COVID-19: Conundrum for borrowers and lenders

By Aniket Sawant and Shreenath Pandeya, SNG & Partners

The COVID-19 pandemic has caused significant disruption and slowed down the economy. In the finance sector the ability of borrowers to perform their obligations under financing agreements has been severely impacted. In light of this, banks, financial institutions and borrowers have had to evaluate existing financing agreements. The question of the applicability of the legal concepts of force majeure and of the doctrine of frustration under the Indian Contract Act, 1872 (ICA), to obligations under financing agreements has become crucial.

Force majeure clauses in agreements allow the non-performance of an obligation under a contract due to unforeseeable events that occur outside the control of the parties. The ICA does not expressly provide for force majeure. The courts in India have formulated an opinion to strictly abide by the provisions of the contract and assess as to whether the particular event falls under the purview of force majeure in terms of the contract. Accordingly, for borrowers to take advantage of force majeure in the present crisis, it will have to be ascertained whether any specific force majeure clause has been incorporated in the particular financing agreement. However, Loan Market Association templates, as well as most financing agreements do not contain such force majeure clauses. The intent of such exclusion seems to be that borrowers should not be allowed to escape their moral and legal obligations merely by claiming non-performance due to force majeure events.

In the absence of any force majeure clauses in financing agreements, the parties can only rely on the doctrine of frustration under section 56 of the ICA, which provides that contracts may be avoided on the grounds that the performance of contracts has been rendered impossible due to events or changes in circumstances. The burden of making a successful claim that COVID-19 results in frustration of a financing agreement is heavy. Consequently, it may be difficult for borrowers to rely on this provision to escape their obligations. It may be argued that borrowers should not be allowed to take advantage of the doctrine of frustration as they will be placed in an unfairly advantageous position. This will adversely affect the ability of lenders to recover their debts and consequently their risk appetite and lending capacity.

Material adverse change (MAC) and material adverse effect (MAE) clauses are used in most financing agreements. These enable a lender to declare a default if there arises an unforeseen adverse change in the business, assets, operations of a borrower or its ability to perform its obligations, or in the lender’s ability to enforce its rights under the financing documents. If such a change occurs, the lender may seek to terminate the contract or to demand early repayment. Whether the COVID-19 outbreak is a MAC under financing agreements has to be analysed on a case-by-case basis, and depends on the drafting of the clause and its effect.

The COVID-19 outbreak may result in non-payment, cross defaults and the cessation of business, which would cause a default. The non-satisfaction of financial covenants such as the maintenance of cash flows, debt service coverage and the inability to pay interest may also occur. While the borrowers have to inform the lenders upon the occurrence of such events, it will be difficult for lenders to trigger a default pursuant to MAC clauses or any other breaches or defaults under the financing agreements. This is because of the exemptions set out by the Reserve Bank of India in its notification of 27 March 2020, and the recent judgment of the Delhi High Court in Anant Raj Limited v Yes Bank Limited. Lenders may therefore adopt such measures as allowing grace periods for repayment or charging default interest due to the delay in payment.

The approach of the regulator will be important following the viewpoint of the Bombay High Court in making its interim order in Rural Fairprice Wholesale Limited and Anr v IDBI Trusteeship Services Limited and Ors. The high court restrained IDBI Trusteeship and others from directly or indirectly selling shares of Future Retail Limited (FRL) that had been pledged by Future Corporate Resources, the promoter of FRL, to secure debentures issued by Rural Fairprice Wholesale, after the significant fall in share prices due to COVID-19. The order of the high court was upheld by the Supreme Court.

The implications of the COVID-19 pandemic have to be decided on a case-by-case basis. Considering the uncertainty of the future and the complexity of the situation, it is advisable for parties to conduct a thorough legal analysis of their contracts to evaluate their risk exposure. They should accordingly renegotiate agreements and devise strategies to manage forthcoming crises.