COVID-19 and its potential impact on trade finance

1. Force majeure generally

Under English law, force majeure (FM) needs to be included as a specific clause in the relevant contract.

When negotiating commercial contracts, a common point of debate is whether or not FM should extend to - or exclude - payment obligations.

For loan agreements governed by English law, the only FM protection given to an obligor is the 2-5 business day grace period usually granted for non-payment. This is triggered by a material disruption to payment or communications systems or to financial markets (the Disruption Event definition in LMA documentation).

Under a number of other governing laws relevant to trade finance eg Belgium, China, France, Germany and Italy, FM forms part of the domestic regulations, and so should be considered in addition to any contractual FM provision. In China, a trade body has been issuing FM certificates to affected companies as a means of offering (at least under Chinese law) evidence of the existence of FM. Despite some confusion on the subject, it is unlikely that such certificates exonerate holders from performing their contractual obligations. You can learn more about this in the recent webinar by our colleagues in China and Singapore and in this article.

It is possible that similar approaches may appear in civil law jurisdictions, depending on future events.

2. Frustration versus force majeure

If no FM clause appears in an English law contract, a party can seek to rely on the doctrine of frustration as a basis for not performing its obligations. The two concepts are mutually exclusive, so if there is a FM clause then frustration cannot apply. The webinar also links to an article discussing the background to FM and the doctrine of frustration under English law.

The point to bear in mind is that if a contract does not address FM, it is still possible for a party to argue for similar relief based on frustration. So the circumstances relating to Covid-19 and business interruption can - in theory - be argued under most English law contracts.

3. Implications for providers of trade instruments

In relation to a documentary letter of credit, it is possible that making a valid demand might be delayed if the necessary supporting trade documents (invoice, packing list, bill of lading etc.) are unavailable to the claimant. However, this delay operates within the terms of the instrument, which lists the documentation required for a valid demand.

Generally, it will be very difficult for a financial institution to successfully argue FM as a defence to a demand for payment under a standby letter of credit, bank guarantee etc. As these instruments are autonomous to the underlying trade transaction, issues in that underlying transaction cannot be raised as defences to payment. An issuer would need to argue that it is impossible either (i) for it to make the required payment, and/or (ii) to accept what would be a valid demand.

Relevant industry trade terms do deal with FM. For example, Article 26 of UCP 600 (which is commonly applied in relation to documentary letters of credit) states that an issuing bank has no liability or responsibility for the consequences arising out of the interruption of its business by Acts of God, riots, civil commotions, insurrections, wars, acts of terrorism, or by any strikes or lockouts or any other causes beyond its control. That issuing bank will not, upon resumption of its business, honour or negotiate under a credit that expired during such interruption of its business. However, this provision does not provide automatic protection to an issuing bank, and FM needs to be evidenced and proven. It is relevant to note that the treatment of FM differs substantially between UCP 600, URDG 758 and ISP 98.

The threshold for claiming FM in relation to payment is likely to be too high in most cases, since bank payment networks currently remain open and (certainly in European jurisdictions) regulators are asking bank financial institutions to prepare or update Covid-19 action plans. We would expect maintenance of payment operations would be a priority under such plans.

We are aware of at least one historic instance where FM was raised as a defence to accepting a valid demand under a trade instrument. The context to this was that the issuer’s personnel were evacuated from the location in which demand was required to be made, as a result of civil war. There is the possibility to raise similar defences where cities become subject to quarantine in the same way as Wuhan in China or regions (including Milan) in Northern Italy, subsequently extended to all of Italy.

If similar quarantine action is taken in relation to more cities with large financial services industries, it is possible that efforts are made within the trade finance industry to agree on temporary operational workarounds as an alternative to allowing individual issuers to fend for themselves. Any workaround would need to be agreed multi-laterally, given the ability for payment instruments to involve a chain of financial institutions through operations such as advising, confirming and/or negotiating such instrument.

4. Implications for risk participations

In relation to a participant, it is likely to be in the same position as a trade instrument issuer, with respect to payment of demands made under its participation agreement.

5. Implications for trade finance loans

Under a typical trade finance facility, the borrower is in a similar position to the issuer of a trade instrument - the threshold to successfully relying on FM as a defence to payment is extremely high.

A prudent view would be that for such a FM defence to payment to succeed, a borrower or debtor would need governmental authorities to impose complete blocks on movement of workers, and for this to adversely impact its own relevant personnel so that they are prevented from accessing bank services (including remotely through internet banking).

There was little recent relevant historical precedent for such action. However, the cordon sanitaire imposed in Italy over the weekend reinforces the example of Wuhan in demonstrating that current circumstances are fluid. Any legal issues arising as between borrower and lender are likely to be highly fact-dependent, at least in how the general situation has impacted a specific borrower.

Limited recourse loans

Certain commodity finance loan products are structured with some element of limited recourse to the borrower. For example, under a typical prepayment facility, a trade makes an advance payment for goods to a supplier (eg an oil refiner) and funds that payment via a back-to-back loan. The trader’s obligations as borrower are limited recourse – it only has to pay from the proceeds of sale of the goods supplied to it under the trade transaction - but subject to certain exceptions. The occurrence of FM can be one such exception, but it is up for negotiation in each transaction rather than always being conceded by the trader.

Impact on financial covenants

We have begun to see some borrowers seek protection on compliance with financial covenants, where their business performance will be adversely affected by current and ongoing circumstances.

Covid-19 as a Material Adverse Effect?

We understand some firms are advising that the current circumstances may trigger a MAE under loan facilities. On the current facts, we think such advice would be rather aggressive. More likely consequences are events of default relating to insolvency and/or cross default for borrowers in industry sectors particularly vulnerable in the current environment. Air travel and tourism are obvious sectors, as is the business conference sector.

Lenders will need to consider whether to accept an element of borrower protection when negotiating new contracts. A lender could seek to limit the impact of current circumstances solely to business interruption arising when complying with official Government guidance. A lender may not want a borrower to avoid an event of default where the borrower has decided on a shutdown ahead of any official guidance. Clearly, there are business relationship issues to consider here also.

When attempting to define the current circumstances in contracts, it may be prudent not to limit description specifically to Covid-19, given the virus does mutate naturally over time and it is possible that eg a related ‘Covid-20’ infection is identified later in the year. A description relating to eg disease and public health emergencies would avoid this particular drafting issue.

Business interruption

Some traders and borrowers in Asian jurisdictions have found it difficult to access authorised signatories in a timely fashion, where they are not at their usual place of business. Lenders are being asked to accommodate such issues eg by accepting electronic signatures or to waive minor discrepancies.

New lending

Where lenders are negotiating to offer to arrange financing on a committed basis, there can be difficult issues of contractual interpretation where commitment papers have not yet been signed by all parties, and one party involved seeks to change its position in relation to ongoing participation.

6. Implications for supply chain finance platforms

From a credit perspective, the potential impact of Covid-19 on supply chains may lead to an increase in the rate of late or non-payment of debts. However, we currently do not see significant repercussions for the legal enforceability of SCF platforms and transactions. The risk of general FM-type events, such as sanctions, war etc., is not affected by the current circumstances. Under a typical buyer-led SCF structure, the buyer accepts the irrevocable nature of purchased trade receivables.

In our view there is a very high threshold for the buyer to argue successfully that it is prevented from making timely payment due to FM. This essentially requires evidence that the banking systems have closed or there being no way for the debtor’s personnel to access such services. It is up for debate whether the threshold for claiming FM on the basis that its account payables personnel are unable to access and operate the buyer’s accounts is lower than it would be for a trade instrument issuer, but in our view the threshold remains very high. A buyer may also benefit from a short ‘Disruption Event’ grace period for late payment in its contract.

7. Implications for receivables financing

Most supplier-led receivables financing is carried out in relation to trade transactions where the supplier has performed its obligations in full, leaving only the payment obligation of the debtor (which is purchased by the financier). The financier would transfer value only upon the final invoice being issued. The seller will represent that it has fully performed its obligations and that the receivable is due in full with no deduction. Any subsequent breach of those representations would give the financier recourse back to the seller for the amount of the relevant receivable.

Where the underlying debtor fails to pay a purchased receivable on or before its due date and claims FM as the cause of such failure, under a typical limited recourse receivables financing it is likely to be the purchaser (rather than the seller) who will hold the risk of late or non-payment. Recourse back to the seller typically only arises where the non-payment is linked to a breach by the seller of its obligations under the underlying trade transaction, or where a dispute has arisen between seller and debtor.

It is also increasingly common to finance future receivables (pre-acceptance financing). Where a financier has paid value for future receivables where the seller/supplier still has outstanding performance obligations, it is possible that eg delays in shipment of goods (or performance of services) could allow a debtor to argue that it is entitled to delay payment. This in turn may trigger full recourse back to the seller.

8. Implications for trade receivables financed off-balance sheet

Where receivables are being sold to a special purpose vehicle which is financed by the issue of notes secured on a global portfolio of receivables, a slowdown in global or regional trade could eventually have implications for the structure. As trade receivables typically have a short tenor, the structure will be reliant on constant replenishment of the asset portfolio in order to generate returns to pay interest on the SPV notes. An inability to source sufficient new trade receivables can mean that a structure has to be terminated early. This happened with certain trade receivables securitisations several years ago. Reliance on trade receivables generated from supply chains involving Ukraine caused problems as a result of the downturn due to the civil war.

These issues are not faced under financing structures which issue notes secured on specific receivables portfolios and where the notes are paid down over time and replaced by new issuance of notes secured on new receivables.

Find out more about the spread of COVID-19 in Italy and related employment issues.