The COVID-19 pandemic is a stress test for our health care systems, social solidarity and any economic activity. As governments implement unprecedented emergency measures, COVID-19 will also have an impact on project finance. For example, COVID-19 could lead to a completion delay, a significant reduction in project revenues, or an event of default. Could COVID-19 qualify as a force majeure event? You can prepare for any impact and mitigate the turbulence by closely monitoring your project financing scheme.
The facility agreement usually contains certain events that, if any such event would occur, gives the lender the right to cancel the facility and accelerate outstanding loans. These events are referred to as ‘events of default’. Although the impact of these events can be enormous, these are not always carefully monitored by the borrower. A number of these events of default can be triggered not just by the borrower itself, but also by (major) project parties. Although such events may be beyond the borrower’s control, it will bear the consequences when these are triggered by another project party.Avoid a surprise and stay in close contact with contracting parties. Examples of events of defaults that could extend to project parties are:
The borrower may have additional financial indebtedness. If so, a cross default provision will likely be included in the facility agreement. This means that the non-payment of such other financial indebtedness when due automatically constitutes an event of default under this facility agreement. In other words, a breach of undertakings or any other (payment) obligation under the other loan agreement could therefore (indirectly) lead to an event of default under the facility agreement.
The concept of force majeure is a common feature of most commercial contracts, including those which form the basis for any project financing. A force majeure provision prevents one party from fulfilling its contractual obligations where these obligations have become impossible or impracticable to perform due to an event that parties could not have anticipated or controlled. A party can base this right on Dutch applicable law (to the extent it is not contractually excluded or waived) or an agreement. The effect of a force majeure event depends on how the agreement is drafted. Most force majeure clauses are suspensory which means that the appropriate obligations are not cancelled but suspended for the continuation of the force majeure event. Once the force majeure event is triggered, the non-performing party’s liability for non-performance or delay in performance is removed, usually for continuation of time the force majeure event.
To asses to what extent COVID-19 qualifies as a force majeure event, the exact wording of a force majeure event is relevant. For example, is a reference to ‘disease’ ‘epidemic’ or ‘quarantine’ expressly included? Many contracts contain no express reference to such terms and contracts that do often use such generic terms without defining them. This leaves open many questions and no doubt this will lead to much debate among contract parties. What is ‘epidemic’ exactly? Do quarantines need to be mandatory declarations by government authorities (such as in Italy or in Spain) or do they cover voluntary actions by private parties (as is the case in the Netherlands)?
Most contracts will define force majeure events by reference to general criteria, with a non-exhaustive list of matters that may constitute a force majeure event. In the absence of a reference to specific events, a party may have to rely on more general contractual terms, such as circumstances beyond a party’s reasonable control or for which they could not reasonably have provided for etc. COVID-19 is likely to lead to some level of claim under such generic standards, but it is not clear exactly what related impacts are seen as direct and material versus incidental. The result is that many parties will be struggling to understand the contractual impact of COVID-19.
We expect that, going forward, both sides may expect and demand that disease-related outbreaks and related actions like quarantine be expressly included and defined in detail. Lenders will be particularly concerned about the outbreak of the virus or mitigating measures falling within the definition of a force majeure event in a contract. These concerns may regard claims arising under contracts, delays in projects or supply chains that may lead to delays in revenue generation or the risk of corporate insolvencies. Lenders may therefore request that the relevant agreements carve out COVID-19 or epidemic related wording.
The facility agreement contains financial obligations. In project finance cashflow is key and generally it is measured to what extend project revenues generate sufficient cashflow to enable the borrower to meet its payment obligations under the facility agreement. This is the debt service cover ratio (the DSCR). The DSCR is usually measured semi-annually and starts in the operation phase of a project. This ratio is therefore not relevant in the construction phase. A deterioration in the borrower’s debt service capacity could lead to mandatory prepayment obligations, a restriction of distribution rights and, ultimately, to an event of default.
We anticipate that the impact of COVID-19 on a project in particular materialises during the construction phase. A delay in supply of construction materials or a shortage of employees are likely scenarios that could delay completion of a project. In any event, the semi-annual testing would give the borrower in most circumstances a reasonable period of time before a breach of the DSCR becomes relevant. Note , however, that if the facility agreement contains a keep honest clause (see below) the borrower will have to inform the lender at an early stage.
Projects costs, particularly during the construction phase, are carefully monitored. The borrower will have to submit budgets and updates on a regular basis and any (material) deviation from the financial model must be justified. A sharp increase of project expenditures is usually not allowed, although these budget regulations occasionally provides for some headroom. A limited increase in expenditure could therefore be absorbed. A sharp increase could however lead to a funding shortfall – the project costs for construction then exceed the amounts available under the facility agreement. Such funding shortfall may be for the account of the constructors.
The term ‘material adverse effect’, in summary, describes events of such magnitude that they should trigger consequences under the facility agreement. The exact scope of a material adverse effect varies per agreement. The purpose in each case is to cover unforeseen risks that are not covered explicitly by any of the representations, undertakings or events of default.
A material adverse effect quite often refers to an event that has, or is reasonably likely to have, a material adverse effect on the business, operations, property, condition (financial or otherwise) or prospects of the borrower. The occurrence of such event would trigger an event of default. The lenders may cancel the facility and accelerate the outstanding loans. Based on this criteria, COVID-19 would most likely qualify as a material adverse effect event and trigger an event of default for many borrowers. We believe it is unlikely that Dutch lenders will invoke a material adverse effect clause in connection with COVID-19 as it is unprecedented in the Dutch loan market that this clause on its own is used as an event of default. COVID-19 will very likely not change this approach. The consequences, both for the financial markets as well as the reputational risks for the respective lender would be enormous.
A borrower is obliged to promptly notify the lender of its awareness of any default. Instead of waiting to see how things develop, the borrower should notify the lender immediately, even if the grace period for the underlying default has not yet expired. For example, suppose that the borrower realises that it will no longer be able to comply with an undertaking in the facility agreement for which a grace period of 15 days has been agreed. Once the borrower realises that it can no longer comply with the particular requirement and the grace period has not yet expired, no event of default under the facility agreement has occurred yet. Nevertheless, the borrower will have a duty to notify the lender of this event and not doing so will constitute an event of default on its own.
Occasionally, the facility agreement contains an obligation for the borrower to notify the lender in the event it expects that it will not comply with its financial ratio’s (mostly the DSCR, see above) in the foreseeable future. Such notification requirement applies, even before the breach of the financial covenant has occurred (even if it is not entirely certain that a breach will occur). This early warning obligation is referred to as the keep honest clause. If included in the facility agreement, it is meant to ascertain that the borrower remains in a continuing dialogue with the lender. The exact scope of a keep honest clause depends on the drafting. It may lead to a drawstop, which means that following such notification the borrower would no longer be allowed to draw any loans under the facility agreement.
As of now the impact of COVID-19 on projects and projects financing is unclear. It is nevertheless important to carefully consider all possible implications of this unprecedented event as it may lead to various breaches of obligations under the facility agreement (as set out above). Most important at this stage is to proactively keep the lenders informed and not try to sit out the crisis and wait for it to pass by. If a breach of any of the obligations is expected, the borrower should notify the lender without delay, even without a keep honest clause in place. This gives the lender time, to consider the ramifications and, together with the borrower, resolve any COVID-19 related issue. A solution might be that an event of default is waived or that the facility agreement is amended. We believe that under these extraordinary circumstances lenders tend to be flexible and pragmatic when confronted with any COVID-19 related issues. In the Netherlands, Dutch lenders have confirmed that for loan arrangements for small and medium sized enterprises a payment holiday has already been announced which may be extended to include larger loans in due course.