It is clear from the factual and legislative developments that contracts and commitments for loans in Germany will be affected by COVID-19. At this time, the biggest risk for borrowers is that the deterioration in their financial position threatens to activate certain termination rights on the part of the lenders.
As a rule, the borrower's obligation to pay interest and repay principal under a facility agreement is not conditional on the borrower's financial conditions. It must be performed as an absolute obligation and is often supported by collateral which might be realised in priority by the lender in case of default.
Remedies under German contract law
Borrowers whose financial situation deteriorates as a result of COVID-19 should pay particular attention to the following contractual and statutory provisions:
- Financial Covenants: Loss of sales due to the corona-crisis may have direct impact on financial covenants. Financial covenants such as debt to equity ratio, debt service ratio and interest cover ratio are an essential part of facility agreements and are standard market practice. They serve lenders as a classic early warning system regarding the financial situation of the borrower. If they are not adhered to, this constitutes a reason for termination under the facility agreement. At the same time, the breach often leads to an automatic increase in the margins as part of interest rates and the loss of further opportunities to draw on the loan.
- Insolvency or insolvency proceedings: In addition, most facility agreements provide for an extraordinary termination right of the lender due to insolvency of the borrower.
- Material Adverse Change Clauses: The legal consequence of the activation of a material adverse change clause is the right for the lender to terminate the facility agreement. Whether a company` s economic difficulties lead to the activation of such clause always depends on the specific circumstances of the individual case. According to case law of the Federal Court of Justice, whether a "material" deterioration exists can only be decided after an overall assessment of the individual case and weighing the interests of both parties to the contract (BGH III, Urteil v. 6. März 1987 – ZR 245/84). A substantial deterioration is not to be determined solely arithmetically, but rather by economic considerations, taking into account the public perception. If the deterioration is only of a short-term or insignificant nature, termination of the loan is generally excluded.
If the financial indicators stipulated in the covenants are complied with, this generally speaks against a significant deterioration of the borrower's financial position or earnings situation. If, on the other hand, the covenants are not met, the borrower should contact the lender at an early stage and try to cure this breach of contract. This is usually done by applying for a waiver letter. However, waivers or associated contract adjustments ("covenant resets") can often only be obtained against payment of a fee or risk premium.
Particularly in the case of financing commitments, the affected borrowers should clarify with the lenders at an early stage whether the commitment still exists.
- Increased Cross Default Risk: Under a cross default clause, the lender has the right to terminate a facility agreement if the borrower or, where applicable, members of the group are unable to meet financial obligations exceeding a certain threshold towards another creditor. Due to the current dramatic developments in some sectors of the economy and the associated potential defaults, borrowers are exposed to an increased cross default risk and face the possibility that the loan will be accelerated by the lender.
- Special termination right pursuant to Section 490 German Civil Code (Bürgerliches Gesetzbuch – BGB): Generally, extreme events such as pandemics do not exclude the application of Section 490 BGB. It contains the general rule in German credit contract law for extraordinary termination of facility agreements. According to it, the lender is generally entitled to terminate the loan without notice after disbursement in case either a significant deterioration occurs or threatens to occur in the financial circumstances of the borrower or in the value of collateral granted to secure the borrowers obligations under the facility agreement which threaten the repayment of the loan. Whether these conditions are met depends on the circumstances of each individual case.
Within the scope of Section 490 BGB, it is irrelevant whether the deterioration of the borrower's financial prospects is beyond his control. Therefore, even a force majeure event does not restrict the lender in his right to terminate the contract. Thus, even if the borrower's economic problems are exclusively based on the effects of the Corona crisis, the lender remains entitled to terminate the loan in accordance with Section 490 BGB if there is otherwise a threat of default.
- Basis of transaction ceases to exist (Wegfall der Geschäftsgrundlage) pursuant to Section 313 BGB: There is no general rule on the non-application or suspension of contractual arrangements with regard to loans in the event of pandemics or force majeure other than the one being introduced with regard to consumers under the new German law for the mitigation of the consequences of the COVID-19 pandemic. The lender bears the risk that the borrower defaults on the loan. In return, the borrower's repayment obligations are basically independent of the fate of the investments made with the loan value.
However, it is conceivable that the Corona crisis could lead to a claim for adjustment of the facility agreement under Section 313 BGB due to the "loss of the (major) business basis". Such a loss of the "major" business basis is said to exist if the fundamental political, economic and social conditions of the contract change, for example due to revolution, war, expulsion, hyperinflation or (natural) disasters. So far, case law has been very restrictive in assuming such a "common danger". Among other things, such a "disappearance of the great basis of business" was assumed in the context of German reunification or because of the November Revolution after WWI. It will have to be seen how German courts will deal with the economic effects of the corona pandemic.
The Federal Financial Supervisory Authority`s (BaFin) treatment of deferrals
Deferrals are a common method offered by lenders to support otherwise solvent borrowers in case of acute liquidity problems. Under the current circumstances the question arose whether a deferral on the payments of the loan granted by the lender to the borrower leads to the loan being considered as a "defaulted exposure" pursuant to the Capital Requirements Regulation (CRR). This would lead to a significant increase in the regulatory capital requirement for this loan on the part of the lender.
On 20 March 2020 the German financial services authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) clarified this question in its Q&As. In case a bank defers a claim, such claim does not have to be counted as defaulted if interest on the deferred amounts is agreed corresponding the original terms of the loan. In this case, such deferral does not constitute a default pursuant to Art. 178 CRR. According to BaFin such deferral has the effect that the liability remains within the notified limit, so that no "overdue material liability" according to Art. 178 (1) b) CRR arises. Furthermore, such deferral does not reduce the debtor's financial obligation, so that no "crisis-related restructuring" according to Art. 178 (3) d) CRR exists.
Moreover, MaRisk does not fundamentally oppose such a flat rate deferral. In particular, it does not regulate the criteria and conditions under which a deferral in favour of a borrower may be granted at all. This must be decided by an institution within the scope of due diligence obligations customary in the industry and under its own business policy responsibility. In the event of a singular crisis like this, different standards than in normal times must certainly be applied to what may still be considered customary in the industry.
Recommended course of action
Affected borrowers should create transparency at an early stage and contact the lenders as soon as possible. If necessary, a "Covenant Holiday" can be agreed or any other waiver letter can be signed. In general, open communication strengthens the confidence of lenders in the company's crisis management. Financing commitments or other assurances should be reviewed. If necessary, a bridge loan from KfW can be applied for through the respective house bank. A summary of the government-backed aid programmes can be found in this Blog-post by Alina Weber and Katharina Giehrl.
Authored by Dr. Christian Herweg, LL.M. (Cambridge), Dr. Jan Fürbaß and Katharina Giehrl, LL.M. (London).