Already, the COVID-19 pandemic has had far-reaching effects on the global economy and particularly on the German economy as well: interrupted international supply chains, travel restrictions, or the cancelation of major events and trade shows – all of this poses considerable challenges for the manufacturing, trade, transportation, tourism, and event organizer sectors in Germany.
In the following, we will review important loan agreement clauses that companies and banks need to consider against this backdrop. If a borrower’s operative business is already affected by COVID-19 or if it is foreseeable that it could be affected, it is advisable to examine general provisions in existing financing agreements and, where necessary, to communicate with lenders openly and at an early stage.
Numerous – including bilateral – agreements include conditions, such as and particularly in the form of limits for certain financial ratios. One of the more common financial ratios is the leverage covenant, which defines the maximum ratio of the borrowers’ net debt to their EBITDA.
When companies are suffering (or expecting) declining sales due to COVID-19, leading to a drop in EBITDA while net debt remains the same, the contractually agreed financial covenant may be breached. Depending on the contractual design, this may lead to an increase in interest payments or the prohibition of further drawdowns under the loan commitment in addition to the existence of a right of termination.
Due to the highly favorable financing environment for borrowers in recent years, many loan agreements saw extensive adjustments to the items relevant for computing compliance with financial ratios. Loan agreements will frequently contain individually adjusted EBITDA definitions, which often also provide for the option of “add-backs,” i.e., the addition of amounts leading to significant increases in this financial ratio in favor of borrowers under the loan agreement. In connection with COVID-19, borrowers should therefore carefully examine whether, on the basis of agreed financial ratio definitions and add-back clauses, it is possible that EBITDA higher than actually generated can be used for compliance with the financial covenants. This could be the case, for example, in association with certain insurance claims that have arisen due to COVID-19 impairments and which can then be added to EBITDA, depending on the detailed provisions of the loan agreement.
Grounds for termination for lenders may also result from the infringement of other loan agreement conditions, however, which may already be violated for logistical reasons, for example, due to COVID-19. Examples might include delayed auditors’ certificates due to travel restrictions or cases of illness, lacking or delayed dividend payments due to bans on large events, which might also include annual general meetings.
In addition, loan agreements frequently contain MAC termination rights – i.e., termination rights of lenders due to a material adverse change in borrowers’ business activities, net assets, financial position, or results of operations, and, in some cases, the business prospects. To what extent COVID-19 justifies the assumption of a corresponding material adverse change already now or in the future will have to be left to the examination in the individual case – both of the MAC clause itself and of the specific circumstances of the company. MAC clauses based on the material adverse change in borrowers’ prospective success will certainly have to be eyed most critically. As a result, however, as long as agreed financial ratios have not yet been infringed and it cannot be established with sufficient certainty that the borrowers’ business activities, net assets, financial position, results of operations, or business prospects have not only temporarily undergone a material adverse change, a MAC right of termination will likely be excluded. Lenders should also be aware that improper termination may result in claims for damages.
In addition to contractual MAC grounds, termination by lenders based on the statutory right of termination from Section 490 Civil Code because of deterioration of borrowers’ financial circumstances is often an option. According to this provision, specifically tailored to loan agreements, lenders may terminate loan agreements extraordinarily if borrowers’ financial circumstances or the value of the collateral provided for the loan are significantly deteriorating or are expected to significantly deteriorate, thus jeopardizing repayment of the loan, even if the collateral is realized. Again, each individual case must be carefully examined to assess the existence of the right of extraordinary termination under Section 490 Civil Code. It is important to note in this context, however, that “force majeure” does not exclude the right of termination under Section 490 Civil Code.
In addition to the extraordinary right of termination under Section 490 Civil Code, there is also the right of termination in relation to continuing obligations for cause under Section 314 Civil Code. In contrast to the extraordinary right of termination under Section 490 Civil Code, however, it requires that the party giving notice of termination (which may be either lender or borrower) cannot reasonably be expected to continue the loan agreement until the regular end of the term, taking into account all circumstances of the individual case and weighing the interests of both parties. Depending on the circumstances of the individual case, this may be given where serious disruptions of the basis of trust and similar threats to performance of the agreement are concerned. The fault of the party receiving notice of termination (usually the borrower) is not relevant. Disruptions arising from a party’s own area of risk, however, will usually not give rise to a right of termination. This may be relevant to the issue of whether borrowers have taken all necessary and, generally, reasonable steps in advance or after the occurrence of the default in delivery to mitigate the effects of “force majeure” and, for example, to secure alternative supply chains.
Borrowers should also review their financing agreements to ensure that they are able to continue to provide the contractually agreed repeating representations at the relevant times (such as at the beginning of a new interest rate period). If this is not the case, lenders may also have rights of termination in this respect.
If the review of existing financing agreements reveals breaches of agreed financial covenants or infringements of other conditions or suggests that such breaches may occur in the future, borrowers should actively and openly seek discussion with lenders about any such breaches and possible steps already taken or planned. Lenders should carefully consider whether there are in fact grounds for termination and how to react in each specific case. In the event of new financing transactions, lenders should also examine whether to set higher requirements and standards for contractual due diligence with respect to termination rights for force majeure in material supply agreements and with respect to insurance cover for business interruptions.
Waivers, mostly on a temporary basis, by lenders and/or temporary or permanent contract adjustments, e.g., in the form of a headroom agreement for financial ratios or an extension of deadlines for the submission of annual financial statements beyond the usual 180 days, are regularly considered as a possible remedy for infringements (also impending infringements) of financial ratios, other conditions, or representations.
It may also make sense to agree to suspend principal and/or interest payments or to retain interest for a certain period until the borrower’s liquidity situation has improved again after the COVID-19 pandemic has abated.
In summary, with respect to the effects caused by COVID-19, precautionary critical reviews of the existing loan agreement documentation is recommended. In addition, affected borrowers should analyze the current sets of measures of the Federal Government and the relevant legislative initiatives launched in relation to their specific situation to be able to take advantage of appropriate assistance.