The disruption of coronavirus

Beyond the obvious health implications and concerns arising from the outbreak and spread of Coronavirus (COVID-19), the economic impacts of it are becoming increasingly apparent, and felt, as each day passes. An example of this is the Reserve Bank of Australia slashing interest rates to an unprecedented low of 0.5 percent, at least in part to counter the expected economic downturn arising from the outbreak.

These impacts are already leading to challenges for financiers and their borrowers arising from the disruption being caused to workforces, service providers, supply chains and customers. It is apparent that businesses can expect disruption for months to come.

Whilst certain sectors, such as those focused on the 'indoor economy' including TV streaming services and food home delivery apps have experienced spikes in demand (and we've all seen the pictures of empty toilet roll and pasta aisles in certain supermarkets), many more, such as tourism and business travel related industries, are being immediately and negatively impacted.

Other sectors, such as the construction industry, the education sector and the student accommodation industry, are likely to experience delays to their international and local supply chains and disruption to their customers.

Financiers themselves are facing disruption to their workforces and service providers, with recent highly publicised incidences of companies sending entire workforces home and schools closing raising the very real prospect of the same happening at a major office of a large financial institution. We expect that the disaster recovery teams at all financial institutions are currently working very hard to design plans to facilitate a continuance of operations and the delivery of vital products and services to customers and the economy at large.

7 ways in which financing arrangements may be impacted

There are a plethora of ways in which financiers and their borrowers could be affected. Our preliminary thoughts on seven of these are discussed below.

  • Payment defaults – the most obvious effect is that the disruption of payment flows arising from the business interruption events described above is likely to lead to cash flow issues for borrowers impacting their ability to make scheduled repayments of principal and / or interest. Payments may also be missed simply because staff making or authorising payments are absent due to illness or required self isolation.
  • Financial covenants:
  • relying on earnings such as interest cover and debt service cover or minimum EBITDA tests – as the business of a borrower is disrupted, its earnings are likely to decline in the short to medium term meaning that its ability to comply with look back and look forward financial covenants based on those earnings may begin to come under pressure; and
  • relying on equity values such as net worth or funds under management tests – as share values plummet in the wake of the economic uncertainty caused by the outbreak, the value of portfolios will decrease and make it harder for borrowers to comply with financial covenants tested by reference to the value of those equities. On the other hand, the volatility of the markets will be attractive for speculators notwithstanding the risk the current market position poses for potential margin calls.
  • Project delays – the real estate sector relies heavily on imported goods and materials for use in the construction of large scale commercial and residential projects. Developers and builders are already commenting about delays in this supply chain and their concern about the impact that this will have on their ability to deliver construction works on time and on budget. Both of these factors are tested in construction finance agreements and so it is likely that developers are already speaking to financiers about requests for extensions of time for the completion of separable portions due to complete shortly. In the longer term, 'Sunset Dates' in contracts with purchasers of the finished product – again the subject of tests in construction financing agreements – may also soon be tested.
  • Material adverse change – aside from payment defaults and financial covenant breaches, the economic impacts of the disruption may lead to material adverse impacts on a borrower's business or prospects and / or its ability to comply with its obligations under its financing arrangements. In the current circumstances, we expect that financiers will be reluctant to rely on a MAE to be able to enforce rights against particular borrowers – however, if they do decide to go down that route, they will need to consider the drafting of the relevant MAE provisions in their facility agreements to determine whether the circumstances are such that they are able to do so.
  • Cessation of business clauses – the majority of financing arrangements include undertakings and defaults regarding a borrower ceasing to carry on its business or a material part of it. Government mandated lockdowns may mean some businesses, particularly in service industries, may face prolonged or undefined periods of closure.
  • Cross defaults and breach of material documents – even if a borrower is able to comply with its obligations to its financiers, business and / or cash flow disruption may lead to defaults under its obligations to other counterparties. For example, a supply agreement to supply certain goods to China may be unable to be fulfilled due to a ban on entry with no defined end date.
  • Liquidity crisis – borrowers with large undrawn commitments may decide to draw down on them so as to bolster their own emergency war chests. Financiers will need to be able to respond to this and will need to make sure that they hold adequate deposits and / or have access to wholesale funds in order to be able to do so. It is also possible that there may be an increase in the calling of bank guarantees and letters of credit in the trade and construction related sectors.

Where to from here?

The economic impacts of the virus may turn out to be more severe and longer lasting than the physical ones. We expect that the economic community will work together proactively to look to mitigate the impacts of the disruption on the economy. Government and government agencies will be required to play a significant role in assisting businesses to continue to operate as normally as possible. Financiers will also have a role to play in supporting their borrowers through this turbulent period – although ultimately protection of their capital will be a key concern.

We will continue to monitor the situation as it develops, in particular the way that it impacts financiers and their borrowers, and will look to produce a follow up article in due course providing some practical examples of the issues faced and suggestions for strategies and approaches to dealing with them.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.