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Practical Business Issues And COVID-19
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Shapiro,
Mark S. Redinger,
Mark S.

April
2020

Industry Alerts

Toronto

In this series, DW LLP will explore different
issues related to the financial impact of COVID-19 on businesses, employment,
financial matters, and commercial issues.   We aren’t
giving you legal advice but rather some practical tips about dealing with events
as they arise.  This article will cover debtor-creditor
matters and we intend periodic alerts to cover other topical issues related to
the on-going pandemic.

The Implications of COVID-19 on Creditors
and Borrowers in Canada

In the current crisis, there has been much discussion about the availability
of remedies under Force Majeure and Material Adverse Change (MAC) clauses in
respect of COVID-19.

Force Majeure and MAC clauses are remote provisions in agreements that
lawyers love to debate.    At a very
high level the principle behind such provisions is that a party should not be
obligated to perform its obligations under the contract if a material event
(such as an ‘act of the almighty’) has changed the environment in which the
agreement was originally drafted.  Litigation around these
provisions is scant although when it is engaged it is understandably highly
contentious.[1]

The most typical example in a debtor-creditor context permits a lender to
deny funding on the occurrence of Force Majeure event or MAC in the
borrower.  As lender friendly provision they clauses do not
generally protect borrowers from paying creditors or suspending default rights
in lending arrangements.

Why is COVID-19 Different?

We do not have any precedent for the entire shut-down of sectors of the
economy that parallels what we are experiencing with COVID-19.
The two events most often cited for comparison, namely the attacks on the
World Trade Centre and the Pentagon in 2001 and the SARS Pandemic in 2003, were
relatively short in duration and isolated geographically.
Neither event involved a prolonged disruption to the supply
chain.  What makes COVID-19 unique is unknown duration of the
disruption, the global geographic spread and the fact that it is not sector
specific.

In this environment, what steps can parties take to ensure that once the
crisis passes, their contractual rights remain in force?

Non-executory arrangements typically have
time-sensitive obligations, for example interest and principal payments, rent,
reporting requirements (financial statements or otherwise) which cannot easily
be waived, or which one party, or the other, may, for commercial reasons, desire
not to waive.

Absent contractual protection, or government
decree, or a negotiated waiver, some commercial parties may be surprised to lean
COVID-19 does not provide relief from the risk of a default by one party or the
ability of another to call a default.

Never waste a good crisis….

A typical small business is an intertwined market participant. It will owe
money to its various suppliers, the landlord, the bank and employees; in turn
these parties will owe money to their suppliers, lenders, banks, employees and
so on.  But what happens when the supply chain breaks down
(not merely slows down) and payments are not flowing at all?

Absent COVID-19 and in an isolated incident, our business example may face
all manner of remedies including notices of default or enforcement actions
brought by its creditors.  It would have similar remedies
against parties that owed it money.

But when the system breaks down, what can a creditor really do, and what to
borrowers have to do?  While remedies through the courts may
be forestalled, can creditors really rely on defaults caused by events beyond
the borrower’s control after the dust has settled?

Courts in Canada have been trending, albeit in varying circumstances, to a
broader obligation of good faith in the course of commercial
conduct.  There is no reason to believe that coming out of the
COVID-19 crisis this will reverse or moderate and the crisis may give judicial
authorities more opportunity to push the law in this area even
further.  Parties that are advancing claims or relying on
events that occurred as a result of the current crisis should be extremely
careful in their conduct.

In Bhasin v Hrynew the Supreme Court recognized an organizing
principle of good faith. Contracting parties are expected to have appropriate
regard to the legitimate contractual interests of the contracting parties, not
seek to undermine those interests in bad faith, and act honestly in the
performance of contractual obligations. This duty of good faith and honest
performance extends to the exercise of contractual discretion and may include
situations where a creditor is contemplating in advancing a default.

In Greenberg v Meffert, a real estate company refused to pay an
ex-employee commission he had earned while he was employed. The company relied
on the terms of the employment agreement which gave it sole discretion to decide
whether to pay commission earned by an ex-employee. Notwithstanding the language
of the agreement, the Ontario Court of Appeal found the company exercised its
discretion improperly after previously reassuring the plaintiff he would receive
the commission. The Court noted that provisions which make payment or
performance subject to the discretion of a party must be exercised reasonably.
Moreover, any discretion must always be exercised honestly and in good
faith.

While the law in Canada is evolving, courts in the United States have imposed
a requirement to act reasonably when exercising a contractual discretion. In
Legend Autorama Ltd v Audi of American Inc., the New York Court of
Appeal found that notwithstanding the words “sole discretion,” every contract
contains an implied covenant of good faith and fair dealing, which encompasses
any promise that a reasonable person would understand to be included. Some
American courts have held that this duty does not prevent a lender from
enforcing the terms of the contract as written; however, it appears that lenders
must still act in good faith.

Another concept that may be relevant in evaluating the risk of exercising
discretion is the concept of lender’s liability which is a
well-developed in the United States.  For example, in
Koontz v Wells Fargo, N.A., a lender had the sole discretion to modify
the terms of a mortgage or close on the property after the borrower had
defaulted. The U.S. District Court of West Virginia found that despite having
sole discretion, the lender was confined by the covenant of good faith and was
required to act toward the borrower in a commercially reasonable manner. In the
United States, lenders who have been found to act in bad faith can be liable for
compensatory damages and consequential damages.

Being on the right side of the
point…

Given the current climate, parties should be careful when advancing on
defaults. While a contract may specify a right or remedy a court may disagree,
often with disastrous results. Advancing or relying on a default that occurred
in the middle of an ongoing pandemic may be considered unreasonable.

Commercial parties should assume that in the event of a subsequent dispute
their actions will be closely scrutinized after the fact by persons that may not
be overly-sympathetic to their contractual rights in approaching choices. A
party should consider the following advice:

1. Act Reasonably – Notwithstanding what the commercial
agreement states or a party’s rights and obligations – if your decision is
challenged before a court or tribunal in the future, will you be able to
convincingly explain why your actions were reasonable and in good faith given
the COVID-19 crisis?

2. Consider the Broader Implications – Often there is a
broader context to your arrangements. Does ‘squeezing’ one aspect of the supply
chain potentially negatively affects other parties?   You
do not want to be the poster child for shutting down an entire business
operation or sector.

3.  Document, Document, Document – Write
everything down; communicate via email; and if you agree to waive or alter the
strict terms of your agreement, specify that it is temporary and not a
waiver.   Also, keep a record.

Finally, how can we help?  In uncertain times it’s often
not just legal advice you need. Checking your decision-making can provide
comfort in your choices and avoid longer-term issues. If have an issue that
sounds similar to the above, or you just want a second view, give us a
ring...

[1]
The ABCP in Canada involved considerable discussion about the ability of
liquidity providers to rely on MAC provisions to avoid providing liquidity in
strained credit markets.

Related Services

COVID-19
Developments

Corporate

Banking
& Financial Services

Contacts

Mark
Redinger

Partner
Toronto

T:416-646-4601

E:[email-masked]

Mark
Shapiro

Partner and
Canadian Litigation Practice Group Chair
Toronto

T:416-646-4603

E:[email-masked]

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