Loans affected by the epidemic
In the new economic reality, businesses that took out loans may be asking themselves many questions. Will existing loans still be paid out? Will an expiring credit line be extended? And will the state of epidemic justify not repaying debt already incurred?
COVID-19 and the related restrictions introduced overnight by country after country have shifted businesses into a new reality. Among the challenges is ensuring the continuity of bank financing and the capacity to repay existing debt.
Will existing loans still be paid out?
Disbursement of the facility depends on a number of conditions, and the COVID-19 epidemic could directly impact two types of conditions:
- The absence of circumstances that would justify the lender’s termination of the facility agreement (no events of default)
- Documentary conditions for utilisation, requiring the borrower to present specified documents to the bank.
Facility agreements normally provide that one of the conditions for availability of each type of loan is a lack of an event of default or a default (the latter being a situation that could become an event of default if not cured within the time allowed by the facility agreement). This should be borne in mind, as borrowers often associate an event of default only with grounds to terminate or accelerate repayment of the loan, but an event of default is also relevant for drawdown, the interest rate, or other specific rights of the lender.
The outbreak of an epidemic may result in occurrence of various events of default described in a facility agreement. To ensure that the loan will still be paid out, it is particularly relevant to examine the provisions of the agreement governing events of default involving:
- Lack of payment required by the agreement (e.g. when due to the epidemic the borrower fails to pay an instalment or interest)
- Breach of financial covenants (e.g. due to a decline in revenue)
- Cross default
- Suspension or restriction of operations (e.g. in sectors such as tourism, hotels, or shopping malls)
- Expropriation (typically this provision is broad, covering all governmental actions preventing or significantly limiting the borrower’s operations)
- Existence of a material adverse change (MAC).
An event of default involving the MAC clause plays a special role in this list. This clause involves an actual or potential event of default that may have a materially adverse impact on certain issues, such as the capacity of the borrower (or sometimes the borrower’s entire group) to perform its obligations under financing documents, but also on its business, operations, assets, financial situation, or even prospects. Significantly, MAC refers to any events that have or may have a certain result, but does not specify what those events are. For banks this provision acts as a sort of escape valve allowing them to withdraw from financing if the event impacts the financing but is not covered by other provisions of the agreement.
MAC clauses are fiercely negotiated, and thus the scope of the clause may vary widely, from a narrow clause more friendly to the borrower, to a broader clause advantageous to the lender. The broader the MAC clause, the greater the likelihood that the existing epidemic will meet the conditions for application of the clause even before any actual problems arise on the part of the borrower. On the other hand, as the MAC clause is a safety salve for lenders, in the absence of additional breaches, banks have been hesitant in the past to rely on this clause alone, particularly as whether it is applicable in the given situation can be interpreted in different ways. In this context, it should be pointed out that in an extreme case it might be argued that exercise of the MAC clause by the lender to refuse to disburse the loan could constitute abuse of a subjective right and thus be open to challenge by the borrower.
Financing agreements also contain a cross-default clause, providing that the terms of financing are deemed breached if the borrower breaches the terms of other financing. Thus even if one agreement does not include provisions directly tied to the occurrence of an epidemic, this does not guarantee that the loan will be disbursed. The borrower’s overall commitments need to be examined holistically.
Documentary conditions for disbursement of loan
Disbursement of loans may also be blocked by certain documentary conditions precedent, in particular for unreleased tranches of term loans. This applies to any documents subject to assessment by the bank, depicting the current or future situation of the borrower or projects implemented by the borrower, which could reveal a current or potential impact of the epidemic on the project (such as the timetable of work, advisers’ reports, and financial models). For example, a report by the bank’s oversight inspector verifying the timetable for completion of a construction project might indicate that the timetable is unrealistic because in the current epidemiological situation construction materials cannot be obtained. Another example is a situation where the bank finds that the financial model presented by the borrower is unreliable because for the next few months there will be much lower sales of its products (such as aircraft).
In short, although loan agreements rarely contain provisions expressly concerning epidemics, the epidemic’s impact on the situation of the borrower may be covered by other provisions. Only a careful analysis of all provisions will determine whether the funding will be disbursed under the given circumstances.
Will a revolving facility be extended?
Borrowers whose revolving facility has just expired or is about to expire find themselves in an even harder situation. The Polish Bank Association (ZBP) and the government emphasise the need to extend revolving credit facilities, but the changes to the law allowing calculation of creditworthiness as of the end of 2019 will only concern SMEs. Therefore it is not known to what extent banks’ revised policies in this area will also apply to larger companies.
What about repayment of loans?
The epidemic is greatly worsening the financial situation of some entities. In the case of loans already paid out to borrowers, the question being asked by both lenders and borrowers is whether it is lawful to rely on the epidemic to justify failure to repay loans.
From a legal point of view, this requires an analysis of issues such as force majeure, impossibility of performance, and extraordinary change in circumstances.
Force majeure is understood to mean an unforeseeable external event whose effects cannot be prevented. Force majeure is not regulated in detail in the Civil Code, but its impact on the obligations of parties to a contract typically results from inclusion in the contract of detailed provisions on force majeure.
Facility agreements usually do not contain provisions releasing the borrower from the obligation of repayment due to the occurrence of force majeure. Neither do any regulations of law provide borrowers such grounds. A defence relying on force majeure will therefore not apply in the case of facility agreements.
In fact, we should add, in facility agreements the notion of force majeure is more likely to arise in the form of negative consequences for the borrower. For example:
- A separate event of default connected to the occurrence of force majeure or the effects thereof under contracts concluded by the borrower with third parties (e.g. contractors for a given project)
- Exclusion of the bank’s liability for damages resulting from the overall lack of operations due to force majeure.
Impossibility of performance
In the case of many contracts, occurrence of an epidemic may result in impossibility of performance (for example, a ban on public events would prevent the staging of a concert). In such instances, the question arises whether the party to an obligation can refrain from performing by asserting that performance is impossible. In the case of borrowers (e.g. in the business of organising public events), it might seem logical to argue that since they cannot lawfully earn money to repay the loans, the repayment itself is impossible. But in the case of monetary obligations, such as repayment of loans, these regulations do not apply, as under the long-established legal view, a lack of funds for repayment is not regarded as impossibility of performance.
Extraordinary change in circumstances
The principle that contracts must be performed is not an absolute rule. The law provides for departures from this rule. One is Civil Code Art. 3571 (known as the clause on extraordinary change in circumstances). This clause authorises the court to modify certain contractual provisions, or even dissolve the contract, if due to an extraordinary change in circumstances performance would entail excessive difficulty or expose a party to a glaring loss which the parties did not anticipate when concluding the contract. Unlike in the cases discussed above, this provision can play an important role in determining whether loans paid out must be repaid, and if so when. This is because it may be assumed that situations will arise where an epidemic and the related limitations—particularly when their effects exert a great and long-lasting impact on the borrower—may be regarded as an extraordinary change in circumstances.
The use of this provision will require the borrower to demonstrate a number of conditions. In particular, the facility agreement should have been concluded before the epidemic became common knowledge (i.e., a facility agreement concluded in 2020, when the possible consequences were already known, will be less susceptible to application of this provision than an agreement concluded for example in 2017). Additionally, the borrower must show excessive difficulty or a glaring loss connected with repayment of the loan, and that it is connected with the epidemic. Moreover, the courts are not inclined to give protection to parties who delay in coming forward, and thus an extraordinary change in circumstances should be asserted before falling into arrears in payment of instalments and interest, by promptly filing a statement of claim.
But time is the most important element when analysing the possibility of applying this provision. The borrower will not obtain the potential benefit of the change (e.g. postponing or reducing the obligation) until after the court issues a ruling, and the borrower cannot stop paying before that by relying on Civil Code Art. 3571. In certain situations, it is possible to consider seeking interim relief to secure a claim under this provision, so that the court orders for example an injunction against pursuing execution. Without such security, until the court issues its judgment the parties will be fully bound by their existing facility agreement.
It should also be pointed out that the application of Civil Code Art. 3571 can be modified or excluded by agreement of the parties. It may be considered whether inclusion in the facility agreement of a clause treating a material adverse change as an event of default, as discussed above, may be treated as expressing the parties’ intent to allocate the risk differently than in the Civil Code, thus excluding application of the regulation on extraordinary change in circumstances. In our opinion, such an argument should be approached cautiously, bearing in mind the exceptional nature of this hardship provision in the Civil Code, particularly when applied to an epidemic, as in the absence of an express exclusion, the intent of the parties to eliminate this special method of protecting the borrower would have to be inferred through interpretation.
The foregoing shows that despite exceptional circumstances borrowers should first follow the beaten path and take up discussions as soon as possible with their lenders if they experience or anticipate problems with liquidity caused by the epidemic. According to the Polish Bank Association, many banks have introduced, or are in the process of introducing, the possibility to file a free and simplified application for a repayment holiday (a grace period in repayments of three to six months). Nonetheless, according to the information we have received, these measures are focused on SMEs. Banks may take a more demanding approach to larger enterprises, particularly if they are backed by financially strong sponsors the borrowers could look to for support. Businesses already directly affected by the epidemic, such as tourism, transport and shopping malls (the last particularly due to planned statutory rent reductions) will also have a different risk profile. In such situations, the only solution may be thorough financial restructuring or even opening of formal judicial proceedings.
The situation is highly dynamic and uncertain, but it is worthwhile now, with refreshed knowledge of the contents of the borrower’s own facility agreement, to identify potential risks connected with external financing. If the situation requires, the borrower should begin discussions with the bank as soon as possible.
Artur Bednarski, adwokat, Patrycja Polasz, adwokat, solicitor (England & Wales, currently not practising) Banking & Project Finance practice, Wardyński & Partners