Impact of COVID-19 on project finance: a German law perspective

By Dr. Matthias Winter, Dr. Benjamin von Bodungen, Pascal Leitmann, Timo Foerster

04-2020

As COVID-19 continues to send shock waves through the economy, project finance developers prepare to sail through turbulent waters. Solutions are required for the manifold challenges of the crisis – be it the implications on ongoing projects under existing project documents, potential project delays or the resulting necessity to manage development capital differently.

The impact is not limited to a single branch of the industry – regardless, whether it considers the aviation, the railway or the energy sector: the current shutdown of public life impacts every sector, if not each alike.

To handle the crisis’ impact, it is of importance to identify the arising legal risks as well as the economic consequences while also maintaining business relationships. To achieve this balancing act, a dialogue with affected parties should be sought promptly and pragmatically, and damage-reducing solutions should be found through legally accompanied negotiations.

Below, we shortly address the most common issues arising due to the crisis which we have observed in the past few weeks. As the events are dynamic and evolving, we update the relevant sections and formulate solutions to the problems, as they arise.

1. Addressing the standstill - Impacts on Contractual Performance Obligations

State-imposed restrictions to combat the crisis and the resulting inability of contractual partners to fulfil performance obligations such as delivery and maintenance may endanger project finance structures by possible delay and thus lead to a collapse of the project’s projected cash flow.

This leads to the question how a possible delay is to be assessed legally.

  • 1.1 Contractual solutions: force majeure clauses

    The legal concept of force majeure is not a part of German civil law – it is a civil law concept that originated in the Napoleonic Code. In German (as well as English) law documentation, commercial contracts often adopt this concept by including a force majeure clause which seeks to protect the parties from effects of unforeseen events or circumstances.

    If applicable, the force majeure provision typically suspends the affected obligation. This means that the appropriate obligations are not cancelled but suspended for the continuation of the force majeure event. The affected party is not deemed to have fallen behind in regard to their contractual obligations, usually for as long as the ability to meet these obligations is impaired by the force majeure event.

    Typically, force majeure provisions consist of two elements which must be fulfilled in order for the provision to be applicable: an absolute and a relative component.

    Force majeure – absolute component

    The absolute component typically consists of an external event which is neither predictable, nor attributable to the parties and cannot be prevented through customary measures. Most contracts will provide for a non-exhaustive list of such events and will include such events as acts of war, embargos, lightning strikes, et cetera. Such catalogues regularly include events such as “diseases”, “epidemics” or “pandemics”.

    As to whether COVID-19 is covered under a force majeure provision, first of all the wording of the clause in question is decisive. But even if events concerning the general public’s health are not covered expressly, the relevant factor for the absolute component is that the event may not be attributable to any of the parties. This is regularly the case for epidemics (for the SARS-Virus see Amtsgericht Augsburg, judgement of 09.11.2004; for COVID-19, currently there is no court decision).

    Force majeure – relative component

    More difficult to assess is whether the relative requirement of the force majeure clause is met as well. Even if the current situation may be classified as a catalogue event under the force majeure provision, for specific application on a contractual obligation, force majeure provisions regularly demand that the event actually prevents the affected party from carrying out its obligations under the contract, be it in full, in part or in due time.

    This relative component of the typical force majeure provision requires individual assessment for each case.

    Especially in the context of the dynamic development and continually evolving catalogue of measures, an impairment of contractual duties must be determined individually and with regards to the specific sector.

    The requirement of specific impairment leaves room for interpretation and therefore much debate between parties – when exactly is a specific performance obligation impaired? This might be evident in the case of the mandatory curfew as was imposed by government authorities in France or Italy. As for Germany, this may be more difficult to analyse since not only the federal government has taken measures to combat the crisis, but also every federal state as well, not including a mandatory curfew (with the exception of Bavaria).

    Therefore, the answer for this might not only be different in-between the different sectors (e.g. for maintenance obligations in the rail sector than for delivery obligations in aviation), but also different from jurisdiction to jurisdiction.

    Please note that the party obliged to perform regularly must do everything reasonable to prevent or overcome the occurrence of the force majeure event. It is therefore of importance that each affected party take precautionary measures, exercise due care and, under certain circumstances, procure replacement. With view to this a force majeure event does not automatically exclude claims for damages.

  • 1.2 Solutions under German law and further contractual provisions

    If the contract itself does not contain a force majeure clause or the clause is not applicable (as may be the case, see above), German law as well as the contractual arrangements provide for legal institutions and clauses respectively which, depending on the individual case, may allow for appropriate solutions. This includes "hard-ship" clauses, the legal institutions of impossibility or omission of the basis of the transaction. For contractual clauses, the restrictions of the law on general terms and conditions must be examined as well.

    In each case, the affected party should inform of the impairment to discuss possible solutions together. This may be the application of a force majeure clause, of German civil law or even an amendment of the respective agreement.

  • 1.3 Claims for compensation and liquidated damages

    Whether claims for compensation asserted by a party are justified must be examined more closely in each individual case.

    First, an obligation must be agreed upon and breached thereafter. Further, contractual penalties and liquidated damages generally require fault.

    If there is no obligation to perform due to e.g. a force majeure provision or impossibility, fault may regularly not be assumed. Nevertheless, non-delivery is to be compensated if a procurement risk or a guarantee has been assumed.

    Furthermore, the respective contractual penalty clause, if it is a general business condition, must be effective and appropriate. Otherwise the clause is invalid, and the customer cannot rely upon it. 
2. Impact on Loan Agreements

Besides the asset-related contracts, loan agreements may currently be affected too. This may be due to the borrower’s financial situation possibly deteriorating.

In principle, the lender has a legal right to terminate a loan if the financial situation of its borrower deteriorates significantly or the value of the loan collateral decreases significantly.

Further, as the projected cash-flow is key, the lender and the borrower typically agree on financial covenants in the loan agreement, then a loss of income from business operations can lead to a breach of these covenants, especially if the financial covenants are based on current and future income.

Generally, the relevant cash-flow is measured by the extent the project revenues generate sufficient cashflow to enable the borrower to meet its payment obligations under the facility agreement (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.

Legally, the reason why the financial circumstances of a borrower deteriorate significantly or why financial covenants such as the DSCR are broken is irrespective of fault.

As COVID-19 may have a foreseeable negative impact on operative business, borrowers should review existing financing agreements, especially with regards to the provisions considering financial ratios and to possible contractual rights of termination such as special termination rights for good cause or Material Adverse Change clauses as well as legal termination rights (due to deterioration of the financial situation or the loan collateral or for good cause) and contact the lender.

In addition, the borrower should assess whether he may apply for state liquidity assistance aid programmes such as the German development bank’s programme or the German economic stabilisation funds. Depending on the terms of the agreement and in compliance with the respective guidelines on the use of funds, the borrower can use these to make partial unscheduled repayments of the loan in order to remedy a breach of financial covenants.

Last reviewed: 1 April 2020