Covid-19’s impact on finance contracts: are there any grounds for the borrower to ease or otherwise mitigate its contractual obligations?

Ivan Abad

Uría Menéndez, Madrid

ivan.abad@uria.com

Fernando Azofra

Uría Menéndez, Madrid

fernando.azofra@uria.com

Introduction

A basic contract law principle is that contracts are binding on the parties. No party can default, delay or amend its contractual obligations other than with the other party’s consent. Romans coined the expression pacta sunt servanda ​​​to emphasise the relevance of this key element of contracts. So crucial is this concept in contract law, that it has often been linked to the motto of Ferdinand I, Holy Roman Emperor from 1556 to 1564: ‘Let justice be done, though the world perish’.

However, the stringent application of this basic contract law principle may in some cases lead to extremely unfair consequences, contrary to good faith, which is also a key element in continental legal systems. In these, scholars and case law have traditionally construed any exception to this essential principle very restrictively, but as a means to avoid any such extreme and unfair consequences deemed to be in conflict with justice. To deal with these exceptional situations, the various civil legal systems envisage certain mechanisms, such as (1) the force majeure regime and (2) the rebus sic stantibus doctrine (or variants of the same).

The Covid-19 pandemic has placed parties to commercial contracts at risk of defaulting on their obligations, either directly because of governmental decisions (eg, lockdowns, curfews, travelling bans) or as an indirect result of the demand shock that the pandemic has caused. Affected obligors claim that this constitutes either (1) a force majeure event that should release them from complying their contractual commitments or, more often, (2) an unexpected and extraordinary change of circumstances that justifies amending the contract, or rebalancing its terms, under the rebus doctrine (or similar legal constructs). We believe that neither of these mechanisms is an option for financed parties in financing agreements.

Brief reference to the force majeure regime

Although this article intends to scrutinise the rebus doctrine, we briefly refer to the force majeure regime.[1] Force majeure may be defined as an unforeseeable event, beyond the control of a party to a contract, which renders performance by such a party impossible, hence releasing it from compliance. A force majeure event can also render performance more onerous, and its occurrence may have other consequences, such as the deferral of the duty to perform, the amendment of the contract, or the waiver of the affected party’s obligation to pay damages.

The Spanish Supreme Court has repeatedly stated that:

• the force majeure regime should be construed restrictively and on a case-by-case basis;
• for an event to release a party from its obligations, it must entail a physical or legal, objective, absolute and lasting impossibility to comply;[2] and
• payment obligations never become impossible to perform (money does not perish), and, hence, force majeure as grounds not to honour payment obligations has been consistently rejected.[3]

Given that the borrower’s or the obligor’s main obligations under any financing agreement are pecuniary ones, force majeure cannot be validly argued in order to release the financed party from its contractual obligations.

Rebus sic stantibus

Spanish scholars[4] and case law have construed rebus sic stantibus doctrine as follows:

• it allows a party to a contract to mitigate the negative effects of a risk not specifically allocated to any of the parties to the contract;
• it materialises upon the occurrence of an extraordinary change of circumstances, considered unforeseeable given the normal scope of the obligations of such a party;
• the change of circumstances is not attributable to any of the parties and causes a serious imbalance in the obligations to be performed by each party within the normal course of the contractual relationship; and
• such change or event cannot be technically construed as a force majeure event.

Therefore, a party seeking relief under rebus sic stantibus needs to justify that the occurrence of extraordinary and unforeseeable events has made the performance of its obligations excessively onerous, to the extent that they have significantly and permanently altered the balance of the exchange under the contract (quid pro quo), all such resulting in an unreasonable imbalance in the reciprocal obligations of the parties.

It is somewhat similar to the international soft law figure of hardship.[5] Occasionally, in order to uphold the application of this exceptional relief, Spanish courts have resorted to the ‘disappearance of the foundation of the contract’[6] (in line with the German Wegfall der Geschäftsgrundlage) or ‘frustration’ (recalling the English law concept). Spanish courts have not used the French law concept of imprévision or the US law construct of impracticability.[7]

Unlike in Germany, France, Italy or Portugal,[8] the rebus doctrine is currently not expressly recognised by statute in Spain.[9]

Spanish courts have traditionally been reluctant to apply the rebus doctrine in practice. Even in litigation based on the very severe effects of the 2008–2012 economic crisis, the Supreme Court held that global changes to the economy do not justify applying this relief.[10] In 2014, the Supreme Court handed down two rulings that supported a more flexible and ‘standardised’ application of the rebus doctrine[11], but subsequent rulings returned to the more limited and stringent approach.[12]

The Covid-19 pandemic has propelled claims in which claimants (mostly, tenants struggling to pay their rents) have resorted to the rebus doctrine. The claim has been endorsed at least once[13] and various judges are granting interim relief, even ex parte, such as rent reductions and forbidding landlords from enforcing guarantees on the lease, terminating the lease or evicting the tenant.[14] Where the courts have rejected such interim relief, the decision was rather based on lack of periculum in mora (ie, there was no reason to uphold the interim relief so as to avoid that the final ruling in favour of the claimant would in practice not be enforceable as a result of the time taken for the ruling to be issued), but the courts in those cases did not address whether the claimant’s request seemed prima facie well founded (fumus boni iuris). As sustained to date, the rebus construct requires the following:

1. The change of circumstances must be completely unforeseeable. Normal or inherent contract risks and those expressly assumed by each party are excluded. If the contract provides a mechanism to assign risk to one of the parties, the contract prevails (and the rebus doctrine does not apply);
2. The change must have caused an exorbitant disproportion of the reciprocal considerations exchanged between the parties, which entails the complete disappearance of the balance of the contract;
3. Scholars consider that the rebus doctrine exclusively applies to contracts with outstanding reciprocal obligations (or executory contracts under US law).[15] In principle, the doctrine only applies to continuing-performance contracts (tracto sucesivo), such as lease and supply agreements. Though the Supreme Court has accepted that it could apply to single-performance contracts when the execution of the reciprocal obligations is deferred (contratos de tracto único con ejecución diferida), it has declared that in those cases the mechanism is even more exceptional;[16]
4. The scope of the rebus doctrine is therefore narrow, as opposed to the German Wegfall der Geschäftsgrundlage or the Portuguese alteração anormal das circunstâncias (the scope of which is, potentially, wider, even though the courts apply them rather strictly). Likewise, the Italian Codice Civile expressly provides for the application of the eccessiva onerosità (hardship) relief to contracts where only one of the parties has outstanding obligations;[17]
5. No other means or remedies are available: the rebus doctrine does not apply if other legal or contractual remedies are available; and
6. Courts have been reluctant to allow contract termination based on the rebus doctrine. Termination is only an option if the contract cannot be amended or rebalanced. This is consistent with the German Wegfall der Geschäftsgrundlage and the French imprévision, and is contrary to the standard outcome of the Italian eccessiva onerosità[18] and the English frustration (termination of the contract). In Portugal, both consequences (termination or rebalancing) seem feasible.[19]

Rebus sic stantibus and financing agreements

In view of the features of the rebus doctrine explained above, it is no surprise that there is no case law on its application to financing agreements.[20]

During the 2008–2012 economic crisis, rebus relief was particularly popular in real estate acquisitions, where the buyer wanted to terminate the agreement after having failed to secure acquisition finance. The Supreme Court generally refused to grant rebus relief in these cases[21] essentially on the basis that it is the buyer who typically bears the financial risk of the acquisition. This relief was however granted[22] where the contract expressly provided for the buyer’s step-in right into the existing construction finance, which was rendered impossible due to the seller’s delay in delivering the property (a case that has more to do with default-based contract termination than rebus relief).

Even those scholars who are more supportive of the rebus relief[23] have traditionally rejected its application to financing agreements. Though the rebus doctrine could theoretically apply to finance contracts, the debtor’s financial difficulties have not been considered a valid justification to rebalance a finance agreement,[24] for the following reasons.

1. Absence of the risk’s unpredictability: the rebus doctrine requires that the risk not be expressly allocated to the party seeking the relief. As the Supreme Court has held,[25] in financing agreements, the risk of the borrower’s economic activity is generally and exclusively allocated to the borrower. Therefore, no change of circumstances can justify that such risk, which is inherent to the borrower, should shift to the lender by means of the rebus doctrine;
2. Even if a supervening extraordinary change of circumstances (such as the Covid-19 pandemic) were to occur, that risk would most likely be captured by the provisions of the facility agreement and its consequences normally allocated to the borrower: such a supervening event will likely constitute a material adverse change/effect (MAC/MAE). MAC/MAE clauses are usually aimed at protecting the lender, hence excluding the application of the rebus doctrine by the borrower;
3. Absence of reciprocal obligations to rebalance: the rebus doctrine requires that the balance in the parties’ reciprocal obligations be completely impaired (ie, the consideration of one of the parties becomes unreasonably disproportionate), so it only applies to contracts with reciprocal obligations;
4. Although financing agreements can be construed as bilateral contracts,[26] after the lender has made available the loan or where no further credit draw-downs can be made, the contract can no longer be considered an executory contract (ie, a contract with outstanding obligations for both parties). Such contracts cannot become ‘unbalanced’ or in need of any rebalancing that would enable the application of the rebus doctrine;
5. This would also be the conclusion if rebus relief were sought whilst draw-downs are still available to the financed party: it cannot allege the rebus doctrine to modify its obligations to serve the debt already drawn down even if the lender has still to deploy some or all of the credit amounts. The borrower’s obligation to serve borrowed amounts are unrelated to the lender’s obligations to continue to enable draw-downs under the facility (there is no reciprocity between such obligations);
6. Existence of a more appropriate legal framework: the rebus doctrine applies secondarily. Where Covid-19-related legislative measures have been enacted to mitigate or reallocate the effects of the pandemic in certain types of contractual relationships, they apply and rebus relief is excluded. An example of this is the mandatory loan moratoria for financially vulnerable borrowers[27] or borrowers exploiting certain economic activities (such as tourism-related activities[28]) enacted in March and July 2020; and
7. The rebus relief has never been considered suitable to deal with a debtor in financial distress. Debtors unable to pay their debts as they fall due should seek relief and protection under pre-insolvency and insolvency arrangements and proceedings, and not under contract law-related mechanisms or schemes such as the rebus doctrine.

Therefore, the obvious conclusion seems to be that rebus relief sought by financed parties in finance agreements should not be granted.

The very disruptive effects of the Covid-19 pandemic might weaken this conclusion. On 30 April 2020, the First Instance Court 60 of Madrid granted ex parte relief to a Spanish steel group (Celsa) in connection with a refinancing agreement. The interim relief involved the following:

• the deferral of the finance parties’ payment obligations for 12 months;
• a 12-month suspension of the financial ratios covenants; and
• a ban on the lenders’ right to terminate or accelerate the finance agreement and to enforce the collateral in respect of the deferred payment obligations or suspended financial covenants.

The Court granted these interim measures based on the rebus doctrine, endorsing the financed parties’ claim that the Covid-19 pandemic entailed an extraordinary and unforeseeable change of circumstances that merited a rebalancing of the parties’ obligations.

Many scholars[29] have been critical of this decision, mainly for the reasons set out above. The First Instance Court 60 of Madrid subsequently reversed the interim relief as Celsa had also requested it before the First Instance Court 30 of Barcelona which, on 29 April 2020, rejected it on the basis that the refinancing agreement was no longer an executory contract (as the creditors had already made available all the loan amounts) and Celsa’s embedded claim concerned contract amendment instead of contract rebalancing (which is the only available relief under the rebus doctrine).