REAL ESTATE INVESTMENT ALERT
Can COVID-19 infect your finance arrangements?
The impact of the outbreak of COVID-19 is getting larger and larger by the day.
Each day new consequences are being identified affecting a broader range of people, livelihoods, companies, industries and markets.
In this edition of our Real Estate Investment Alert we discuss:
- The concept of “force majeure” and whether such a concept can be used to protect borrowers in circumstances where their property investment or development is adversely impacted by COVID-19,
- Clauses found in finance documents which can work against borrowers in the above circumstances, and
- How to deal with the impact of COVID-19 in relation to your finance arrangements.
If you would like to read more please click HERE or see below.
Force Majeure – can it be used by a borrower in respect of its obligations under loan documents?
There has been recent commentary on the use of “force majeure” clauses (found in certain contracts) in the context of the COVID-19 pandemic.
Force majeure clauses deal with circumstances which are beyond the control of a party to the contract. They generally provide that the non-performance by a party to the contract that has been affected by such circumstance will be excused and not regarded as a default under the contract. This enables the contract to be kept alive and adjusted to account for delays arising from the “force majeure” event.
Although used in many commercial, building and project contracts, such clauses do not apply to borrowers under loan documents. As result, to the extent the value, income or progress of a property or development project is adversely affected by COVID-19, a borrower will not be able to benefit from an equivalent clause in respect of its obligations under loan documents (even though a party to an underlying transaction document relating to the property or project may be able to rely on such clause in respect of its obligations to the borrower).
Unlike the position of a borrower, there are a number of clauses in loan documents which lenders may rely on to protect their interests in these circumstances.
Clauses found in finance documents which can work against borrowers in the above circumstances
COVID-19 is having and will continue to have, a number of consequences for property investors and developers. Examples include:
- Delays in the supply of building materials and shortages of staff at building sites causing delays in completion and cost overruns,
- Cashflow issues for operators, tenants and owners of income-producing property, thereby affecting the ability of such parties to pay their debts,
- Increasing anxiety amongst consumers affecting confidence and their willingness to buy assets, including property,
- Changes in work habits leading to more work from home and reducing the need for office space,
- Increasing popularity of online purchases rather than in-store, and
- Deferring travel plans and changing travel habits.
These circumstances may lead to:
- Failure by borrowers to pay interest under loan documents,
- Higher costs of, or delays in, completing projects,
- Increased probability of purchasers of off-the-plan properties rescinding sale contracts or being unable to complete their purchases,
- Insolvency of builders,
- Failure by tenants to pay their rent,
- Insolvency of tenants,
- Higher vacancy rates in commercial, retail or other types of property
Although these circumstances are outside the control of the borrower, a number of standard clauses in loan documents provide the lender with rights in these circumstances which work against the interests of the borrower.
Many of such clauses are not identified or highlighted to a borrower in the initial term sheet or letter of offer provided by a lender and so borrowers are often unpleasantly surprised when the lender seeks to exercise such rights. This is particularly so where the circumstances leading to the exercise of these rights are beyond the control of the borrower.
Such clauses include:
Loan documents will contain a number of negative undertakings on the part of the borrower. These will include restrictions on:
- Entering into or varying leases, sale contracts or project documents,
- Waiving rights under such documents,
- Terminating/rescinding such documents or agreeing to do so, and
- Agreeing to extensions of time under building contracts or variations to a project.
In addition to restrictions, loan documents will impose obligations on borrowers to:
- Pay interest and fees as required,
- Satisfy certain financial undertakings,
- Enforce their rights under the above types of documents as directed by the lender,
- Fund all cost overruns in relation to construction projects, and
- Comply with the terms of project or transaction documents.
Failure to comply with these undertakings (irrespective of whether or not such failure is outside the control of the borrower) will generally amount to an event of default.
Events of Default
The list of events of default in loan documents is generally quite long and broad in its scope. As mentioned, many can be triggered by events unrelated to the borrower, e.g the insolvency of the builder in a construction project or the occurrence of a material adverse effect on the borrower (which may arise from circumstances outside its control).
Unless events of default are negotiated (ideally prior to accepting a letter of offer or term sheet), the occurrence of the relevant event will trigger a default. This will not only allow the lender to enforce its security but will also allow the lender to charge default interest (usually 2-3% higher than normal interest but can be much more with certain lenders).
Default interest can be charged in different ways which can make a significant difference to the total amount of interest charged. The default rate as well as how it is calculated should be known prior to accepting a letter of offer or term sheet.
Lenders generally reserve their rights to review the terms and conditions of a loan during the course of the loan.
The frequency of such reviews and the circumstances which can trigger such reviews need to be understood prior to accepting a letter of offer or term sheet in order to be able to have the best chance of negotiating such lenders' rights. As is the case with certain events of default, review events can arise in circumstances outside the control of the borrower.
How to deal with the Impact of COVID-19 in relation to finance arrangements
It is clear that the consequences of COVID-19 mentioned above can lead to breaches of undertakings, the occurrence of events of default and the exercise of a lender’s review rights.
None of these are in the interests of borrowers. Those clauses are for the benefit of the lender.
Although the impact of COVID-19 on the property market is still evolving, borrowers should understand how it may affect their finance arrangements. They can then start considering their response to the concerns likely to be raised by their financier’s if/once the relevant consequences arise. By doing so, borrowers will be better placed to:
- demonstrate why the circumstances should not be of concern; or
- negotiate any changes that may be required to the finance arrangements.
Borrowers’ should also get advice on clauses such as those referred to above when reviewing any letter of offer or term sheet for any proposed new loan facilities they are considering entering into. Dealing with these matters before accepting any such letter of offer or term sheet will maximise their chances of avoiding unpleasant outcomes or, at the very least, make them aware of these clauses so they accept the terms with their eyes open.
We trust you enjoyed this Alert.
Please feel free to contact us about our fixed fee initial term sheet review (FFITR) service which will assist you in minimising the risks associated with signing initial or indicative finance term sheets without fully understanding what is in, or is missing from, them.
Peter Faludi Consulting
The comments made in this Alert do not constitute the provision of any legal, tax or accounting advice by Peter Faludi Consulting or any Director or employee thereof and therefore you should not rely on this Alert in making any decisions relating to present or future transactions in which you are involved. We strongly recommend that you seek legal, tax and/or accounting advice (as relevant) in relation to the same.
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