The impact of COVID-19 virus on financing transactions has come into focus given the effect of the virus on the world's economy.
Most financial commentators are predicting worsening economic conditions worldwide until there is a slowing of the infection rate or the development of an effective vaccine.
While the travel and airline industries are being directly affected, manufacturing, retail and other industries relying on supply chains from and to China are also feeling the tension.
With the volatility in world markets impacting on finance transactions, we look at certain key aspects of existing and future finance transactions under English and Australian law which we are discussing with clients. Importantly, we put forward some practical suggestions to consider when structuring a finance transaction.
Key aspects considered
Material Adverse Change/Effect
Many financial contracts such as loans, leases, underwriting agreements, secondary trading contracts contain a Material Adverse Change (MAC) or Material Adverse Effect (MAE) clause. A MAC/MAE clause can:
- be invoked to allow a financier not to provide initial or ongoing funding if it is a condition precedent to the funding by a financier;
- cause a breach of representation which could lead to an event of default – for example, if a counterparty represents to a financier that there has been no MAC/MAE since the date of the latest financial information provided to the financier; and
- cause a direct event of default if a MAC/MAE is an event of default itself.
Whilst many MAC/MAE clauses are negotiated, the standard definition of MAC/MAE used in the Asia Pacific Loan Markets Association is a useful reference point. The definition contains three limbs being an event or circumstance which is material adverse effect on:
- First limb - the business, operations, property, condition (financial or otherwise) or prospects of the counterparty corporate group taken as a whole;
- Second Limb - the ability of a counterparty to perform its obligations under the [Finance Documents]; or
- Third Limb - the validity or enforceability of, or the rights or remedies of a finance party under, the Finance Documents including security documents or impacts on the value of the secured property.
The first limb will be most concerning for counterparties if sales and earnings retract. Businesses impacted directly by COVID-19 and the economic downturn such as that in the travel industry may also expose parties to the second limb of the definition. The third limb would be unlikely to be invoked in the current circumstance.
The courts have considered few cases on MAC/MAE clauses and the Australian and English courts take a slightly different approach. What is certain from the cases is that financiers will need to determine a MAC/MAE has occurred with reference to existing circumstances at the time if a MAC/MAE is called, that is a financier cannot look forward to pending or worsening business or financial conditions that impact on a counterparty and cannot act pre-emptively.
Force Majeure and financing of assets/supply contracts
When a financing transaction involves the construction, supply and/or leasing of assets the underlying contracts subject of the finance transaction may contain an "Excusable Delay" or "Force Majeure" clause. The purpose of the clause is to allow the parties time to complete the contract or, if that is not achievable, to terminate the contract.
The inclusion of an "Excusable Delay" or "Force Majeure" clause in a contract may impact financing transactions where a financier is:
- financing an asset under construction, generally in long term financing transactions; and / or
- looking to the receivables payable under a supply contract to repay a financing.
Considerations of the terms of an "Excusable Delay" or "Force Majeure" clause are in sharp focus in asset finance and project finance transactions. For example, where a financier funds a counterparty for the progressive payments relating to the construction or supply of an asset, the financier will generally take security over the underlying contract. These contracts usually relate to large scale equipment with long lead times. With supply chains being threatened and the manufacturing industries facing a retracted labour force due to quarantine restrictions any delay could impact on the value of the security over such contract. Financiers should review existing contracts to assess the position and complete extensive due diligence on future contracts.
As an example, assume that a financier lends to an airline customer funds to pay pre-delivery payments for an aircraft and takes security over the purchase contract with the manufacturer, with the expectation that the pre-delivery financing will be refinanced on the final delivery of the aircraft. Generally, if there is a default then the financier can enforce the security, exercise the airline's rights under the purchase contract and fund the construction of the aircraft to completion so it has a viable asset to sell to recoup the loan. Let us assume the underlying contact which the financier is funding contains a Force Majeure clause in the following form:
"Manufacturer shall not be liable to airline nor shall it be in default for any failure or delay in carrying out any of its obligations under this contract including but not limited to its obligation to deliver any equipment on its scheduled delivery date, due to causes not within seller's reasonable control including, but not limited to, acts of God or of the public enemy; war; warlike operations; insurrections or riots; fires, floods, or explosions; earthquakes; epidemics or quarantine restrictions; strikes or other government recognised labour troubles; loss of, damage to, destruction of or accident involving the equipment prior to delivery; serious accidents (except loss, damages, destructions and accidents caused by the negligent acts, omissions or wilful misconduct of manufacturer); or any other cause beyond manufacturer's reasonable control or not occasioned by manufacture's fault or negligence, and any such failure, including failure by manufacturer due to airline's failure to comply with its obligations, shall be considered an "Excusable Delay".
In this case the clause clearly anticipates an excusable delay if supply chains or their workforce is restricted in manufacturing the Aircraft which could allow the manufacturer to invoke the clause. Depending on the credit of the airline the delay in the delivery of the Aircraft may not lead to a default in repayment of the loan. The operation of the clause does have the ability to devalue the security over the purchase contract and in the worst case render the security of little or no value if the purchase contract is terminated for excusable delay.
Also, financiers who purchase receivables under supply contracts from a supplier will need to be cognisant of any "Excusable Delay" or "Force Majeure" clause. This should not affect supply chain financings which are typically short dated and used as a working capital tool for suppliers. Long dated and high value supply or services contracts with credit-worthy buyers such as government entities and investment grade corporates are often traded in the market with the future cashflows being sold at an appropriate discount to give financiers the desired rate of return. The existence of an "Excusable Delay" or a "Force Majeure" clause has the potential effect of interrupting the cashflow due to a financier.
Whilst a delay or termination of contracts is a serious event in these circumstances, usual protections can be employed such as:
- having the parties to the contract agree not to terminate without giving prior notice to a financier or without the consent of the financier;
- allowing the financier to obtain key information and be involved in any discussion process; and / or
- in receivables transactions ensure minimum cashflows payable by the payer are not subject to abatement for any reason, commonly known as a "hell and high water" clause.
It should be noted that the ISDA 2002 Master Agreement contains a force majeure termination event which circumstances extend to parties not being able to make payments or delivery in respect of a transaction due to reasons beyond their control which would lead to a termination with the usual ISDA termination provisions applicable.
Frustration of Contracts
Also, the contractual law doctrine of "Frustration" may also have bearing on the parties' contractual position. Essentially "Frustration" arises where an event occurs, after contract formation, which is beyond the parties' control rendering it impossible to perform the contract or where the relevant obligation is transformed into a radically different obligation from what was contemplated at the time the contract was entered into. As Frustration can lead to a termination, the courts act within very struct parameters. If the event leads to more onerous obligations under the contract or a just a delay to perform the obligations, then a court will not invoke the doctrine of frustration.
For a more detailed look of Force Majeure clauses and the doctrine of Frustration under PRC, Hong Kong and English Laws – see https://www.kwm.com/en/uk/knowledge/insights/noval-coronavirus-covid19-force-majeure-and-frustration-20200220 and under Australian law – see https://www.kwm.com/en/au/knowledge/insights/the-frustrating-impact-of-the-coronavirus-20200226
Business Day and Payment Disruption
One aspect which has arisen which may require review in financing contracts is the definition of "Business Day". Simply, "Business Day" is defined to be a day (other than a Saturday and a Sunday) on which banks are open for general business in certain locations e.g. Beijing, Sydney and New York.
As authorities attempt to contain the spread of the COVID-19 virus by declaring extended public holidays, as was done in the PRC with Lunar New Year, payments systems and banking services will affect payments being made by counterparties. Whilst this may not put counterparties in default with payments to be made on a Business Day, the delay in payments may affect repayment to financier's funding sources which are generally to be made on the same day as receipt of payment from the counterparty.
For example if a payment is due to be made by a counterparty on a scheduled date which is anticipated to be a Business Day and that day is postponed then interest will generally accrue until the payment is made. If a financier's funding arrangement does not use the same definition of Business Day then a payment mismatch could result.
A "Business Day" if extended may also affect the timing of a draw down or funding, serving of notices and remedy periods for any breach of obligations.
Cessation of business covenants
Financing documentation often also contains an undertaking by the obligor not to cease carrying on business or to change its nature. Similarly, there may be events of default for a cessation of business. These impacts should also be reviewed when assessing the impact of measures to contain the virus on financing documentation.
With the potential worsening economic impact of COVID-19 affecting supply chains for manufacturing industries, downturn in the travel sector and lower consumer confidence revenue for businesses affected may drop sharply. Also asset values which are a component of a secured finance transaction may also come under pressure.
Financiers and counterparties will need to monitor financial covenants especially those which have earnings as a component like EBITDA and interest cover ratios. In cases where loan to security values ratios are a component of a finance transaction close monitoring of the value of assets will be required.
What should you do?
Financiers and/or counterparties as appropriate should consider the following actions:
- Assess their finance contracts for the potential impact of any MAC/MAE clause to see if it could lead to a draw stop or an event of default. If that is the case the parties should enter into discussions early on the impact to develop a regime to monitor the effect of COVID-19 on their business.
- Do not invoke a MAC/MAE on the basis business conditions will deteriorate in the future unless it is clear that the prospects of the business are materially and adversely affected, and the MAC clause is prescriptive in that respect If a decline in the financial position or business occurs for a counterparty occurs assess carefully the terms of any clause.
- Businesses relying on supply chains, especially from the PRC should look to the impact on sales revenue going forward.
- If a supply or an asset construction contract is a key feature on a finance transaction review any Excusable Delay or Force Majeure clause.
- Check your definitions of Business Day. If it refers to a city which could declare a non-business day through extension of holidays or due to quarantine restrictions, consider changing that definition.
- Review financial ratios and consider the effects in the medium term whilst COVID-19 impacts on the financial markets and perhaps look at a different regime for that period.
- Look at restructuring transactions and associated waivers and consents and allowing for extended repayment or repricing terms if the projected but reduced cashflow within business will alleviate counterparties going into a distressed position.
- For secured transactions consider the commercial value of security and do an audit of the validity or effectiveness in case of enforcement.
- For new transactions including any refinancing, all of these matters should be considered and discussed between financiers and counterparties with a view to potentially negotiating a balanced risk allocation between the parties.
At a broader level, parties should be alert to the risks of triggering a termination clause in terms of reputational damage and the potential exposure to damages if such clauses triggered are improperly, so the need for caution is essential.
 The authors would like to thank John Stumbles and Agnie Napieraj for their assistance in research and input for this article.
 See generally - Grupo Hotelero Urvasco SA v Carey Value Added SL & Anor , Cukurova Finance International Ltd & Anor v Alfa Telecom Turkey Ltd , Minumbra Lancewood Pty Ltd v AM Lancewood Investment Nominees Pty Limited  NSWSC 1929 and Vision Telecommunications Pty Ltd v Australian and New Zealand Banking Group Limited  WASC 139.
 See generally - Davis Contractors Ltd v Fareham Urban District Council  UKHL and Codelfa Construction Pty Ltd v State Rail Authority of NSW  HCA