Considerations of a financier in dealing with a problematic financing: A practical guide

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The coronavirus pandemic has presented unprecedented challenges to our clients, and leaves our clients uncertain as to what actions they can and are entitled to take to best protect their rights in a potential default situation. We are here to help our clients to analyse the situation so they can make an informed decision.

When a financier knows that a debtor may be in trouble, it is understandable from a risk management perspective why it may like to act fast to issue a notice of default and accelerate the financing.  However, a prudent financier will pause and assess the situation first because a rash action without proper risk assessment can be in itself a risky action.

Minority lender 

Before acting, a financier must be clear about its role in the financing.  In a bilateral financing, a financier is free to take any action alone.  This may not be the case if the financing is provided by a syndication of financiers under which the relevant financing agreement will usually provide that any decision relating to a declaration of default can only be made by the "Majority Lenders" as defined therein.  It means that a lender not constituting a "majority" on its own will not be able to unilaterally make such declaration and instead will need to seek consensus with other lenders in order to achieve a majority "vote" before instructing the agent to make such declaration.  

Risks of financier 

First of all, we cannot emphasise enough that a financier does not have an inherent right to demand early repayment of a committed financing.  Such right can only arise when upon occurrence of certain events expressly provided in the documentation, usually called events of default or mandatory prepayment events.  The main risk for a financier declaring an event of default and accelerating the loan is, if an event of default is wrongfully declared (this could happen when, for example, the financier forgets to take into account any grace period applicable to a particular event of default), the financier potentially being sued by the debtor for breach of contract and subsequently being liable for damages suffered the debtor as a result of such wrongful acceleration.  

In addition, any declaration of event of default will likely trigger a cross-default provision under the debtor's other financing arrangements.  It may contribute to the immediate liquidation of an otherwise financially healthy debtor.  The liquidator of a debtor may also sue for damages if the declaration is wrongful. 

Similarly, wrongful enforcement of security may render a financier liable for trespassing or conversion and the debtor may be awarded damages for loss arising out of the forced sale of assets and loss of future profits from the business.

Choice of event(s) of default

Not all events of default are equal.  An event may trigger various events of defaults and a financier must be able to distinguish one that is more "creditor friendly".

By creditor friendly we mean a lesser risk of a debtor claiming a wrongful declaration against the financier.  Non-payment event of default is a good example.  Once the contractual grace period (if any) has lapsed and the debtor fails to pay, the event of default will be triggered.  It is unequivocal, direct and most importantly, easy to prove.  

On the other hand, material adverse change ("MAC") is quite the opposite. This is an event of default that is "nice" to have but as a catch-all concept to capture unpredictable events. In reality, it is inevitable that certain degree of subjective judgement must be involved in deciding what constitutes an MAC event and therefore making it difficult for the financier to prove.  As such, we would almost always advise financers against using an MAC event of default as the sole event of default for the purpose of accelerating a loan.  

The same logic applies to other event of default such as claiming that an obligor has begun negotiations with another creditor to reschedule its indebtedness due to actual or potential financial difficulties.  Such event of default is not uncommon in financing documentation, but should be invoked with caution, if at all.

What a financier can do: a practical guide

It does not mean that a financier should wait and see without action when it is aware that something ominous may happen soon.  Quite the contrary, a financier should take a proactive role in assessing the situation constantly and work with a reliable law firm to review the entire set of financing documents in advance so that it is well prepared for every possible scenario.  

Whilst a financier would not usually invoke an MAC event of default directly to default a debtor, a financier could claim that an MAC event of default has occurred and bring the debtor to the negotiating table for a restructuring possibility.  A problematic debtor will always welcome such opportunity.  A financier can seize the chance to increase security, extend financing period, or effect cross-collateralisation of different financings.

In doing so, the financier will need to be wary not to give any representation whereupon the debtor may rely to its detriment.  The doctrine of promissory estoppel may be available to the debtor to prevent the financier from enforcing its rights later.  For example, a financier shall be cautious not to be deemed as agreeing a standstill period during the discussion of restructuring.

When it becomes clear that an event of default has occurred (such as when a debtor fails to pay after any applicable grace period of a due date), it is advisable that a financier shall at least issue a reservation of rights letter to the default debtor.  This dispenses the financier with the need to rely on the "non-waiver" clause in the financing document.  The reservation of rights letter should be carefully drafted preserving all rights of the financier so as to prevent the debtor from claiming that the financier has waived its rights or is estopped from pursuing its claim.

Ince team is actively assisting our financier clients to explore various options in a potential default financing situation, especially those relating to ship and aircraft financing.  We provide our client with an objective assessment, and assist them to draft a watertight reservation of rights letter and/or notice of default.  Clear legal advice at an early stage can serve our clients to make well-informed decision.  If the reader is facing similar situation, please feel free to contact the authors and we are happy to discuss with you in this turbulent time.

Janice Lee

Janice Lee Partner

Tonny Lee

Tonny Lee Of Counsel

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