26.03.2020

Practice Areas: Finance

Impact of COVID-19 on financial contracts

Are the difficulties caused by COVID-19 grounds for refusing or delaying the performance  of financial contracts (e.g., financing agreements; OTC derivatives, etc.) in order to obtain more advantageous conditions, or to terminate them?

Under Portuguese law, as a general rule, the risk of circumstances happening after the signing of the contract, which jeopardize the economic balance envisaged by the parties at the time of contracting, shall be borne by the debtor, that is, the one who is bound to perform, since only the impossibility of performance, for reasons not attributable to the debtor, exonerates the debtor without further consequences. To make applicable the impossibility framework, the supervening circumstance must make the performance absolutely impossible, as even an extremely serious and unforeseeable hardship is not considered sufficient, nor is a practical or economic "impossibility", or the exception of the debtor’s ruin. Such cases, the respective "conditions of admissibility" having been verified, set motion the application of Article 437 of the Civil Code, the institute that regulates the "change in circumstances" which is applicable when performance is still possible but entails to the debtor an unexpected loss at the time of the contract and makes unfair the claim for performance by the part of the creditor.

Although in some circumstances the exceptional and temporary measures relating to the epidemiological situation of the novel Coronavirus – COVID 19 may lead to a proper impossibility ( v.g. the measures limiting access to spaces frequented by the public, provided for in Decree-Law No 10-A/2020 of 13 March), it will not be what typically happens in financial contracts, taking into account the monetary nature of performance set forth in them. Therefore, the framework to be applied, in the face of situations of hardship in the performance of the contract, shall be that of changing the circumstances. However, some market disruption events, such as the closure of trading platforms or the unavailability of means of payment may constitute a real scenario of impossibility, in principle only temporary, which excludes compensation for late performance.

Having said that, it is not possible to give a general answer to the questions raised, since only by analysing the specific factual circumstances of each situation, as well as the specific terms of the financing contracts, will allow gauging the existence of the legal conditions for the extinction or suspension of obligations or the modification or termination of the contract.

Does an international public health emergency, declared by the World Health Organization on January 30, 2020, as well as the classification of the virus as a pandemic on March 11, 2020, constitute a "change in circumstances", for the purposes of Article 437 of the Civil Code?

The current situation regarding the epidemiological situation of the novel Coronavirus, the proliferation of recorded cases of the COVID 19 contagion, is a global emergency situation, which, due to the restrictions on the movement of people and goods, has rapidly evolved from a public health issue to a serious disruption of the economy in general. Companies are already faced with severe impacts in the supply and demand of their products and services, impacts that tend to increase. This abnormal nature of the circumstances is quite evident in the exceptional measures adopted by the Portuguese Government in Decree-Law 10-A/2020 of 13 March and regulatory enforcement laws. Specifically with regard to the financial sector, this exceptional nature is a clear result of the ECB’s recommendations and measures and from the EBA measures for the banking sector to mitigate the effects of the coronavirus, measures which are also the subject of the Bank of Portugal's circular letter of 16.03.2020 (see information on these measures below).

These changes affect "the general constraints of social life", the objective grand business foundation ("großen" Geschäftsgrundlage), not configuring, therefore, for any party, the "risks arising from the contract", and which makes it unenforceable that contracts remain untouched, since a causal relationship between those changes in circumstances and the hardship in the performance of the contract can be evidenced. The framework of “change in circumstances” can be applicable, so that the burden deriving from these exceptional circumstances may be distributed equitably among the parties. 

 

The contract has become excessively burdensome; what should one do?

Article 437 of the Civil Code allows the injured party to request, from the other party, the modification of the contract (which may undergo a moratorium, either regarding payments to be made or the execution of the contractual mechanisms to be applicable facing “events of default", such as "draw-stops", "step in", "call options" or the enforecement of collateral; or, even, a review of the financial conditions of the contract, for example) or, in the extreme case, its termination.

The law gives preference to a solution that distributes the losses, in lieu of an "all or nothing" solution that results from the termination of the contract. On the other hand, it implicitly imposes on the unharmed party, a duty to renegotiate the contract in good faith. Thus, once the disruption in the contract is established, a negotiating process should be initiated as soon as possible to deal with the change in circumstances. In any case, the accessory duties arising from good faith of loyalty and protection are intensified in this scenario, and appropriate measures should be taken to mitigate the damages that the party affected by the change in circumstances may suffer. If a solution of modification cannot be reached through negotiation, then termination may the solution. Both modification and termination may be achieved out of court. The termination must be well grounded, since it shall occur  outside the conditions established in law is tantamount to breach of contract.

 

What if a law other than Portuguese law applies to the contract?

Several legal systems have solutions that are comparable to the Portuguese framework of "change in circumstances". Thus, since the reform of the German Civil Code of 26 November 2001, the problems of changing circumstances have been included in the impossibility framework, in Section 275, Abs. 2, and in Section 313, which codified the Störung der Geschäftsgrundlage. The same happened with the French reform of the Civil Code of 2016, which introduced Article 1195 in the Civil Code, extending the theory of imprévision to Private Law contracts. Although somewhat different in nature, more restrictive, the institutes of frustration of contract and commercial impracticability of English and American law, respectively, can also be applied to limit the effects of hardship on contracts, caused by the coronavirus.

It is also worth mentioning the possible application of instruments relating to international contracts, and it has already been stated that in the solution to the problem caused by the change in circumstances in international contracts lex mercatoria comes into play, which may be particularly relevant if an arbitration clause has been included in the financial contract. Take, for example, Articles 6.2.1, 6.2.2 and 6.2.3 of the UNIDROIT principles (2016) on international commercial contracts; and Article III-I:I  I0 of the Draft Common Frame of Reference DCFR/2009.

 

If a foreign law applies to the contract that does not recognise the legal relevance of disturbances to financial contracts caused by the Coronavirus epidemic, can Article 437 of the Civil Code be applied?

Article 3(3) of the Rome I Regulation, which is of universal application, provides that "where all other elements relevant to the situation at the time of the choice are located in a country other than the country whose law has been chosen, the choice of the parties shall not prejudice the application of provisions of the law of that other country which cannot be derogated by agreement." Thus, in a purely national contractual relationship, even if a foreign law is chosen, article 437 of the Civil Code will be applied. It should be noted that in some court decisions relating to the international nature of the contract, for this purpose, it was considered sufficient that the contract is established using models drawn up by international associations, such as the ISDA, and that it is a contract often used in international practice, in which case the change in circumstances provided for in Article 437 of the Civil Code would not apply.

 

If the financial contract includes a "force majeure clause", a "hardship clause", an "economic-financial equilibrium reset clause", a “material adverse clause”, or other equivalent, what happens?

The Law does not prevent the parties from contractually establishing what legal effects should result from circumstances subsequent to signing the contract, and as such, the regime in Article 437, due to its subsidiary nature, will only apply if the parties do not establish a contractual solution to the change in circumstances, as it is the case of the contractual clauses referred to in the question. Thus, for example, if the force majeure clause of the 2002 ISDA Master Agreement is applicable, for derivatives covered by it, this will be the clause governing the consequences arising from the disturbances caused by the coronavirus. The first step will therefore be the interpretation of the contractual clause, in order to confirm that the situation falls within the stipulation of the clause. Only in the case it does not will the legal solution (article 437.º) be applicable.

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