COVID-19 is having a profound effect on the financial performance of many businesses.
In response, the Australian Bankers Association announced a business relief package which is available to business customers of participating banks that have total business loan facilities of up to $10 million and have advised their Bank that their business is affected by COVID-19. Assistance will come in a variety of forms for customers with participating banks conceptually agreeing to:
- the deferral of loan repayments for six months for businesses who need assistance because of COVID-19;
- waiver of fees, restructuring of loans, and provision of further credit to help businesses survive the COVID-19 pandemic; and
- not enforce business loans for non-financial breaches of the loan contract (such as changes in valuations) for a period of six months.
In addition, Banks are also offering loans, including overdrafts, with no repayments for the first six months, at very low interest rates, supported by the Government, through an SME loan guarantee pursuant to the Guarantee of Lending to Small and Medium Enterprises (Coronavirus Economic Response Package) Act 2020. This is of course subject to certain lending criteria. The Government announced this scheme would initially be intended to support loans to SME’s by eligible lenders which:
- are for a maximum commitment of $250,000 per borrower;
- would be up to 3 years in term, with an initial 6 month repayment holiday; and
- would be in the form of unsecured finance.
Clearly, participating Banks are providing a supportive and flexible approach. However, noting that:
- the announced measures do not all have the same effect;
- the measures do not apply to business loan facilities of over $10million; and
- there are numerous other financiers who may not be participating Banks under the announced business relief package,
it is helpful for both financiers and their customers to:
- consider the impact of various financing covenants which may need to be deferred, amended or waived; and
- understand the distinction between the deferral, waiver, amendment or forbearance of financing covenants.
Covenants for consideration
It is obvious that many customers will need to defer payment obligations during the course of the COVID-19 pandemic. As loans are reviewed, other provisions of financing arrangements also need to be considered. They include:
1. Utilisation of facilities which are not fully drawn
It may be tempting for business customers to draw down on undrawn facility commitments to bolster cash reserves. It should be noted however that subsequent utilisations of facilities are commonly conditioned on there being no subsisting misrepresentation or default at the time of utilisation and that no default will likely ensue as a result of such utilisation. In addition, many facilities provide for representations to be repeated throughout the life of the facilities. Further utilisation of facilities may increase the prospect of default in these circumstances and thought should be given by customers as to whether they should seek their financier’s agreement to the amendment, deferral or waiver of such conditions.
2. Material adverse change
Many facilities contain a representation by the customer during the facility that there has been no material adverse change and provide that it is a default if a material adverse change has occurred. The operation of these clauses is very much a question of the language used. Commonly, a material adverse change will be assessed against the financial condition of the customer’s business and the customer’s ability to perform their obligations under the relevant finance documents. Measuring the performance of the customer against such obligations will inherently be more difficult than assessing the performance of the many other obligations under the finance arrangements (e.g. whether the customer provided financial statements by the date required). Financiers and customers should consider if it is sensible to suspend the operation of such material adverse change covenants during any period in which the financier supports its customer through the COVID-19 pandemic. There may of course still be valid and important reasons from the financier’s perspective to retain such clauses.
3. Financial covenants and valuations
Business loans often require the customer to adhere to various financial covenants. These include maintaining a certain loan to valuation ratio in terms of security provided, ensuring a certain level of earnings to cover interest and/or debt commitments and gearing commitments. The COVID-19 pandemic may significantly impact the ability of a customer to comply with such covenants. Asset values and earnings may drop significantly making compliance with these covenants problematic. Performance of these covenants may need to be suspended, deferred or amended where financiers are supporting their customers. It may also make sense to defer any obligations which require assets to be revalued as the delivery of valuations will trigger measurement of some of these covenants.
4. Carrying on business
Business finance agreements typically require customers to carry on their business in the ordinary course and it is a default if they fail to do so. Clearly, many businesses have already ceased business as a result of government imposed restrictions. For those businesses that are continuing, the coronavirus has altered the way in which business is conducted. By way of example, restaurants and cafes have adapted to offer take away options only. Many businesses (including in the education and professional services sector) operate online and may continue to do so for a considerable period. Certainly, many businesses have been materially disrupted by the onset of the COVID-19 pandemic and these traditional covenants may carry less relevance in the current environment for certain customers.
5. Performance of key contracts
It is common with business finance arrangements that borrowers are required to diligently perform key business contracts and ensure they are not terminated without financier consent. Key business contracts are generally identified as those contracts which are important to ensuring the borrower can meet repayment obligations and maintain the value of its business. These covenants may become problematic as a result of the COVID-19 pandemic.
It may be the case that the relevant key contract contains a force majeure clause whereby the contracting parties have agreed that the occurrence of an event (such as an act of god or pandemic) should excuse a party from its obligation to perform the contract. Even if a contract does not contain such a clause, the legal principle of frustration may apply. The law recognises that, without default of either party, a contractual obligation may have become incapable of being performed because the circumstances in which performance is called for is something radically different from that which was contemplated by the contract. A frustrated contract is automatically terminated. Therefore, financiers and customers need to assess the extent to which key contract covenants need to be amended.
There are without doubt a number of other covenants in each finance arrangement which will need to be considered. Having identified covenants for which performance has become problematic, the financier and customer need to assess how they might be addressed.
Deferral, variation, forbearance and waiver
Deferral is often the first option to be chosen by financiers and their customers, particularly where the financier and customer need to deal with an immediate issue. Deferral of obligations allows finance parties time to determine if amended terms can be agreed for the continuation of business finance arrangements. Where an obligation is deferred, the time for performance of an obligation is deferred to a later date although the obligation to perform that obligation must still be performed by that later date. Deferral of an obligation may be effected by way of variation. Deferring an obligation under a financing arrangement will likely mean that the performance of the relevant obligation will still need to be considered further. For example, where interest continues to accrue, and particularly where it is compounded or capitalised, it is possible that the customer will not be able to meet the deferred obligation at that later date on the same basis. A variation of the deferred obligation may be required.
Most finance arrangements will require a variation to be effected in writing as an express term of the original financing. A variation must be the subject of agreement between the parties. A unilateral variation will not be binding. However, writing is not required:
- for an alteration in how a contract is to be performed;
- to make an election between rights arising in respect of the contract (e.g. whether to affirm or terminate the contract following breach by the other party); or
- for a party to be estopped from exercising rights or remedies arising in respect of the contract,
as the original terms of the contract are unchanged.
Waiver is to be distinguished from variation. Waiver does not require an agreement between the financier and the customer. Waiver does not require consideration. Waiver is generally to be considered to be effected in one of two ways:
- Election: Where a party to a contract is entitled to terminate the contract on account of the other party’s breach of contract, and the law does not require that the party terminate, the party may instead prefer to affirm the obligation to perform the contract, and actually perform or call on the other party to perform. In other words, by making that election the innocent party has waived the right to terminate the contract; or
- Estoppel: Where one party has engaged in conduct which makes it unfair, inequitable or unconscionable for the party to insist on performance of a particular obligation or otherwise continue to assert a right in respect of the obligation that has been waived.
It is possible that a customer may still be liable for damages for breach of a finance covenant, even when the financier has waived that breach and elected not to terminate the financing arrangement. It is commonly an express term of the finance documentation that a waiver be effected in writing, and it is desirable from the perspective of both the financier and customer to enter into a written waiver where possible to clarify whether the waiver operates in respect of a right only or whether it also operates to preclude other contractual remedies.
Forbearance may be used to deal with a default or likely default, and should be distinguished from a release. A forbearance to take action may well amount to no more than a postponement from taking action without a release. A forbearance from taking action may be used to maintain the status quo for the remainder of the term of the finance facility. It may also be used as a basis for obtaining additional enforceable collateral or additional obligations (for example, a financier may forbear from enforcing its rights for a period of one month while the customer procures additional security to be given for its obligations). Forbearance from taking action will commonly be used by financiers where they seek to reserve their ability to exercise rights in respect of a particular breach at a later point in time. Forbearance is commonly documented by way of a deed.
Ultimately, the approach taken in dealing with problematic finance covenants will depend on the intention of the parties and the circumstances of each case. In some instances, a waiver may be desired and agreed (for example, the payment of a particular fee). In others, a forbearance may be appropriate while the customer addresses the particular breach (for example, a breach arising from default of the customer not related to the pandemic such as granting other security in the customer’s assets).
For further information, please contact:
David Murray-Nobbs | Partner | +61 2 9225 2714 | firstname.lastname@example.org
Jonathan Grunstein | Special Counsel | +61 2 9225 2621 | email@example.com
or a member of our national Banking and Finance team.