The second wave: The pandemic changed the world, but how has it changed disputes?

As businesses assess the damage from the pandemic and their options for redress, COVID-19 is shifting the pattern of claims and disputes. An expert panel of HKA Partners – experts in forensic accounting and commercial damages – shared their insights into the types of disputes they are seeing, and expect to see, now that businesses have been able to assess how the pandemic has, and continues to impact them.

Economic Backdrop and Insolvencies

How corporate insolvencies and disputes play out over the coming months, and medium term, will be influenced heavily by the macro-economic backdrop. David Bones, HKA Americas Partner, painted a dark and clouded picture. The economic shock has been sharp, exceeding previous recessions, but we can’t be sure it will be short.

The IMF puts the decline in 2020 GDP at 4% for the US, with Africa and Oceania facing a similar scenario, while the fall in Europe reaches 5.5%, plummeting below 20% in South America. For Asia and the Middle East the contraction is no more than 1.5%. While the predictions are for a significant 2021 recovery, boosted by vaccination rollouts, many risks remain to puncture what may be a slow return to normal activity, David warned.

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Yet the fiscal response worldwide has been aggressive, especially in Europe, where a $5 trillion stimulus package compares with around $3 trillion in each of North America, Asia and the Middle East. While some household names – from Hertz and JC Penney to Debenhams and Cirque Du Soleil – have been laid low, the anticipated, massive wave of bankruptcies has not broken. Yet. Filings tend to lag economic shocks, our economic damages expert stressed.

Trends so far are mixed. Chapter 11 filings in the US were 35% up year on year by August 2020, but tripled for larger companies with assets of over $50 million. For Chapter 7 filings – the most common form of bankruptcy – the increase was just 13%. Meanwhile in the UK, almost two thirds (64%) of big companies were in September adjudged at risk of insolvency.

While the monthly trends in bankruptcy filings were still flat or downward, in the US and UK respectively, several factors would determine the size and speed of the almost inevitable surge coming down the pipeline.

“If the fiscal stimulus is temporary, filings will accelerate,” he warned. Alternatively, additional government reform and support, and successful containment of the coronavirus, could encourage lenders and creditors to ‘stand and protect’ in hope of recovery, rather than foreclose and take on assets of dubious value.

More than $70 trillion of worldwide corporate debt also casts a deep shadow. Leverage is higher in the UK (with credit to the non-financial sector of more than 380% of GDP). The Eurozone, Japan, US and now China are not far behind, with exposure lower (around 330%) in Germany.

It remains to be seen if governments can stabilise markets to avoid a rash of bankruptcies. Policymakers face an unenviable dilemma. Extending policy support for businesses for too long would delay essential corporate restructuring, increasing the eventual losses, undermining the recovery and intensifying concerns about financial stability. However, taking away those programmes too soon could short-circuit the recovery, leading to a surge in defaults, he concluded.

“Most commentators expect a dramatic increase at the end of this year or early next, and we’re beginning to see that in the UK retail sector,” Colin Johnson, webinar moderator and HKA Europe Partner, added.

Mergers and Acquisitions

Turning to mergers and acquisitions, APAC Partner Jonathan Humphrey reported that though M&A activity was depressed, HKA is not seeing a reduction in the volume of disputes, rather their form and substance is changing. While post-closing disputes are concerning issues such as closing price adjustments, fraud and breaches of warranties, the biggest shift as a consequence of COVID-19 has been towards pre-closing disputes.

Focussing on pre-closing disputes, Jonathan says that it is no surprise that failure to complete claims are becoming more widespread as buyers look to forestall agreed transactions amid the fallout from the pandemic, while sellers try to enforce completion. Market volatility has impacted the economic viability of transactions. The main COVID-related reasons stated for non-completion are force majeure, material adverse change and failure to obtain funding.

While non-COVID reasonings tend to involve alleged regulatory issues or claims a seller failed to meet obligations, the underlying reasoning, although unstated, is often the economic impact of the pandemic.

The merits of such reasonings for non-completion vary.  For example, when invoking a ‘material adverse change’ clause, one needs to demonstrate the magnitude and duration the decline. The impact of the crisis is likely to meet these tests in many cases, but the third requirement of disproportionality might not be fulfilled, Jonathan warned. Determining whether or not the impact on the target company was disproportionate in comparison with competitors or the industry as a whole requires thorough analysis.

Sellers are not willing to accept the reasons buyers give for terminating agreements, giving rise to disputes and increasingly complex assessments of damages due to the changed economic circumstances.

The general approach to assessing damages is to compare the position of the seller if the transaction had closed (the ‘counterfactual scenario’) with their actual position.

Evaluating the counterfactual scenario, hitherto relatively straightforward, has become complicated by closing price adjustments. Closing accounts require close scrutiny to ensure they accurately reflect the impact of COVID-19 at the specified date, as certain balances, such as accounts receivables reserves, can be open to over or under statement, for example have sufficient provisions for doubtful debts been included.

For the actual scenario, fair market value is the price a willing buyer would pay and a willing seller would accept. When the buyer has pulled out, the starting point for damages may be the full purchase price, however the company remains in the seller’s hands. To fully assess the actual value which the seller’s retain, one likely needs to use hindsight in the actual scenario.

“Hindsight often seems like a contentious word in valuation disputes but that’s in respect of the counterfactual scenario,” Jonathan explained. “In the actual scenario, the full consequences of failure to complete can only be assessed with a hindsight view.”

Jonathan Humphrey, Partner, Asia Pacific

The true value of the company will only be known by reference to a hypothetical willing buyer. Finding one, especially in a volatile market, takes time.

Jonathan expects more failure to complete claims to enter formal disputes over the coming months as extensions expire and sellers who’ve already had deals terminated consider their options.

Commodity-Related Disputes

Unexpected fluctuations in commodity prices can impact the profitability of parties to a trade, especially where the impact has been significant. While metal and agricultural commodities have recouped losses caused by COVID-19, and in many cases are trading higher, oil prices are still trading at a significant discount.

While there can be disputes all alone the chain, Jonathan identified that the area where he has seen the most disputes is in relation to commodity trading. Where trades\ contracts are breached, this leads to claims for damages.

The economics of any trade, and therefore the drivers to breach a contract, is affected by the buyer’s intended use of the product.  If purchased for the buyer’s own use, this could result in excess and over-priced stock, causing cashflow problems. If the buyer is to sell to third parties, the terms on the sales contract are important as this could result in a loss in a falling market.  A key impact on any loss will be whether the buyer has entered into a hedge.

The key considerations in quantifying damages relating to breached trading contracts concern whether there’s a loss, the date of breach, the approach to pricing, for example whether there is an available market, and the steps taken in mitigation, Jonathan observed. When considering appropriate mitigation and the pricing to alternative buyers, depending on the industry’s conventions, spot pricing or a spread of days might be most appropriate. If there is not an available market, the hedging strategy and techniques applied would be expected to reflect normal practice.

“Some commodity price disputes are coming through, but their number will depend on how markets recover,” he added.

Lack of Financing

In the present climate,  lack of financing can be one of the most common drivers of disputes as companies fail to raise funds to continue trading in the downturn or to honour contracts. David Saunders, HKA Europe Partner, provided an overview of the different types arising.

When insolvencies are running at a higher level, more disputes occur as liquidators or administrators sue third parties for precipitating the failure – for instance, by frustrating contracts – or looking to reverse transactions that might have been pushed through prior to insolvency, prompting action against directors or other company officers.

In the case of construction, lack of financing means that owners can no longer proceed with projects or contractors incur delays or fail to complete works due to lack of funds.

“However, we’ve not seen a landslide of disputes related to the first wave of the coronavirus,” he said. “It’s probably still too early to see investor state disputes specifically related to COVID given six-month cooling off periods. However, as governments start looking to reduce their deficits and borrowings that have sky-rocketed during the pandemic, there’s a possibility that some of their actions will lead to claims from investors.”

David Saunders, Partner, Europe

The unknowns surrounding ongoing government support for businesses during further waves of coronavirus make predictions more difficult. Early warnings of an upsurge in claims around force majeure do not seem to have been borne out so far. “Some parties have received notice of force majeure events, but we are not seeing it lead to significant disputes at the moment,” David said.

Companies are being pragmatic – by finding alternatives to launching a dispute, taking the long view of their commercial relationships, or because “alleging a claim for force majeure one way up the supply chain may result in having to accept claims going the other way down the chain,” he added.

Nevertheless, COVID is expected to have a wide impact on contractual disputes, with changes to the underlying nature of contracts, demand choked off, higher material costs, and supply chain problems leading to contract breaches whether due to government restrictions, a lack of employees, or logistics disruption.

“You also need to beware of false COVID claims,” he warned. It was essential to investigate the underlying dynamics to identify the true cause as some companies may use coronavirus as cover for pulling out of a contract.

In construction, HKA is seeing more delay and disruption claims and disputes over contract termination. The pandemic is also likely to spur more class actions not just by consumers against airlines or ticket sellers, but in other sectors, for instance where a company had downplayed the likely effect of the pandemic or talked up its significance, in the case of a pharmaceutical company, for example.

In the insurance market, a UK test case will have huge implications for companies forced to close by lockdowns. The Supreme Court’s judgement – recently announced ­– opens the way for a wave of claims  for business interruption, offering a lifeline to many small businesses and the prospect of higher pay-outs and more complex claims by larger concerns, especially in the hospitality and retail sectors.

COVID is also having effects on other disputes, not least when it comes to valuation dates. HKA is seeing cases where the valuation date has been set to 31 December 2019, so that – without hindsight – calculations fail to take account of the impact of the pandemic.

Great care also had to be taken over valuations that are based on multiples, David cautioned, especially in periods of high volatility in stock markets. 2020 saw a sharp drop in March/April, followed by upturns as the prospects for vaccines strengthened.

Companies are delaying decisions to press forward with claims, often focusing on stabilising their core business before committing to arbitration or litigation. This has also led to pressure on fees. Other cases have been delayed due to difficulties in assembling information or preparing for tribunals when staff are on furlough, while virtual hearings are helping other disputes get back on track.

Asked how tribunals assess whether pandemic control measures (such as forced closures) were disproportionate, David emphasised the importance of comparing the actions and effects for a specific business with its market. “If the whole market was affected, it’s difficult to argue that the effects were disproportionate.”

Colin Johnson added: “Sharp-eyed lawyers may be able to make investment treaty claims if the impacts are far greater on international companies than national entities so there’s a question of fair and equitable treatment.”

Third-Party Funding

A final question concerned the increased use of third-party funding in disputes. More jurisdictions were allowing this, Jonathan confirmed, citing its acceptance in arbitration in Singapore, followed by Hong Kong, although some restrictions remain in litigation. “COVID is changing the landscape of who will be using third-party funding,” he said.

Whereas this was previously seen as a route to justice for the cash-strapped, now large, well-resourced companies are taking advantage. The main reason is to shore up their balance sheet and protect the profit and loss account – and thus the perceived value of their business. Self-funding means “profits are lower, but any recovery sits below the line and doesn’t impact value”.

Alongside the need to put one’s core business or supporting evidence in order, lack of finance could also be a brake on disputes, Colin pointed out. He stressed how long it had taken for many claims to emerge following the last crisis. “We will be watching what effect the increased availability of third-party funding has in accelerating these cases, and also, in taking on insolvency cases where previously there wouldn’t have been the appetite.”

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