Litigation Trends Forecast 2020
The rapid spread of the novel coronavirus (COVID-19) and the world’s attempts to stem it already have caused significant economic disruptions. We expect the repercussions from those disruptions to shape the commercial litigation landscape for the remainder of 2020 and years thereafter. Although we are still at the outset of this crisis and many of its impacts on commercial litigation have yet to arise, below we highlight some of the trends that we expect to see.
Increased Contract Litigation
Efforts to contain the COVID-19 pandemic already have resulted in, among other things, mass cancellations of public events, international travel restrictions, business closures, quarantines, “social distancing,” and other disturbances to typical economic behavior. These disruptions are certain to have caused—and will continue to cause—various contracts to go unperformed, often because performance by one party has become impractical or impossible. In other instances, contracting parties may see different opportunities in a rapidly changing market and look to the disruptions to avoid existing obligations.
Contracts often allocate the risks of unforeseeable and uncontrollable events in force-majeure and material-adverse-effect or material-adverse-change (MAE/MAC) clauses, which may excuse a party’s nonperformance due to changing circumstances beyond its control. Courts interpret force-majeure clauses narrowly, so relief is often limited to specific types of disruptions explicit in the applicable clause. Even when the clause includes a broad catch-all provision, courts still may interpret the clause narrowly to provide an excuse only for those types of unforeseeable circumstances enumerated in the contract. Similarly, the applicability of a MAE/MAC clause is likely to depend on a judicial determination of whether the changes in circumstances qualify as “material” under the contract. To show materiality, the party seeking to invoke the MAE/MAC clause may have to show that, in light of the pandemic, performance under the contract would cause long-term detrimental impact, not just short-term losses, and that the pandemic’s effect on the party is unique, and not an industry-wide condition.
Even if a contract does not contain these provisions, parties may attempt to rely on the common-law doctrines of frustration or impracticability to excuse performance. In those instances, courts excuse performance when the principal purpose of the parties’ agreement has been thwarted by the unforeseen circumstances such that performance by one party becomes essentially worthless to the other.
Ultimately, whether the business disruptions associated with the pandemic will provide contracting parties a basis to be excused will depend on the terms of their particular contracts, the parties’ underlying reasons for contracting, and the relevant jurisdiction’s treatment of these issues.
Influx of Bond and Structured Finance Litigation
The potentially unprecedented disruptions of the economy have brought grim predictions of the COVID-19 pandemic’s ultimate economic impact. Notwithstanding the U.S. government’s unprecedented support of the corporate debt markets, corporate debtors in many sectors will struggle to make payments on existing loan obligations, credit markets will tighten, and there likely will be a surge in defaults and bankruptcies. This series of events is likely to lead to a wave of bond and structured finance litigation.
One area of particular concern is the collateralized loan obligations (CLO) market. During the 2008 financial crisis, the collapse of the residential mortgage-backed securities (RMBS) market triggered an explosion of litigation, with many cases still ongoing. For several years now, some market observers have seen stark parallels in the U.S. CLO market and have predicted a similar collapse. Like RMBS, CLOs trade as single securities backed by multiple debt obligations, often corporate loans with low credit ratings, including many with looser debt covenants than those associated with healthier corporate debt (so-called “Cov-Lite” loans discussed further below). Over the last decade, the U.S. CLO market swelled to over $600 billion—about half of the U.S. leveraged loan market. At the same time, the restrictions on CLO collateral have loosened as managers and investors sought higher returns. Many have been concerned that in the event of a recession, companies would be less able to service the debt underlying CLOs, potentially leading to concentrated defaults, declining collateral values, rapid sell-offs of CLOs, and the market for CLOs caving. An economy stalled by the COVID-19 pandemic could greatly accelerate these effects, resulting in a rush to the courthouse this year. Early issues we are seeing involve warehouse financing as collateral values deteriorate. We expect ensuing litigation to focus on the representations that CLO issuers made to investors and whether they adequately disclosed the risks of default, the contractual restrictions on the riskiness of collateral, and collateral managers’ conduct.
As more debtors face the prospect of default or bankruptcy, they may seek ways to shield their assets by moving them out of their failing businesses. Whether they are successful may depend on the covenants included in their loan agreements. Corporate loans traditionally included maintenance covenants that may have prevented such asset transfers, imposing certain financial restrictions on borrowers that were measured on set timeframes, so that the borrower had to maintain the financial health dictated by the covenant. Recently, however, in exchange for higher returns, the corporate loan market has turned to Cov-Lite structures, which rely on “incurrence” covenants, which means that compliance with financial covenants are only measured when the borrower engages in certain transactions, like incurring more debt, making a new investment, or transferring assets to a subsidiary. A substantial majority of corporate loans—potentially as high as 85%—are now characterized as Cov-Lite, and the looser restrictions mean that lenders can lose early warning signs that a borrower is in risk of default and lack a key control of the debtor prior to a payment default. In recent years, we have seen borrowers use the greater flexibility associated with Cov-Lites to transfer investments to unrestricted subsidiaries, which no longer serve as guarantors for the debt, with litigation resulting. Increased pressure on debtors may elevate the importance of the looser Cov-Lite restrictions, as creditors seek to recover assets from defaulting and bankrupt debtors and debtors weigh the ability to protect assets with potential fraudulent conveyance claims.
The Days Ahead
We write at the outset of the COVID-19 pandemic, and there is still tremendous uncertainty surrounding its severity and duration and the resulting economic fallout. But as with any economic downturn, we expect that long-running frauds and other corporate malfeasance enabled by a historically robust economy will be uncovered (recall Enron and Madoff).