary debts, since it is encompassed in the chapter of the BCC related to Payment Obligations. However, a broader interpretation of the article seems to prevail among scholars and in wider jurisprudence, which leads to the unpredictability doctrine being used for the rebalancing of contractual obligations in general.

Finally, Articles 478/480 of the BCC provide yet another remedy for a party harmed by unforeseeable events that cause contractual imbalance: termination. Below is the statutory basis the doctrine known as excessive onerousness (teoria da onerosidade excessiva):

“Article 478. In contracts with continuing or deferred performance, if the obligation of one of the parties becomes excessively onerous, with extreme advantage for the other, by virtue of extraordinary or unforeseeable events, the debtor may apply for dissolution of the contract. The effects of the judgment that declares dissolution shall be retroactive to the date of citation.

Article 479. Dissolution may be avoided, if the defendant offers to modify the conditions of the contract, on an equitable basis.

Article 480. If only one of the parties has obligations under the contract, that party may petition for their obligations to be reduced, or that the manner of performing them be altered, so as to avoid excessive onerousness”.

In this case, the requirements for termination sum up to:

• a long-lasting contract;
• an extraordinary unforeseeable event;
• an excessive burden to one of the parties caused by such event; and
• an extreme advantage to the other party.

Both of the final two requirements must be examined through an objective lens (onus of an obligation within the contractual intrinsic balance), hence the debtor’s financial conditions, as well as other external elements to the contract, are deemed irrelevant by scholars and jurisprudence in assessing the excessive onerousness.

Based on a literal interpretation, Article 478 of the BCC only allows the debtor to request the termination of a contract, whilst modifying the contractual obligations is a prerogative held solely by the debtor who voluntarily agrees to offer a less onerous solution, as a means of preserving the agreement.

The dynamic established by the Law is supported by some scholarly opinion and jurisprudence. It would be justified by the very imbalance innate not only to the obligation, but also to the actual position of each party: because debtors are interested in releasing themselves from the obligation, they are entitled to requested termination. Nonetheless, the choice to modify the contract shall be given only to the creditor because they will be harmed by such modification, and hence it must up to them to decide whether preserving the agreement is advantageous enough.

That being said, the prevailing understanding is that any of the parties may seek modification of the contract to rebalance obligations that have become excessively burdensome. Advocates of this doctrine support their position on the principles of the conservation and the social function of the contracts (princípios da conservação e da função social dos contratos). Such principles provide that termination of the contract must be ultima ratio, and that the impacts of a contract on society (and not only the contracting parties) shall be considered.

Therefore, although the unpredictability and excessive onerousness doctrines have emerged with different purposes and remedies, in practical terms, they are currently equivalent to a certain extent, as a result of extensive interpretations of Articles 317 and 478 of the BCC.

In addition to the requirements set forth by the above-mentioned legal articles, there is still another aspect worthy of note whenever a claim for changing of circumstances is raised. Article 421-A, II of the BBC provides that “the risk allocation defined by the parties must be respected and observed”, which means that whenever a so-called unforeseeable event was within the matrix of risks undertaken by a party.

Analysis of recent arbitration awards

This last assessment has been particularly examined by arbitrators in Brazil. In a dispute arbitrated before the ICC, and conducted under its Arbitration Rules, a claim of a fortuitous and unforeseeable event was dismissed for this very reason. The arbitration award was rendered in September 2020, pursuant to Brazilian law, which was applicable to the underlying contract.

The claimant commenced the arbitration to rule out contractual penalties imposed by the respondents due to the breach of its obligations within an agreement for the construction of highways. According to the claimant, a financial crisis that took over Brazil after the execution of the agreement – the alleged unforeseeable event – would have hampered it from obtaining funding with banks, thus preventing the performance of its obligations. For this reason, the claimant invoked a contractual provision that exempted parties from liabilities in case of force majeure.

In response, the defendants argued that the claimant undertook the risk of not obtaining a funding by means of the agreement, since the claimant declared itself to be in a financial condition to perform its obligations.

In dismissing the claimant’s request, the arbitral tribunal first considered the matrix of risks arranged by the parties. In this regard, it was reckoned that the claimant fully accepted the risk of not obtaining a financing, since (i) there was an express clause to that effect in the agreement, (ii) the main agreement and the financing agreement were completely independent of each other, and (iii) as a general rule, a contractual risk lies with the party that is more capable of controlling it. Since the claimant undertook the risk of the event that led to its breaching of the contract, the arbitral tribunal ruled that the risk allocation defined by the parties should be respected and observed.

Furthermore, the arbitral tribunal noted that the alleged unforeseeable event (ie, the economic crisis) did not have a direct impact on the agreement, as it was not the true cause of the claimant’s inability to obtain financing. Rather, the claimant’s own circumstances – such as its involvement with corruption schemes and the filing of a judicial recovery proceeding – would have impeded such financing. Because the absence of fault is of the essence of force majeure, the institution could not be applied to this case.

In any event, the arbitral tribunal also pointed out that the parties disputed whether the economic crisis began after the agreement was executed – as stated by the claimant – or in concomitance with it – as alleged by the defendants. Although provided with multiple opportunities to produce evidence of the outbreak of the crisis, the claimant failed to do so, which added to the reasons for the claim being dismissed. Even if that were not the case, the arbitral tribunal concluded, Brazilian scholars and jurisprudence have, as a rule, rejected the framing of economic crises as extraordinary or unpredictable events, except for specific cases.

In another ICC arbitration, ruled on in 2017, a construction company sought the economic rebalancing of an agreement entered into with the public administration. Among other arguments, the claimant alleged that substantial increases in rainfall rates would have delayed its works, increasing the costs incurred with labour and equipment maintenance.

As for legal grounds, the claimant argued that rainfall would not constitute an event of force majeure, but rather a predictable event with unforeseeable results. In view of this, and considering that the agreement was governed by Brazilian law, the claimant contended for application of Article 65, II, d of the Brazilian Bidding Law (Law No 8.666/1993), which provides that contracts with the public administration may be revised “to re-establish the relationship that the parties initially agreed upon [...] of consequences deemed incalculable or that delay or impede the performance of the agreement”.

On the other hand, the public administration agreed that the rainfall levels referred to by the claimant exceeded historical standards, but reasoned that such events would rather characterise force majeure. As such, neither events, nor their consequences would be subject to any indemnification from the parties, under the terms of the agreement.

To support its claims, the defendants pointed out that the concept of force majeure is contractually defined as: “Any event beyond the control of the Employer or Contractor, as the case may be, and which is unavoidable despite the care taken by the affected Party, and shall include, without limitation, the following: [...] floods and inundations”. Further, clause 37.5 of the Agreement established that “no delay or failure to perform by either party to the Contract caused by the occurrence of any Force Majeure event shall: [...] give rise to any claim for damages or for costs or expenses additional costs caused as a result”. Therefore, the agreement and the allocation of risks arranged by the parties should prevail over the Bidding Law, used as the legal basis of the claimant’s request.

Faced with these arguments, the arbitral tribunal deemed undisputed the fact that certain periods included within the performance of the agreement presented unpredictable rainfall rates. Moreover, although the agreement did frame such events as causes of force majeure, it also established that the application of such institution to the benefit of a party would require that such party notified the other, within 14 days – which did not happen in this case. Thus, as the contractual rules drawn were not followed, it would be impossible to classify the effects of rain as a result of force majeure.

Nonetheless, the mere fact that “floods and inundations” were explicitly governed by the agreement prevented their framing as unforeseeable supervening events. In addition, the claimant failed to prove that, although glimpsed by the parties, the rainfall had had unpredictable impacts on the object of the agreement, which prevented the application of Article 65, II, d of the Bidding Law. For these reasons, the arbitral tribunal dismissed the request for economic rebalancing of the agreement based on the unpredictability theory.

The awards examined are in line with the legal articles mentioned above and the principles of Brazilian law applicable to contractual relationships, namely pacta sunt servanda and the good faith. In both cases, the claims for intervention over the contract’s obligations were dismissed as they were contrary to the allocation of risks established by the parties, whilst the events supposedly causing an imbalance were not truly unpredictable, nor did they have a direct impact on the contractual relation.

Judicial precedents

Judicial courts’ decisions tend to be similar to those rendered in arbitration. After the outbreak of COVID-19, many of the lawsuits filed before courts referred to the pandemic generically, failing to indicate its specific effects in underlying contracts, in unjustifiable attempts to evoke the concept of force majeure or the unpredictability and excessive burdensomeness doctrines.

Although some Brazilian courts tended to be more flexible at first, granting interim relief at the beginning of the pandemic, decisions gradually shifted in a direction more similar to the arbitration awards examined above. In this regard, a particularly relevant effect of the pandemic on the country’s legal system was reconfirming that the financial condition of a party is not relevant to assess an imbalance in the contract – especially when the unforeseeable event affects both parties, as was the case of the pandemic.

In one of the leading cases, the Superior Court of Justice settled that “the review of contracts due to the pandemic is not a logical or automatic consequence, and the nature of the contract and the conduct of the parties must be analysed – both in the material and in the procedural sphere – especially when the supervening and unpredictable event is not in the domain of the economic activity of the parties”.

In another proceeding, the Superior Court of Justice held that “the principles of social function and contractual good faith must be weighed in these cases with special rigour in order to clearly delimit the hypotheses in which onerousness stands out as a structural factor of the contract – a condition that must be rebalanced both by courts and the parties involved – and those that show a moderate burden or even a situation of opportunism for one of the parties”. The State Courts of Appeals of Sao Paulo, Rio de Janeiro and Distrito Federal, among others, all have similar jurisprudence.

Overall, even after COVID-19, courts sustained that judicial intervention over contracts must be exceptional and restricted to cases of immediate effects over the balance of the contract. Otherwise, contracts shall be performed in accord with the parties’ declared intents.

Duty to renegotiate

In cases like the ones mentioned in this article, a common debate concerns the existence (or lack thereof) of a duty to renegotiate contractual conditions in the face of disturbances caused by unforeseeable events. The matter is still controversial among scholars, as only part of them argue that the dogmatic construction of such duty, under Brazilian law, would be possible.

According to these scholars, Brazilian legislation would be too retrograde and formalist in not expressly imposing the duty to renegotiate, to the detriment of new contractual principles, such as that of good faith and social solidarity. Thus, such duty should be enforced by means of Article 422 of the BCC (“The contracting parties are bound to observe the principles of probity and good faith in entering into the contract and its performance”) and with inspiration from the principles of European contract law. In practical terms, these scholars maintain that an attempt at renegotiation should be sought before the filing of a judicial claim by the injured party (a “best efforts obligation”).

Nevertheless, most Brazilian authors are against the possibility of dogmatic deduction of a legal obligation to renegotiate. Overall, they argue that the principles of probity and good faith set forth in Article 422 of the BCC should assure the performance and not the changing of contracts. In addition, reference is made to provisions included in the BCC by the Economic Freedom Law (Law 13.874/19), particularly those of the sole paragraph of Article 421 and Article 421-III, by which the principle of contractual autonomy was strengthened, with an equivalent decrease in the possibility of judicial interference.