Borrowers beware – financier’s rights may not be affected by COVID-19 policies

Borrowers beware – financier’s rights may not be affected by COVID-19 policies

REAL ESTATE INVESTMENT ALERT

April 2020

Borrowers beware – financier’s rights may not be affected by COVID-19 policies

Since our last Alert, the regulatory environment in Australia has been turned on its head by a wave of changes, the likes and speed of which has not been seen before.

In circumstances like this, it is very difficult to formulate a strategy as to how best deal with the consequences of COVID 19 on business without first obtaining expert advice.

In this edition of our Real Estate Investment Alert, we outline a number of changes that have been introduced which are relevant to borrowers who are property investors and developers (as well as other business borrowers) and consider whether they will make any difference to borrowers in respect of their financing arrangements.

In particular, we discuss:

  • Changes to statutory demands and insolvent trading
  • Principles relating to commercial lease negotiations
  • Loan relief available from banks for small business
  • Dealings with non-bank lenders
  • Impact of FIRB changes on some COVID-19 strategies

Changes to statutory demands and insolvent trading

Statutory demands

As you are aware, where a company owes a debt in excess of $2,000 to another person, the creditor may serve a statutory demand on the debtor under Section 459E of the Corporations Act, requiring the debt to be paid within 21 days.

Unless there is a legitimate dispute as to the debt owing, failure by the debtor to pay the full amount of the debt within that timeframe will result in the debtor being regarded as insolvent. This is a common way of starting winding-up proceedings.

Failure to satisfy a demand is also generally treated as an insolvency event for the purposes of loan documents as well as leases, sale contracts and other commercial contracts.

Changes to the Corporations Act, enacted as part of the Federal Government’s COVID-19 reforms, have made it more difficult for creditors to rely on insolvency events of default and other clauses triggered by the occurrence of an insolvency event.

Under the changes, the minimum debt that can be the subject of a statutory demand has increased from $2000 to $20,000. In addition, the period by which payment must be made has been increased to 6 months. Accordingly, the ability of a financier to rely on an event of default triggered by the borrower failing to satisfy a statutory demand will now be deferred.

The above reforms are only to operate for six months from 25 March 2020 (unless extended by regulation or Ministerial order).

Similar changes have been made to the Bankruptcy Act for individuals.

From a borrower’s perspective, the reforms are beneficial but they do not prevent its creditors from taking action if a different event of default occurs under loan documents or other contracts, including events of default which may be triggered as a result of COVID-19 consequences. They also may not prevent financiers from taking advantage of any review rights they might have.

Insolvent trading

A major risk for directors of companies is that reduced cash flow caused by the impact of COVID-19 on their business or that of their tenants may increase the likelihood of the directors incurring debts on behalf of the company at a time when the company is insolvent, i.e it cannot pay its debts as and when they fall due.

As the Government wishes to keep businesses operating, it has made changes to the Corporations Act which significantly reduce the risk for directors of insolvent trading.

Under the new rules, directors will not be held responsible for insolvent trading if the debt is incurred:

  • in the ordinary course of business during the 6 months period commencing from 25 March 2020 (or such longer period as prescribed by regulation or Ministerial order), and
  • prior to any administrator or liquidator being appointed and during that period.

Although this is a good result for the borrower, it does not override restrictions on incurring financial indebtedness usually contained in finance documents, breach of which will trigger an event of default.

Principles relating to commercial lease renegotiations

On 7 April 2020, the Federal Government released its mandatory code of conduct which sets out the “good faith leasing principles” to apply to negotiations between landlords and tenants in respect of commercial tenancies, which include retail, office and industrial premises (Code).

The Code is to be legislated by each state and territory.

The Code applies where the tenant has suffered or is suffering financial stress or hardship due to COVID-19, has a turnover of no more than $50m and is eligible to participate in the JobKeeper Program.

The Code sets out 11 overarching principles and 14 leasing principles which are to be taken into account by both landlord and tenant when negotiating potential changes to leases currently in place.

Although we do not intend to summarise these principles in any detail, it is useful to mention a number of them relevant to the theme of this Alert.

Overarching Principles

The overarching principles include an obligation on both parties to negotiate in good faith, in an open, honest and transparent manner. The landlord must take account of the impact of COVID-19 on the revenue, expenses and profitability of the tenant and the changes made to the lease should be proportionate and appropriate having regard to the impact.

Leasing Principles

Some of the main specific leasing principles are:

  • If the tenant suffers distress, its landlord is not entitled to evict the tenant for non-payment of rent during the pandemic and a reasonable subsequent recovery period. As there is no specific timeframe mentioned, the term for which this restriction applies is unclear.
  • Material failure by a tenant to comply with “substantive terms of their lease” expressly forfeits the protections provided under the Code.
  • Rental waivers and deferrals must be offered to tenants in proportion to their reduction in turnover, with no less than 50% to be by way of waiver (meaning the reduction in rent is permanent) rather than deferral.
  • Deferred rent is to be amortised for no less than 24 months, irrespective of the term of the lease. No mention is made how the landlord can be secured for such payments after the lease expires. In addition, no fees, interest or other charges can be imposed on the waived or deferred rent.
  • The tenant should be provided with an opportunity to extend the lease on the same terms for any period of waiver or deferral of rent. This seems to go beyond the purpose of the Code as it may result in the landlord not being able to relet the premises immediately on expiry of the original lease for a higher rent once the pandemic is over.
  • The landlord cannot increase rent (other than turnover rent in retail leases) during the pandemic and a reasonable subsequent recovery period. Once again, as there is no specific timeframe mentioned, the term for which this restriction applies is unclear.

The above reforms are intended to override existing legislation and leases.

Possible impact on financiers

In terms of financiers, the Overarching Principles provide that both parties are to assist each other in their dealings with banks and other financial institutions to achieve outcomes consistent with the objectives of the Code. When releasing the Code, the Government stated that “it expects Australian and foreign banks, along with other financial institutions operating in Australia, to support landlords and tenants with appropriate flexibility as they work to implement the Code.”

It would appear that the Government will not tolerate actions by financiers which prevent a successful renegotiation of a lease consistent with the principles set out in the Code.

Although not specifically addressed by the Code, the abovementioned statement of the Government, as well as the Overarching Principles, may restrict a landlord’s financier from:

  • withholding its consent to proposed amendments to leases negotiated in accordance with the Code, or
  • calling an event of default if the terms of the loan are not met due to the revised leasing arrangements e.g due to a breach of financial ratios.

Indeed, financiers may need to amend their loan documents to expressly acknowledge these exclusions during the relevant period as part of the renegotiations of the lease between the landlord and tenant.

Although not clear, presumably a mortgagee in possession or a receiver appointed over the landlord could not override the restriction on eviction or any change made to the lease.

The above matters will need to be considered further if/when information regarding these reforms is released by the ABA.

Loan relief available from banks for small business

The ABA has advised that businesses, with total business loan facilities of upto $10m, which have been affected by COVID-19 will be able to “opt-in” and be relieved from strict compliance with certain provisions of loan documents for 6 months.

Subject to certain conditions, banks will not enforce their security in respect of non-financial default “(including changes in valuation)”.  It is interesting that the ABA regards a change in valuation as being a “non-financial default”.  In addition, interest will be able to be capitalised during the deferral period.

The ABA has also stated that other forms of assistance may be available to small business including deferral of scheduled loan repayments, waiver of fees and charges and interest-free periods.

Interestingly, the above change in approach to default does not extend to financial default even though it is the type of default which is most likely to occur. Presumably, the capitalisation of interest and the potential to waive fees and charges and provide interest-free periods will overcome this risk.

The above measures also do not address banks’ rights of review or their ability to change the terms of the loan, often found in standard bank terms and conditions.

For small developers and commercial property investors, these measures may be useful (although not providing complete protection) but for borrowers with loans in excess of $10m the relief measures do not apply.

Dealings with non-bank lenders (NBL’s)

The above measures also do not apply where the lender is an NBL.

NBL’s have traditionally relied on building strong relationships with their clients in order to maintain and grow their business. It will be interesting to see if these relationships will pass the stress test of COVID-19.

It makes sense for all borrowers and their financiers to be discussing the consequences of COVID-19 to assist each other make it to the other side of the pandemic in reasonable shape. Strict enforcement of loan documents in this environment is not likely to benefit either party. The GFC is testament to that.

It is important that borrowers start considering their loan arrangements and speaking to their advisers and financiers (whether banks or NBL’s) as soon as possible.

Impact of FIRB changes on some COVID-19 strategies

There are many strategies that can be followed by borrowers who are adversely affected by COVID-19.

These include asset sales, the raising of capital and refinancing.

The Treasurer’s announced changes to Australia’s foreign investment review rules, which took effect from 29 March 2020, are likely to further inhibit the property market for an indefinite time. The measures are to remain in place “for the duration of the coronavirus crises”.

To the extent a borrower wishes to sell assets to, or raise significant capital from, foreign persons (irrespective of value) after 29 March 2020, they will need to get Treasurer approval, which may now take upto 6 months. Financiers may not be willing to wait such length of time for sale or recapitalisation proposals to be implemented. They may not approve proposals involving foreign persons for this reason.

Refinancing by a foreign financier may also require Treasurer approval unless the relevant exemption applies.

As most financiers are not willing to leave approvals in place for extended periods of time or require drawdowns under facilities to occur within a particular period, the above changes may be an impediment to property investors refinancing where approval from the Treasurer is required. This may limit the strategies available to borrowers in relation to their current financing arrangements.

Conclusion

It is clear that there is a disconnect between a number of the new policies being put in place to keep business operating and people working and the rights of financiers in relation to business borrowers.

Although the small business’ which can take advantage of the announced ABA measures may be insulated from the exercise of enforcement rights of banks, those measures are not a complete safeguard against banks exercising their other rights and powers.

They also do not apply to a large number of property transactions and are not relevant when the financier is an NBL.

The other reforms mentioned above, although beneficial, do not expressly qualify financiers rights when borrowers are adversely impacted by COVID-19.

It will be interesting to see how financiers approach the issues arising for their borrowers given the objectives of the various reforms being put in place to deal with COVID-19.

We trust you enjoyed this Alert.

Please feel free to contact us about our fixed fee loan document health check which will assist you in understanding your financier’s rights under current loan arrangements and help you in determining the strategy to adopt in your discussions with your financier.

WISHING YOU A HEALTHY AND PEACEFUL EASTER

Peter Faludi Consulting

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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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