The outbreak of COVID-19 has undeniably affected both borrowers and lenders negatively, with the exception of a few players such as those in medical supplies, basic food stuffs and certain technology, e-commerce and entertainment providers.
Businesses have been forced to confront the hard questions about how to continue running their operations seamlessly and keep afloat in the current global crisis. As the impact of the pandemic continues to unfold, almost all businesses have been forced to review their cashflow and liquidity position in order to address a sudden and significant reduction in business revenues.
The unforeseen and dramatic fall in revenues and available cashflows will inevitably put borrowers under significant stress, particularly where substantial repayments are due in the next couple of months. To compound the situation, continued access to funds under revolving working capital facilities or other sources is also likely to be challenging if there is potential for or actual default under the facilities. Ironically therefore, some businesses may be unable to access new funding or further drawdowns of their loans just when they need them most.
Borrowers should therefore take very proactive steps at this time including reviewing the terms of their existing facilities and where possible, engage with lenders at the earliest opportunity, to discuss the potential implications of the pandemic on their loans, particularly because it is difficult to predict with any precision how long the effects of the pandemic are likely to last.
As the situation evolves, one of the questions that corporate borrowers and their boards of directors continue to grapple with is whether a borrower’s obligation to comply with payment obligations under its loan agreements can automatically fall away or be excused in view of the pandemic. The answer to this question is examined below.
In the absence of any specific contractual provision allowing a borrower to defer repayment, a borrower’s obligation to make scheduled loan repayments as they fall due is not exonerated by events outside its reasonable control, which cause it cashflow difficulties.
Many loan agreements will not have any provisions excusing a borrower from its obligations if an event beyond its control were to occur (i.e. force majeure) and borrowers will therefore need to seek alternative forms of relief. On the contrary, COVID-19 may instead lead to what is in effect a ‘material adverse change’ to the borrower’s financial position and ability to perform its obligations, which may qualify as an event of default under its loan agreement. This could in turn trigger a demand from the lender for accelerated repayment of the loan by the borrower. Acceleration when a borrower is struggling to pay even the ordinary scheduled amounts, could put the survival of many businesses at risk.
All is not doom and gloom however, as each case will need to be considered on its own merits, including the wording of the loan agreement and the context in which the loan was made. Clauses that may be relevant include grace periods, disruption events, non-business days among others.
None of the aforesaid clauses would provide a defence for non-payment by the borrower for an irresolute or indefinite period but a borrower faced with financial difficulties may seek some leniency from the lenders under such provisions and in the current circumstances, many lenders may be willing to provide it.
This is especially so, taking into account the measures announced by the Central Bank of Kenya which are aimed at cushioning borrowers and the wider economy against the external shock of COVID-19 and maintaining financial stability in the country. Borrowers must however initiate this process by approaching their lenders, who will consider the respective circumstances of each borrower arising from the pandemic. Parties should ensure to properly document any waivers or amendments to the terms of the existing loan agreements arising from their discussions, for future reference.
It is important to bear in mind that lenders also have their own financial obligations to meet and if their loan assets become non-performing on a large scale, then the very fabric of our financial markets is at risk. It is with this risk in mind that policy makers and banking regulators in countries like Singapore are considering lightening the burden on banks by temporarily lowering the thresholds or measurements for capital adequacy and loss provisioning for non-performing loans. In a similar vein, the Central Bank of Kenya has lowered the Cash Reserve Ratio and provided flexibility in respect of loan classification and provisioning for loans which were performing before the pandemic.
Temporary insolvency measures
In addition to the measures mentioned above, the government is also proposing emergency funding and relief from taxes, among other initiatives.
Notwithstanding the raft of measures introduced, some borrowers may regard COVID-19 as being so adversely disruptive to their immediate operational survival that they are unable to recover in the short-term, leading them into some form of insolvency process. In such cases, the government should consider temporary measures that can help borrowers weather the storm, without placing themselves prematurely or unnecessarily into insolvency.
This is especially pertinent considering the duties of directors and their potential liability in relation to companies in financial difficulty – case in point being liability for wrongful trading.
Under existing laws, a director of a company may be held liable for wrongful trading if he knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation or insolvent administration and, despite this, failed to take every step to minimise the loss to creditors. If found guilty, such a director may be required to contribute to the company’s assets, as the court may consider proper, for distribution to creditors. It should be noted that there are instances where continuing to trade may actually reduce the losses to creditors and as such, closing the doors once a company is in financial distress may not be the optimal solution either. It is for this very reason that directors should seek legal and financial advice which is tailored to their particular circumstances, in order to make an informed decision on the best approach.
Given the challenges above, the government should consider temporarily suspending the wrongful trading provisions for company directors in order to provide comfort to directors who may be reluctant to continue acting for companies experiencing financial difficulties or who might otherwise file for insolvency, perhaps unnecessarily or prematurely, as a result of temporary challenges arising from COVID-19. Precipitate action may in itself be more damaging to creditors in some circumstances than waiting until the situation becomes clearer. In addition, putting a company into insolvency may put it beyond all hope of recovery due to the reputational damage suffered, when the company’s financial distress would have been reversed within a reasonable period post-pandemic.
Crucially, given that other creditors (apart from lenders like banks and financial companies) also have a right to commence insolvency proceedings against borrowers in financial distress, a temporary measure such as provision for restructuring plans that bind dissenting creditors should be considered. Under current laws, company voluntary arrangements and schemes of arrangement must be approved by a majority of the unsecured creditors and meeting the approval threshold can be a real challenge.
A pre-insolvency moratorium (similar to one available to a company in administration) may also be useful as it would prevent such creditors from taking enforcement action against a company while it considers options for its rescue.
Other temporary measures that are worth considering include increasing the statutory minimum amount of debt owed before a creditor can initiate insolvency proceedings (the current amount being KES100,000) and the time required to comply with a statutory demand. Under the current laws, a debtor is required to comply with a statutory demand within 21 days, failing which insolvency can be initiated. Granting greater latitude to borrowers during this time by temporarily increasing the amount and period mentioned above may forestall the potential harm to the economy should many businesses satisfy the current legal criteria for insolvency as a consequence of the pandemic.
Similar measures have been announced or proposed in other countries such as the UK, Australia, Germany and Spain and perhaps Kenya should consider borrowing a leaf from their book.
The article was also featured on the Business Daily on 28 April 2020.