COVID-19 and Facility Agreements

By Alexandra Clynes, an Associate at Harneys in the Banking and Finance Team in the Cayman Islands 

We are all aware of the worldwide personal, financial and economic impacts of COVID-19.  If not already, COVID-19 consequences will extend to finance and security agreements and parties should consider how they may be affected and should begin considering how they can mitigate the impact. Most experts agree that a global recession is inevitable and may have a circular effect on finance: if businesses can not afford to repay their loans, the banks will not lend; if the banks do not lend then many businesses will not have working capital to fund business operations, leading to their demise.

There is a symbiotic relationship between Cayman Islands holding entities and their subsidiaries.  In most cases, the holding entities will not be a contracting party or involved in daily business operations but rather rely on the success of their subsidiaries to generate and maintain their income.  This income is then used to service facility agreements and to provide operating capital back to their subsidiaries.

The triggers those Cayman Islands entities, whether as borrowers and/or security providers (together, Obligors) are likely to encounter in their facility or security agreements are discussed below:

1. Force Majeure

A force majeure clause is a provision which permits parties to suspend or terminate an agreement when certain circumstances beyond their control make performance of the contract impossible or impractical.  What events constitute a force majeure will depend on what parties agree when they enter into the agreement,typically force majeure clauses include events such as earthquakes or terrorist attacks. Recently, many articles have been circulated which discuss force majeure clauses and whether or not a pandemic of this nature satisfies the force majeure tests and requirements in the relevant jurisdiction.  However, this is primarily the case in operating or service contracts, as many facility agreements (regardless of governing jurisdiction) do not contemplate force majeure events such as COVID-19 because it did not exist at the time of contract.

1. Financial Reporting

Many facility agreements with major banks and lenders will include information and financial reporting undertakings, including but not limited to: (i) the provision of audited or unaudited financial statements; (ii) information regarding the financial condition and the business operations of any Obligor under the facility agreement (as reasonably requested by the lender); (iii) maintaining a set net worth; and/or (iv) maintaining certain financial covenants, which may include a certain loan to value ratio.

In the current economic climate, lenders will likely scrutinise an Obligor’s financial statements and financial condition, highlighting any liquidity or solvency problems at the earliest interval possible.  Supply issues, frustrated contracts, or other defaults may have a negative impact on a Cayman Islands Obligor as the effects of COVID-19 advance up the corporate structure.

If an Obligor is unlikely to meet its financial covenants due to a displaced loan or a downturn in asset value they should alert lenders prior to providing financial statements or other financial information. This will enable Obligors to prevent breaching existing financing terms and have an opportunity to proactively renegotiate terms.

1. Events of Default (including Cross Default)

What constitutes an Event of Default (EOD) will vary between contracts, however common EODs include (i) non-payment; (ii) breach of any representations, warranties or financial covenants (as referred to above); (iii) cross default in other material contracts of an Obligor or group entity (which is often broad enough to include any other financial indebtedness becoming due and payable as a result of a default, regardless of the lending entity); (iv) insolvency and insolvency proceedings; (v) cessation of business; and (vi) Material Adverse Change(discussed further below). Any Obligor may trigger one or more of these EODs as a result of the economic impact of COVID-19 which would give rise to the lender being in a position to accelerate the debt owed to it and permitting the lender to refuse to provide any further loan, or use such EOD as a trigger for the enforcement of security or guarantee, or the commencement of insolvency proceedings in relation to the Obligor(s).

Perhaps the most common covenant placed on Obligors is the requirement to notify a lender immediately once an EOD occurs along with providing details of the remedial steps to be taken.  Each of these EODs is reasonably foreseeable and it is recommended that an Obligor be proactive and discuss the possible waivers, grace periods or forbearances before an EOD even occurs. Obligors need to be considering how any new money could be injected into the group, with a view to rescheduling any existing indebtedness that could trigger EOD under the existing facilities. This open dialog will build trust and will aid in avoiding EOD triggers and the lender’s or secured party’s enforcement rights.

1. Material Adverse Change EOD

A common EODis any material change to an Obligor’s business or financial condition deemed to have a “Material Adverse Effect”.  This is to give the lender enhanced rights and remedies upon the occurrence of an event where an Obligor’s business, prospects or ability to make loan repayments are materially impaired. In some cases, it might allow a lender to stop making advances or demand early repayment. The lender is often responsible for deciding whether a fact, change or circumstance will have a Material Adverse Effect.

Material Adverse Effect is often defined as (or similar to):

“a material adverse effect on:

• the business, operations, property, condition (financial or otherwise), performance prospects of:
  1. any [Obligor]; or
  2. the [Group] taken as a whole;
• the ability of any [Obligor] under any [Finance Document] to which it is a party; or
• the validity, legality or enforceability of any [Finance Document], or the rights or remedies of the lender under, any [Finance Document].”

Based on what we know about COVID-19 and its projected impact on the global economy, it is likely that some lenders will deem this impact to have a Material Adverse Effect on business operations and financial condition and performance where COVID-19 has an unexpectedly serious effect on the borrower, beyond what the parties might reasonably have expected.  In turn, this may trigger an EOD as referred to above. On the other hand, consideration of materiality may include durational significance, and short-term disruptions or difficulties caused by COVID-19 and its effects may not be enough to trigger an EOD, at this point this remains an uncertainty.

1. Compliance with Laws

Notwithstanding each of the above covenants and EOD, a general representation, warranty and covenant which is included in facility and security agreements is that the Obligors will do all things necessary to ensure compliance with all applicable laws, including any applicable government authority notices, rules and regulations.  In the current climate governments are enacting legislations that restrict business activities, operating hours and periods of isolation and quarantine for the foreseeable future.  These legislative changes  could be in direct conflict with the obligations under a facility agreement.  This conflict serves to reinforce our view that all parties to a facility agreement should open negotiations as soon as reasonably practicable to assess any potential for default and difficulty with compliance.

Practical considerations

Obligors whose ability to comply with the provisions of the facility agreement and other finance documents due to the impact of COVID-19 may consider the following:

• any government assisted loans/schemes that may help with cashflow (although there may be a prohibition against incurring further financial indebtedness in the facility agreement – this should be checked and a waiver sought if required); and
• early discussions with lenders for:
  • waiver of breaches or potential breaches;
  • certain “standstill periods” on the calling of EODs and/or the enforcement of security;
  • periods of forbearance or other repayment holidays; and
  • relaxation of covenants (in particular, financial covenants).

Any advice provided in this article is intended to be general in nature, and should not be relied upon for any particular party contract.  If you are concerned about your ability to comply with any particular contract, you should check its terms and seek independent legal advice about potential consequences and your options.