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07 Jul 2020

Finance litigation: 10 legal risks


As the economic fallout from the COVID-19 crisis develops, the risk of default in commercial lending rises. Banks face increasingly challenging choices. Should they enforce margin calls, exercise termination rights or follow guidance from regulatory authorities1 to act “in good faith” and waive covenant breaches arising directly from the pandemic? To add to the difficulty, decisions on rapidly decreasing collateral clearly need to be made quickly. In this article, we examine key issues to be aware of from a legal perspective and highlight practical steps that can be taken to minimise risk.

1        Waiver: traps for the unwary

At the outset of the pandemic, the Prudential Regulatory Authority urged lenders to take account of differences between normal covenant breaches and those relating to COVID-19. But what are the short and long term consequences of waiving breaches of covenant and how can banks minimise adverse consequences?

In agreeing (temporarily) not to enforce a legal right, a key concern is that the waiving party accidentally agrees to a wide and binding waiver of current and future breaches of contract. Alternatively, the waiving party finds it is prevented from denying it has made such an agreement by the doctrine of estoppel. Most lenders will already have mitigated this risk by including standard “no waiver” clauses (such as that adopted by the Loan Market Association) in their documentation. “No waiver” clauses are designed to protect parties to contracts by providing that any delay or failure to enforce rights under the agreement (for example the right to terminate immediately for breach), does not result in the loss of that contractual right or remedy.

2        Estoppel

While “no waiver” wording is useful, it will not always protect a party from all arguments. An initial failure to act in the face of an event of default is unlikely to constitute, without more, a waiver of rights. Continued silence in the face of multiple breaches, however, coupled with a suggestion that a lender has promised not to enforce its strict legal rights may lead to difficulties. Defendants in financial litigation often make use of the doctrine of promissory estoppel. In effect, this prevents a finance party from suing for breach where it can be proved that it represented it would not enforce its strict contractual rights. Estoppel is a legal concept designed to operate as a “safeguard from injustice”.2 It is not, therefore, something which can easily be excluded even with the most careful drafting. The safest course is therefore expressly to reserve rights from the outset of any negotiation and carefully document any agreements reached (for example, to reserve the right to insist on payment at any time, and if possible to document that the borrower agrees that it will not rely on the lender’s forbearance – although note that borrowers may resist these sorts of provisions).  

3        Documenting a variation

If an agreement is reached (either following a breach or in anticipation of one), a variation of the existing contract needs to be documented3. As with any variation, unless the agreement is by deed then consideration is required. The scope of the variation needs to be clearly defined. Will it be permanent or, for example, revocable on reasonable notice?   Parties also need to ensure that they comply with any requirements in their existing finance documentation for modifications, including obtaining all necessary consents. Recent cases show that the court will carefully scrutinise compliance with “no waiver” clauses to analyse whether or not a waiver or other contractual forbearance has been agreed4. Taking the trouble to document a change fully is time-consuming but potentially crucial to limit the risk of subsequent litigation.

4        Verbal variations – “no oral modification” clauses

Despite best efforts, parties often reach (or allege that they have reached) temporary, unwritten agreements which they plan to document at some point in the future. Many lenders will be protected from the adverse consequences of any such alleged agreement by “no oral modification” clauses in their finance documentation. That these clauses work was confirmed by the Supreme Court in MWB Business Exchange Ltd v Rock Advertising Ltd5, where a “no oral modification clause” was held to preclude a later, verbal variation. Since that decision, the courts have also applied the principle to agreements in which one party forbears to sue another.6 As set out above, whether or not such clauses work in the face of arguments on estoppel remains to be seen.

5        Acceleration or affirmation: choose it or lose it

Most finance agreements allow a lender, in response to a range of breaches of contract, to elect to accelerate repayments or to terminate. The way in which such a clause works is dependent on the precise wording of the contract. If the contract provides that once such a right arises, it cannot be lost by delay in acting, a court may allow a lender to enforce its rights as and when it chooses. However, in Tele2 International Card Company SA & Ors v Post Office Limited [2009] EWCA Civ 9, it was held that a significant delay and continued performance of the contract without any form of protest was an affirmation of the contract, meaning the right to terminate had been lost. Crucially, the court also held that the “no waiver” clause in the contract did not remove the obligation on the innocent party to choose whether or not to affirm the contract. While the facts of the Tele2 case were extreme (no action was taken for over a year), prudent lenders should not rely solely on the “no waiver” wording. Careful consideration of the operation of existing contractual protection is key and pending such review, lenders may opt to expressly reserve their positions by issuing reservation of rights letters.

6        Managing margins

Market volatility resulting from the COVID-19 pandemic is having a significant impact on margin-based financing. Finance documents often provide that if collateral value falls below the agreed loan to value ratios, borrowers can be required to make good the difference. Failure to do so can entitle lenders to liquidate their positions or, in some instances, terminate immediately. Disputes arising from margin calls exercised in the last financial crisis are still being heard in the courts today. To avoid protracted litigation, lenders need to ensure that they carefully comply and document compliancewith contractual provisions (including required calculations) and applicable regulatory guidance. . If a counterparty is afforded the option of making good the required margin, the terms upon which it can do so must be made expressly clear. If the lender wishes to reserve the right to terminate or close out a position immediately, then consideration should be given to expressly reserving that right.

7          Material adverse change clauses

Many finance contracts do not contain force majeure clauses but may contain material adverse change clauses. These can provide lenders with the options of seeking further security, calling an event of default, accelerating repayment or terminating. Whether or not COVID-19-related events will trigger such clauses depends on the wording of the clause. It may also depend on guidance or legislation issued by different governmental authorities. Treasury guidance7 currently provides, for example, that banks should be willing to “maintain and extend lending despite the uncertain economic conditions.” Decisions on whether or not to invoke material adverse change clauses are high-risk, not just in terms of potential litigation from an aggrieved counterparty but also from a reputational perspective. Case law suggests that a general reference to external market changes will not be sufficient to justify invoking a material adverse change clause.8 Further, it will be for the lender to evidence that the change is not temporary and that it is materially significant. There are currently no reported cases in the English courts as to whether the COVID-19 pandemic constitutes a material adverse change.

8          Notice requirements

Whatever route is taken in response to contractual difficulties, complying with legal notice clauses is key. Even if the substantive requirements for calling an event of default have been met, if the appropriate contractual procedure has not been followed, any action may be invalidated. Review the relevant clause and, if necessary, seek agreement to modify it to permit notice to be sent electronically. Timing is also crucial. Some clauses require notice to be sent immediately or “as soon as reasonably practicable” and a delay in notifying your counterparty may invalidate your attempt to rely on it or lead to a damages claim9. As the economic downturn progresses, assignments of loans are likely to rise and notification (together with appropriate consent) clauses will need to be adhered to.

9        LIBOR transition and negative interest rates

Although interim deadlines for LIBOR transition have recently been relaxed, the permanent discontinuation of LIBOR is still scheduled for the end of 2021. For more detailed information on the impact of LIBOR transition see our article here. In addition to hampering the ability of many banks to effect the transition, the current crisis has also had the effect of increasing the likelihood of interest rate benchmarks (including LIBOR) becoming negative. If finance documentation does not already include adequate provision for a negative interest rate environment, a borrower’s request for amendment or variation may provide an opportunity to consider making such provision. For an analysis of the English court’s most recent interpretation of this scenario, see our article here

10        Preserving privilege

The issues highlighted in this article and experience from previous financial crises suggests that litigation in the financial sector in the coming years is highly likely. While there is an element of pure legal analysis to such disputes, contemporaneous documents are often key to substantiating or disproving a claim. In a crisis (and while socially distanced from each other) it is easy to forget about the need to preserve legal privilege. All too often, it feels safer to copy multiple parties into emails and to ensure that all relevant information is shared. However, just copying a member of the legal department or an external lawyer into an email will not make it privileged, especially if litigation is not in contemplation (which it probably will not be when, for example, serving default notices). There have been a number of key decisions on legal advice privilege recently, including a requirement that the dominant purpose of a communication – even with your lawyer – must be to obtain legal advice10.  Also, when litigation is under contemplation, it is important to remember that parties are under a duty to preserve, and possibly disclose, relevant documents. Appropriate policies need to be put in place promptly to ensure that unhelpful emails are not created, privilege is preserved where possible and documentation is properly retained.

2 MWB Business Exchange Ltd v Rock Advertising Ltd  [2018] UKSC 24

3 Lenders should consider whether any other transaction documents also need to be amended, such as security documents or intercreditor agreements.

4 Sumitomo Mitsui Banking Corporation Europe Ltd v Euler Hermes Europe SA [2019] EWHC 2250

5 [2018] UKSC 24

6 GPP Big Field LLP v Solar EPC Solutions SL [2018]  EWHC 2866 (Comm)

8 Grupo Hotelero Urvasco SA v Carey Value Added SL [2013] EWHC 1039

9 Videocon Global Ltd & Anor v Goldman Sachs International [2016] EWCA Civ 130

10 The Civil Aviation Authority v Jet2.Com Ltd [2020] EWCA Civ 35 and see: https://www.shlegal.com/news/when-is-talking-to-your-lawyer-not-a-privilege-caa-v-jet2-and-rbi-v-ace-ashurst