Impact of the COVID-19 Outbreak in Financing Agreements

13 March 2020

As the magnitude and effects of the recently declared coronavirus pandemic are escalating to an unprecedented level, the business and banking industry will most likely be confronted with various challenges.

As several industries have already been affected in a short period of time since the COVID-19 outbreak, this will impact, sooner rather than later, the companies’ ability to maintain a steady cash flow, a decent profit margin and, in the end, their capability to duly perform and comply with the obligations under their financing agreements.

Thus, both creditors and borrowers have to prepare for a worst-case scenario and properly understand what are the commitments and undertakings expected of them in the event of a pandemic, as well as for a significant financial impact due to a potential economic slowdown.

Please see below a selection of aspects to be considered amid the recent development of events.

1. Failure to perform contractual obligations due to extraordinary events

1.1. General considerations

One of the expected scenarios in the current circumstances is the expected non-performance of the borrowers’ obligations under the financing agreements.

The Romanian legislation provides several situations in which a contracting party is relieved, under certain circumstances, from performing its contractual obligations, leading either to temporary postponement of the relevant obligations or to a termination without fault of the agreement. Most commonly available options for the borrowers include: (i) force majeure (Romanian: “forta majora”); (ii) fortuitous events (Romanian: “caz fortuit”); and (iii) hardship (Romanian: “impreviziune”).

●Force majeure is an event that prevents a party from performing its obligations under an agreement. In case of agreements where the performance of obligations is continuous (as is the case for facility agreements), successfully invoking the force majeure will lead to the temporary postponement of the specific obligations that can no longer be performed.

●Force majeure bears similarities with the fortuitous case, both as regards the conditions that have to be met in order to qualify an event a fortuitous case or force majeure, and with respect to the effects of successfully relying on such event (i.e., temporary postponement of obligations). As opposed to the force majeure event, where the assessment on whether the event can be removed is made by reference to the utmost level of diligence applicable to a certain case, when assessing the invincible and inevitable character of the fortuitous case, the assessment is made specifically from the perspective of the party relying on it.

●Hardship represents an exceptional event that alters the contractual balance between the rights and the obligations of the parties in such a way that the performance of one party’s obligations becomes extremely cumbersome. The options in case of hardship are negotiation with a view to adapting the agreement affected by it so as to re-establish the contractual balance or termination thereof.

1.2. Limited applicability of force majeure and hardship in relation to credit agreements

Can borrowers rely on legal or contractual provisions in case of their own non-performance of their contractual obligations?

As a general rule, the force majeure will not be applicable for obligations to provide generic goods (and money is considered a generic good – as opposed to specific or individualized goods). Thus, force majeure will not excuse the non-performance of a payment obligation under a financing agreement.

The facility agreements also generally include borrowers’ waiver of the right to rely on force majeure, fortuitous case or hardship to excuse the non-performance due to extraordinary circumstances. Such waiver will apply to other obligations that the corporate borrowers undertake under facility agreements – more details in the following sections.

Nevertheless, a case-by-case or category analysis is recommended, as the contractual arrangements may differ depending on whether the facility agreements are concluded on LMA standards or bank standards and on the age of such standards. The parties may also need to assess if there are any procedural requirements to allow reliance on force majeure, such as ascertaining certificates issued by the Chamber of Commerce (that recently announced that it is not in the position to issue such certificates).

1.3. Disruption events

While the borrower may not always rely on force majeure, fortuitous case or hardship, the facility agreements may include reference to a “disruption event” which can offer a very limited and temporary relief for the borrower breaching its payment obligations. However, disruption events are heavily restricted to certain specific and extraordinary measures, which would seem to go beyond an epidemic/ pandemic (such as complete failure of payment and communication systems). Given however the accelerated and unpredictable turn of events, one cannot completely rule out that the effects of the COVID-19 outbreak will later result in being qualified as disruption events. The definitions of disruption generally used imply that the unavailability of the payment and communication systems is for a very limited period (a few days).

2. Legal moratorium or temporary contractual relief

While it is unlikely that the borrowers’ temporary relief of their contractual obligations will result, on the short term, from the applicable legal or contractual provisions (especially in case of corporate clients), there is a probability that this will result from governmental measures.

Thus, the competent legislative bodies may establish a legal moratory, as was the case of Italy, where payments under mortgage agreements were legally suspended. Such measures are rather extreme and would likely depend on other actions taken by the state to limit the spread of the COVID-19 epidemic, such as a mandatory “stay-at-home” order or a mandatory order to temporary close certain sectors, which will affect the employment terms.

With or without such measures taken by the Romanian authorities, one may expect that there may be spill-over effects from measures imposed in other states (e.g., Italy, China etc), that will limit the circulation throughout the supply chain and will impact Romanian companies and their employees. Banks may need to consider distress scenarios regarding exposed sectors and assess their options that may range from implementing unilateral or contractual grace periods to seeing a spike in non-performing loans.

3. Material adverse effect

Facility agreements commonly include material adverse effect clauses. These usually appear as repeating representations and warranties and/ or as triggers for events of default.

Material adverse effect clauses allow banks to unilaterally determine whether an adverse change has occurred in the borrower’s circumstances with respect to: (i) the borrower’s ability to perform its obligations under the finance documents, (ii) the validity and enforceability of the finance and security documents; (iii) business, operations, property, financial condition or prospects of the borrower and (iv) the ownership, condition, use or operation of its property.

Each borrower should assess whether the COVID-19 outbreak will impact its business to the extent that a material adverse effect clause could become applicable and trigger the termination of the facility. However, usually material adverse effect clauses are often negotiated and may be worded in broader or narrower terms depending on the contractual wording included in the facility agreement. Therefore, a specific analysis should be performed on a case-by-case basis by reference to the borrower’s actual or potential economic impact of the COVID-19 outbreak. In some cases, the occurrence of a material adverse effect is appreciated in the sole discretion of the lender or agent, while in other facilities is needs to be proved on the basis of a more objective test.

The lenders would need to assess on a case by case basis (or, in the event of less negotiated facility agreements, by category / standards and in conjunction with the relevant activity sector) if the changes to the borrower’s situation or ability are for the short term or the impact would be manifested on the longer term and in each case if such changes amount to a material adverse effect.

4. Events of default

Other than monitoring the borrowers’ compliance with their payment obligations under the financing agreements, the lenders also monitor the observance of other obligations under the financing agreements. This may prove useful as they can serve as an indicator of a potential future lack of funds of the borrower.

4.1. Financial covenants

“Covenant-lite” credit facilities are not as common in Romania as in the U.S. and the Western Europe. Financing agreements frequently include borrowers’ obligations to maintain certain financial indicators at an adequate level and a dip in earnings will impact cash flow and the ability to repay, or to finance operating expenditure or approved and needed capital expenditure.

Usually the financial covenants are assessed periodically (quarterly to yearly), on the basis of financial statements or balance accounts, which means that the dip will be effectively seen later during the year or even beyond 2020.

Borrowers need to consider their short-term business strategies and implementing measures in order to maintain a steady cash flow, such as delaying dividend distributions or substantial asset acquisitions, overdrafts, costs reductions, thus ensuring that financial covenants are not breached. It is also advisable to examine proactively their loan documentation and situation and approach banks with appropriate plans, in the event a covenant might be breached.

The financial and information covenants are among the most negotiated clauses in a facility agreement and close attention should be paid to definitions and other provisions. A general plan might not work for every borrower, so it is expected that certain adjustments might need to be negotiated on a case by case basis.

4.2. Business interruption

Business interruption can negatively impact the borrower’s ability to perform the facility agreement and can be included by the parties as a separate event of default or it could be directly linked to the impact of the financial covenants or causing an adverse material effect.

Business interruption may sometimes be covered in facility agreements by way of an insurance policy aimed at covering this specific risk, the proceeds of which being subsequently assigned to the benefit of the lender. Borrowers should analyse the specific conditions of the insurance policy in order to determine whether it covers epidemics/ pandemics.

4.3. Cross default

Facility agreements frequently include cross default clauses, linking the termination of the credit facility to other agreements or the commencement of enforcement/ insolvency procedures by other creditors. Therefore, the borrowers should be careful not only to preserve the viability of the facility agreement, but also of other contracts in order to avoid triggering a cross default clause due to the COVID-19 pandemic.

4.4. Breach of borrowers’ representations and warranties

The accuracy and validity of the borrower’s representations and warranties under the facility agreement should be of course monitored throughout the term of the agreement.

Moreover, considering that the business activity of a borrower is the sum of the contractual relationships entered into by the former, specific attention should be granted to borrower’s relation with third party contractors and the representations and warranties related to them (especially those regarding disputes and no default). The deterioration of these relationships could anticipate a future breach by the borrower of its obligations under the facility agreements.

While in case of loss of a major supplier or an anchor tenant the effects over the facility agreement are easily foreseeable, financial institutions should also monitor borrowers’ relationships with other contracting parties, which, at first glance would not meet a materiality threshold but could result in a significant impact depending on the specific circumstances, such as the number of affected contracts.

Amid the uncertainty surrounding the COVID-19 pandemic, authorities, borrowers and lenders alike must prepare to face an unprecedented situation caused by the pandemic situation and come together in order to adapt and surpass any financial impasse.

Moreover, as the current focus appears to be concentrated over short-term solutions and impact of the COVID-19 outbreak, the long-term effects over the economic context and credit performance should be also factored-in. With no indications regarding the magnitude and length of the current situation, its ripple effects can only be assessed in abstract at this moment.