The impact of COVID-19 on loan agreements: achieving the best outcome

No one could have predicted the enormous effects COVID-19 would have on not just our daily lives but the economy in general. Raising additional liquidity, whether through the raft of measures put in place by the Government to support UK businesses during these uncertain and challenging times or otherwise, was key for some businesses, but it was just as important to consider existing lending arrangements and how these were impacted.

It swiftly became apparent to lenders that taking a rigid approach to the strict requirements of loan agreements and other finance documents could be counter-productive, as many borrowers were finding themselves in breach or potential breach of covenants through no fault of their own and unable to rectify such breaches immediately. FCA guidance issued at the outset of the pandemic recommended that firms grant payment deferrals for personal loans and residential mortgages to customers who were impacted by COVID-19, but many lenders took the initiative and offered interest or capital repayment holidays to all borrowers and not just those within the scope of the guidance. More generally, it has been encouraging to see a flexible and co-operative approach by both lenders and borrowers communicating openly with each other as was subsequently recommended by Government guidance last month [2].

As we move into the next phase of lockdown easing measures with non-essential shops finally being allowed to reopen for business for the first time since the lockdown measures were imposed three months ago, we consider how existing lending arrangements have been impacted, how lenders (and private banks in particular) have responded, and what else might need to be addressed over the coming months in order to achieve practical and equitable outcomes for all involved during these difficult times.

Impacts of COVID-19 on loan agreements

Like the effects of the pandemic on the economy and society, the impact on loan arrangements can be broader than initially expected. We consider and discuss a few of the key areas below:

Interest and capital payments:

We have seen lenders offering interest and capital payment deferrals, extending grace periods and pushing back the term of the loan accordingly and, where there has been headroom in asset values, extending new lines of credit to fund interest/principal payments or capitalising interest, at least temporarily. This approach is broadly in line with the FCA’s more prescriptive guidance applicable to personal loans and residential mortgages and builds on the themes of encouraging lenders to take a flexible approach which is tailored to that particular customer’s set of circumstances and, of course, to treat customers fairly.

Moving forwards, communication remains key. Lenders and borrowers should actively encourage open communication from each other and a flexible and pragmatic approach should help them achieve a fair and sensible outcome for the time being. Increasingly though, lenders will be mindful of the long-term viability of a particular loan once greater certainty on the economy starts to emerge which may mean that a more formal resetting of loan payment terms and debt quantum is in order.

Financial covenants:

these tend to measure either asset values (such as loan to value covenants) or affordability (such as interest cover ratios and debt service cover ratios), both of which have been affected by the pandemic:

• Asset value tests: Initially the outbreak and the lockdown restrictions made it difficult for banks to obtain property valuations as site visits were not able to be carried out. Due to the uncertainty in determining the actual value of a property, valuers started to add assumptions and caveats to their valuations on the basis of “material valuation uncertainty” so that any client understood that it had been prepared under extraordinary circumstances and should attach a higher degree of caution than usual, keeping the valuation of properties under more frequent review. With lockdown restrictions now being eased, we are starting to see positive movement in the various property markets again, meaning this issue is no longer as acute. Valuations are now able be carried out again with valuers beginning to lift the “material valuation uncertainty” caveat in certain sectors. Lenders have, of course, been reluctant to take any drastic action (and, in some cases, prevented from doing so [3]). However, it remains important for lenders and borrowers to have an open dialogue around valuation levels and for lenders to keep options open until markets return to normal, considering measures such as being flexible as to the timing of scheduled valuations, potentially increasing LTV covenants for a short period and accepting short-term additional collateral to “cure” any breaches.
  
  
• Affordability: Where borrowers are reliant on income from commercial tenants (especially those in retail and hospitality), the impact of the COVID-19 outbreak has been particularly severe, not least as tenants have received a good degree of government protection from any landlord action to claim unpaid rent (see further here). As discussed above in the context of payment defaults, a temporary drop in income caused by COVID-19 has been accommodated by lenders, by and large, but as we move into the next phase of lockdown easing measures, with the re-opening of more shops and non-essential businesses and, hopefully, hospitality businesses very shortly, thoughts will turn to the long-term affordability of a particular loan as against the likely income derived from the secured property, especially where tenants have been and will continue to be financially impacted. A landlord’s ability to agree temporary rent reductions will of course be linked to the willingness of its own lenders to accept a lower coverage of income to debt service for a period of time. Once again, communication here will be key and a willingness and ability on both sides to be flexible (whether by increasing any interest reserve deposits or providing other forms of additional collateral, granting an additional facility to cover interest, or flexing covenants temporarily) will be important in order to help each other through this challenging period.

With breaches of any financial covenants, as with any breach of loan agreement terms, the ultimate remedy for a lender is to take enforcement action. However, that approach will be rife with difficulties (if allowed at all) at the moment, therefore the more lenders and borrowers can work together, the better, with both being mindful of the longer-term relationship between the parties and position of the secured asset in question. 

Material adverse change (“MAC”):

Most loan agreements will include an event of default where the lender believes there has been a MAC in circumstances. Lenders have always proceeded with caution and consideration before deciding to call a MAC event of default, and the current circumstances are no different. Having said that, whilst lenders are typically not willing to call a MAC event of default, they are equally unwilling to grant a specific waiver of the MAC clause to allow borrowers certainty that it will not be called due the effects of the pandemic. This is understandable given that no-one knows quite how long the effects will last, the severity of the impact and the ways in which the impact will manifest itself. Therefore, a cautious approach continues to be sensible all round, with lenders accepting the inherent difficulties in using this clause to its full degree and borrowers having to accept the uncertainty of knowing it remains in the background.

Mandatory prepayment of insurance proceeds:

business interruption or loss of rent insurance has been much discussed over the last three months[4] with some claims being successful, and others not. Many loan agreements will contain mandatory prepayment events which stipulate that any insurance proceeds over a certain de minimis amount must be used in paying down the loan. Liquidity and keeping as big a buffer against the continuing unknown are vital requirements of many businesses right now, and so using cash in this way may not be seen as an efficient use of it by borrowers. Whilst the actual result of this debate will differ depending on the circumstances, communication and flexibility (perhaps placing the funds on deposit for a period of time and taking them into account when calculating financial covenant tests) is once again sensible.

Other covenants:

There are a myriad of other provisions within loans which may also be impacted, from general information obligations to keep the lender informed of other matters (eg: events of default and potential breaches under material contracts due to loss of trade or supply shortages) to cessation of business or abandonment of property developments. When reviewing your position whether as a lender or borrower, think broadly and consider any longer-term effects as, when agreeing a revised position, it is important to have the broader picture in mind and deal with everything at once as far as possible. 

Moving forward

When considering breaches of loan agreements, the Prudential Regulation Authority (PRA) recently stressed in a “Dear CEO Letter”  that lenders should be flexible in respect of covenant breaches that might occur because of the COVID-19 situation. Although recognising that loan covenants are important to a lender’s credit risk management, the PRA said that such risk management should recognise the differences between “normal’ breaches and ‘COVID-19” breaches. The PRA went as far as to say that firms should consider waiving COVID-19 related covenant breaches, where appropriate, and not impose new charges or restrictions on borrowers following such breaches. In our experience over the last few months, lenders have typically done so, adopting a supportive and flexible approach for their clients adversely affected financially by COVID-19. 

At the moment, dealing proactively and considerately with breaches which require immediate treatment remains sensible but, moving forward, each lender should carefully consider its position around the longer-term viability of a particular loan. Lenders will want to preserve flexibility and, although this may not provide borrowers with certainty, it does preserve the status quo for the time being. By biding their time, reserving rights (if necessary), thinking broadly and flexibly, and, most importantly, communicating clearly and frequently with their borrowers, lenders will be in a better position to effectively support their borrowers through any COVID-19 related difficulties.

If you require further information about anything covered in this briefing, please contact Martin Blake, Suzanne Conticelli, or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, June 2020

Footnotes:

[2] In May 2020, the Cabinet Office and Infrastructure and Projects Authority published non-statutory guidance on responsible behaviour in the performance and enforcement of contracts which have been affected and impacted by the COVID-19 pandemic. The main objective of the guidance is to encourage all parties to contract to act responsibly and fairly in the national interest of performing and enforcing their contracts to both support the response to the COVID-19 pandemic and to protect jobs and the economy.

[3] FCA Guidance, last updated on dated 16 June 2020, bans firms from commencing or continuing repossession proceedings on residential property until 31 October 2020.

[4] The FCA is seeking clarification from the High Court (and an expedited court process) aimed at resolving the contractual uncertainty around the validity of many business interruption claims. The FCA has said that while its High Court test case will seek to resolve some key contractual uncertainties to provide clarity for policyholders and insurers, it will not determine how much is payable under individual policies, but it will provide the basis for doing so. The FCA hopes this case will be heard sometime in July 2020.