The global supply chain has experienced massive disruptions, courtesy of COVID-19. As the days and months of the pandemic have built and its impact is felt, logistics and freight companies, manufacturers, and retailers have all taken a significant financial hit. For secured lenders, whether they be bank, independent asset-based lenders, factors, or those in the private equity arena, many of their borrowers are likely to breach or have already breached their financial covenants.

The toll on the borrowing base of these industries does raise significant issues for secured lenders. Given the business shocks caused by the pandemic, there is concern that force majeure clauses in contracts might be invoked by companies so they can gain concessions for delayed delivery of products or non-payment to commercial landlords. In fact, in March, CEVA Logistics and DHL Global Forwarding had both invoked “act of God” actions as they relate to their carriers and logistics servicing companies. As these companies look to force majeure clauses to avoid the financial impact of non-performance or a delay in delivery, secured lenders are taking a closer look at what this might mean for them if one of their borrowers does the same.

The Impact on the Supply Chain

For retailers, manufacturers and other companies sourcing goods and parts globally, the current environment is uncharted territory. “Combined with the increasing need for cash, lenders will be pushed to maximize borrowing capacity,” says Andrew Holmes, head of North America at Demica. Many clothing retailers were challenged before the crisis, but COVID-19 will accelerate the restructuring or liquidation of some of these players, especially as they struggle with plummeting sales and spring and summer inventory they will need to dump, he adds. As the quality of receivables deteriorate, a robust receivables financing structure remains essential in this environment.  

According to Jeff Goldrich, president and CEO at North Mill Capital, there are other complications for the supply chain. With global production concentrated in China, there is concern with quality and getting goods out of China in a timely fashion. “Fronting cash to cover the manufacturers has obvious risk, and we are seeing letters of credit being used for protection,” says Goldrich. “We have not seen that in some time, at least from our vantage point.” Prior to the crisis, most of North Mill Capital’s import clients were buying from Asian suppliers on open terms, but now, due to demand, upfront cash is required. The key, he says, is to make sure deadlines and benchmark dates outlined in purchase orders are being met.

The COVID-19 crisis has also changed what is and how much is being shipped. “We have existing clients and prospects who are getting large orders for all sorts of medical equipment and supplies,” says Goldrich. “We are continuing to aggressively advance on accounts receivable and inventory and taking steps to ensure that the products are what they are purported to be and destined for reputable customers.” But for many products, and not just PPEs, Chinese manufacturing companies are requiring either large deposits or payment in full in advance before shipment. “We have been working with purchase order finance partners in an effort to help with that,” he notes. Another issue is getting any type of goods out of Chinese customs, which is taking a long time, if at all. There are also complexities once inventory reaches the United States.

This is not the market where high-risk appetites alone prevail, says Hailey Benton-Thomas, chief operating officer and general counsel for TBS Factoring Service. “Among industry peers that I’ve spoken with, there seems to be a consensus that there will be supply-chain issues for at least the next six months and that there is no magic bullet to protect our interests,” she says. “It’s these times that require a lender to reach into their tool belt and have options on various deal structures that best fit the situation. Those with a line-of-credit borrowing base are likely looking to convert a portion of their portfolio to cash to prepare for increased ineligibles,” she says. Lower performing accounts that had potential will be the casualties of the crisis for some and opportunities for others. 

Understanding the Risk

Not surprisingly, contractual obligations are sure to be a much bigger and even more significant focus of secured lenders now and moving forward. According to secured lending attorney Jason Miller, a partner in Otterbourg P.C.’s Banking and Finance Department, when the borrower is the one looking to excuse the performance of its obligations to its customers, secured lenders should be mindful of the termination provisions in key customer contracts. He adds, “If the borrower’s non-performance constitutes a breach of the contract that leads to termination by the customer, the borrower’s financial situation may change drastically depending on the relative importance of each contract terminated.” The borrower’s customers may also withhold payment from prior shipments, which negatively affects borrowing availability. 

Secured lenders in logistics and freight, for example, typically have a high volume of clients and debtors, notes Benton-Thomas.  “Each situation involving force majeure will be very fact-intensive. The volume that could arise, combined with the detailed nature of each situation, is worrisome.” Typically, the secured lender’s contract is not the one at issue, but rather a contract somewhere else in the pipeline. “In every situation we are looking at the language in the contract itself to see if force majeure is mentioned, and we then review the severity of the actual COVID-19 impact, along with the timing of the impact compared to the contracted performance, other facts supporting force majeure defenses, such as mitigation, and then, of course, the specific jurisdiction standards,” she says. “These situations cannot be assessed quickly, so if many such arguments are made, it would be highly time consuming and disruptive.” Jurisdictions also vary drastically, so it’s important to also review venue and choice-of-law provisions.

Force majeure is sometimes applied locally in response to disasters, such as hurricanes, but Holmes notes that we have yet to see an example where it can be applied on a global scale. While we are not currently seeing widespread invocation of force majeure, it is impacting some industries already. “Often the threat of invocation of force majeure is sufficient to achieve modification of price or terms,” he adds. “We are seeing this in the oil sector in North America. It hasn’t yet been litigated to my knowledge, but refineries are extracting accommodation from suppliers to reprice the offtake agreements—the threat of force majeure is sufficient to achieve the objective.” And, in many ways, the concession is certainly a much easier thing for the borrower, and lender, than a contractual dispute.

But where there is significant case law and precedent for natural disasters, a force majeure claim based on a pandemic has yet to make its way through the courts. According to Miller, there are relatively few examples of where force majeure arising out of recent events has prevailed in the courts. He does add, “However, hurricanes have their own force majeure case law rules. Hurricanes are always considered force majeure, so long as the asserter did not contribute its own negligence.” For example, mooring a boat inside a hurricane’s projected path has been ruled negligence that prevents prevailing on a force majeure claim.

Loan Agreements in Play

Additionally, if the impact of the COVID-19 pandemic grows, borrowers are likely to look to their loan agreements for potential excuses of nonperformance on a loan, such as force majeure, only to find their loan agreements likely to be conspicuously silent on the issue. “Courts will usually reject a force majeure claim if the parties’ agreement does not contain a force majeure clause,” says Miller. Where this is the case, borrowers will turn to common law mechanisms for excuse of nonperformance, which would be a fact-intensive inquiry based on applicable state law.

When the loan agreement does include such a provision, in many jurisdictions, courts will construe a force majeure clause narrowly as a matter of law. Albeit atypical, for any loan agreements that do contain a force majeure clause, if it does not mention a “pandemic”, “disease” or “measures of any governmental authority,” the secured lender should be able to rest easy, Miller notes. Secured lenders need to double check their form documents to make sure there is no force majeure provision that could adversely affect them. They should also consider preparing responses now to potential comments from borrowers about force majeure that could arise during the loan agreement negotiation process.

Fortunately, secured lenders can take some comfort in what courts have noted before regarding their obligations in a force majeure action. “I have yet to come across a force majeure argument that had any chance of success in our portfolio, though we’ve had several obligors raise the defense,” says Benton-Thomas. While there are many exceptions, and jurisdictions vary, she notes there is little reason for secured lenders to worry.

A Look Ahead

Courts should reject force majeure arguments if they are not listed in the contract. However, there are other ways a party might seek to excuse its non-performance, says Benton-Thomas. “In many jurisdictions, there are common law doctrines that could have the same impact.” There’s the doctrine of impossibility, which is similar to force majeure, and some states, like California, lessen the standard to “impracticability”, which would excuse performance in the event of unreasonable expense. 

The good news is that the exposure of secured lenders to these sorts of claims are limited because nonperformance isn’t excusable if the event preventing performance was expected or was a foreseeable risk at the time of the contract’s execution. Now that secured lenders are several months into the pandemic, borrowers with newer contracts would not be able to avail themselves of the same defenses.