The Unprecedented New Normal

Economic impact of COVID-19

The COVID-19 pandemic has resulted in an unusual complex global economic dis-equilibrium where disruption seems to be the only constant. The pandemic has unfortunately become one of the biggest threats to the world economy today. In theory, the assumption of ceteris paribus, that is “all other things being equal”, is instrumental in determining causation and understanding fundamental economic principles of equilibrium of demand and supply. The unprecedented rampant simultaneous shock waves to both demand and supply curves has left global policymakers and central banks bewildered.

Supply and demand shocks

Supply shock is inevitable as it emanates from drastic lockdown measures implemented worldwide. In evaluating the inescapable trade-off between saving mankind and economy, governments around the world are opting for stringent measures to contain the virus spread. Factories, offices, restaurants, clubs, shopping malls and all other public places have been closed, and people have been ordered to stay at home.

Simultaneously, on the demand side, such an environment fosters uncertainty and fear amongst households and corporates. Consumers feel less confident about the overall future of the economy and prefer to save rather than spend or consume. Rising unemployment rates in many developed economies further exacerbate the slowing demand. Business confidence has also declined as corporates believe that future payoffs from their current investments would be low. Decline in consumer spending and business investment has resulted in a demand shock which has further slowed economic growth and is likely to drive economies towards recession. The combined effect of supply and demand shocks are likely to vary across different sectors with some sectors experiencing far worse impacts than others.

This vicious circle of demand and supply disruption has worsened because the supply chain shock is not just confined to domestic businesses but is a global phenomenon. Many manufactured products require inputs from around the world since many producers manufacture intermediate goods rather than finished consumer goods. China is the largest manufacturer in the world and is responsible for around one third of global manufacturing.¹

According to Cowen & Co.², roughly 20% of the supply chain of retailers in the United States is exposed to China. For instance, the shoemaker Steve Madden sources about 73% of its goods from China and for Best Buy, it is 60%.³ Approximately 18% of India’s total merchandise imports are from China.⁴ The World Trade Organization (“WTO”) expects global merchandise trade to decline by 13% to 32% in 2020.⁵ China released its key economic indicators stipulating that industrial production (a measure of manufacturing, mining and utilities activity) declined by 13.5% and total value of exports declined by 15.9% in February 2020.⁶ Slowdown in the manufacturing activity in China, therefore, is affecting exports and businesses across the globe.

With a comparatively sharper recovery, industrial production for March 2020 declined by 1.1% and total value of exports declined by 6.4% in China.⁷ Similarly, China’s composite Purchasing Managers Index (PMI)⁸ plunged to 28.9 in February 2020 only to recover to 53.0 and 53.4 in March and April 2020 respectively.⁹ Even though the number of new COVID-19 cases in China is reducing and Chinese factories are increasingly ramping up production, supply chains in the rest of the world are expected to remain broken (at least in short term), shrinking the global demand for products manufactured in China’s factories.¹⁰

Unfortunately today, the problem no longer rests just with the world’s dependence on Chinese manufacturing and exports. As the epicentre of COVID-19 has moved from China to Europe and United States, lockdown measures have caused global PMI (excluding China) to fall to the lowest levels since 2009.¹¹ India’s services sector, which contributes 55% of the country’s GDP, registered a sharp decline where the Services PMI fell to 5.4 in April from 49.3 in March.¹²

Challenge to the policy makers

The current scenario of broken supply chains, quarantine measures, travel bans and reduced demand, poses a significant challenge to governments and policy makers worldwide. They are expected to provide adequate essential goods and services including medical care, prevent businesses from insolvency, sustain current employment levels and revive consumer and business confidence in long run.

In lieu of this, several governments and central banks have implemented radical expansionary monetary policies in the form of interest rate cuts and public spending increases. In addition, increasing demand for safe-haven assets amongst investors is pushing bond prices up and reducing yields to historic lows.

The yield on benchmark 10-year US treasury contracts fell in March 2020 to less than 1% for the first time in history.¹³ The objective of expansionary monetary policies is to provide an immediate impetus to the tumbling financial markets and stimulate demand in medium to long term. The extent such measures will be successful in containing this massive disruption of cash flows and its impact on GDP is yet to be seen.

It may also be pertinent to evaluate the potential risk of an increase in inflation resulting from such stimulus in absence of any real economic growth. The resultant combination of rising prices amidst an economic slowdown, that is, stagflation, is even more lethal for economy.¹⁴

The impact on oil prices is driven by forces both of demand and supply. Global economic slowdown caused by the pandemic has reduced oil demand. Future prices for May delivery of oil in the United States turned negative in April for the first time in history as demand slumped and concerns of storage reaching capacity riled the market. Responding to a slow uptick in demand, Brent crude, an international benchmark, is now at close to USD 31 per barrel in the first week of May.¹⁵

China alone accounts for more than 14% of global oil demand and for more than 80% of global growth in demand in 2019.¹⁶ The drastic fall in oil prices and oil demand has been countered by supply cuts at some of the world’s top producers where operating oil and gas rigs are at historic lows.¹⁷

Extent of disruption

The fundamental question is the extent of disruption that could be caused to economies from the lockdown and quarantine measures. Global stock markets lost USD 6 trillion in value in six days in the month of February 2020.¹⁸

Over the period 19 February 2020 to 13 March 2020, the pandemic cost global stock markets USD 16 trillion.¹⁹ Optimism around a vaccine for COVID-19 and various stimulus measures announced by governments and central banks in April resulted in a sharp recovery in global stock markets where the S&P 500 index registered its best month since 1987, climbing 12.7%.²⁰

While this recovery may seem large, the rise in the S&P 500 index in April was driven by gains in the technology sector. On 27 March 2020, International Monetary Fund (IMF) Chief Kristalina Georgieva declared that the coronavirus pandemic has driven the global economy into a recession expected to be worse than in 2009. The IMF’s estimate for overall financial needs of emerging markets is USD 2.5 trillion, at a lower end.²¹

On 14 April 2020, the IMF projected global growth to be negative 3% in 2020, a downgrade of 6% since its forecast in January 2020.²² According to the United Nations trade report, only two major economies are expected to register positive growth – India and China.²³ A 2006 paper by the World Bank puts the potential cost of a severe flu pandemic at 4.8% of global GDP.²⁴ This implies that the potential cost of COVID-19 could be more than USD 4 trillion.

Impact on assessment of damages

Given the global economic slowdown and the extent of disruption to cash flows, it is not unreasonable to expect an increase in number of dispute cases across different sectors as parties are likely to default on their contractual obligations. Industries that are likely to be most affected by the pandemic include aviation, tourism, manufacturing, shipping, transport, hospitality, retail and related services.

Corporates have reached out to insurance firms for claiming monies under the “loss of profit” clause in insurance contracts. The question is whether, as discussed below, COVID-19 is covered under such policies and whether insurers can fall back on force majeure, or Act of God clauses.²⁵

In general, loss of profits is calculated as the difference between the counterfactual (but-for) financial position and the actual financial position of the injured party over the period after the date of breach. Any calculation of loss of profits should be carried out based on facts known or knowable as at the date of assessment, which may or may not coincide with the date of breach. In the current scenario, the choice of date of assessment during the pre COVID-19 period or post may have a significant impact on the calculation of loss of profits.

The but-for and actual financial positions should reflect a credible estimate of the projected future cash flows of the injured party discounted back to the date of assessment using an appropriate discount rate applicable to the inherent risk in such cash flows (also known as discounted cash flow method under income approach of valuation).

However, the pandemic is likely to result in an extended period of volatility and uncertainty in global financial markets and disruption of future cash flows. It may be difficult to quantify the duration of such period of uncertainty and the extent of the damage caused to businesses during such period in both the counterfactual and actual financial positions, depending on the date of assessment. In addition, the impact of pandemic may vary across companies, sectors and geographies.

Therefore, a rigorous cash flow analyses is required to ensure that any uncertainty is appropriately reflected in the financial projections of subject business. It may be relevant to develop multiple financial scenarios and business models to reasonably assess the likely impact of this disruption on future cash flows by accounting for:

• changes in macro-economic factors including real GDP projections, growth rates, inflation and exchange rates after the pandemic;
• impact on underlying industry, demand and supply factors and competition in the market;
• impact on underlying geography and regulatory environment in which the subject business operates; and
• company specific risk factors.

In the current scenario, it may be equally complex to determine an appropriate discount rate that is commensurate with time value of money and risk inherent in such future cash flows. It may be pertinent to assess the extent of reliance on recent volatility as compared to a long-term view of normalised historical data.

Recent dramatic declines in the interest rates, increasing credit spreads, worsening business and consumer confidence and volatility in stock markets might impact the calculation of the risk-free rate, equity risk premium and beta in determining cost of equity. Cost of debt is likely to be impacted by any changes in the business’ credit rating, capital structure and current market conditions. Therefore, the assessment of discount rate might become sensitive to the period of assessment and the extent of reliance on the recent data points.

The presence of contemporaneous documents, parties’ agreed business plans, substantive history of profitability, well-reasoned and conservative assumptions and general availability of historical financial information and quality data on the business will continue to play a pivotal role in minimizing subjectivity and speculation and building a robust and reliable set of projected future cash flows.

An equally pertinent issue is to evaluate whether the discounted cash flow method of valuation is appropriate for businesses facing severe liquidity issues and threats to their continuity and “going concern” amidst such a period of uncertainty.

An alternate approach to measuring value of a business is the market approach wherein subject companies are valued based on market price or selling price of similar businesses. Even in case of applying the market approach to valuation which incorporates growth and risk more directly, it is prudent to evaluate whether the global comparable companies can be considered as truly comparable for benchmarking purposes considering the varied impact of the pandemic on companies and sectors across geographies.

The process of identification of comparable companies and/or transactions may become highly subjective. It may be difficult to assess the application of adjustments to calculated metrics to account for differences in comparable assets. Tumbling stock markets across the globe have pushed stock prices to their historical lows and such prices may or may not reflect the future potential of the business once the economy revives.

A business’ past earnings and profitability (for example Last Twelve Months revenues or earnings) must be applied with prudence given that a business’ performance and recent forecast after the onset of the pandemic may be considered a more reliable indicator of value.

Legal impact of COVID-19 on businesses

Disruption of labour markets, manufacturing capacity and trading routes means that companies in both upstream and downstream markets may struggle to perform under existing contracts and will therefore seek to terminate or excuse themselves from their contractual obligations.

Under English law, parties who have contracted to do something are generally held to that promise, even where events make performance more onerous than originally envisaged. There are however exceptions to that general rule, as well as clauses which might act to relieve parties of their obligations.

Parties to a contract often include a so-called force majeure clause, which defines an uncertain set of circumstances, beyond a party’s control, in which failure to perform a contract will be excused. These clauses are not universal in commercial contracts, therefore definitive guidance is not possible, and each clause will be subject to the usual rules of contractual interpretation.

Some force majeure clauses may have an express reference to “pandemic”, “disease” or similar. This alone is not sufficient however, as it is the knock-on effects of COVID-19 which will be in issue rather than the pandemic itself. The party seeking to rely on the clause will need to point to a specific force majeure event that has occurred; whilst a government-imposed closure of a port would be a clear example of such an event, a recommendation that use is to be restricted to essential imports only is less straight forward.

Having identified a force majeure event, the party will then need to demonstrate that that event has caused or will cause non-performance of its contractual obligations. Whilst this question will ultimately depend on the specific wording in the contract, it is generally the case that a party will need to prove (i) that the event is unforeseeable and outside of its control and, (ii) that the event has prevented performance (or in some circumstances hindered or delayed) of its contractual obligations. In the context of COVID-19, even if a contract has an express reference to “pandemic” as a prescribed force majeure event, it will not be enough to simply show that an event has arisen. What needs to be demonstrated is a causative link between the event and non-performance of the contract.

Many force majeure clauses will not expressly refer to a pandemic. They may instead refer to an “Act of God”, an extremely wide definition that has not been explored at great length in English law, or language such as “any other cause beyond the party’s reasonable control”, which again requires the parties to consider potentially complex issues of causation.

If a party successfully claims force majeure, the consequences will ultimately depend upon the precise wording in the force majeure clause. The most common consequence is that it is relieved from performing its obligations for the period of time that the force majeure event occurs with the contract effectively “suspended” until the event ends and performance can be resumed.

Another potential consequence is termination of the contract. Termination can arise either as an automatic consequence of claiming force majeure or it can be at the option of one of the parties often after the elapse of a period of time. In rarer cases a contract may allow the affected party to claim financial compensation from the non-affected party for costs associated with the event. Should a party successfully claim force majeure as a result of COVID-19, it will need to consider whether it is under a duty to mitigate the impacts of the event.

At common law there is no duty for a party to take steps to mitigate a force majeure event but there is often an express (or implied) provision in the contract. In the COVID-19 scenario, it is unclear to what lengths a party would have to go to mitigate the impact that COVID-19 might have on their ability to perform under their contract. With the situation and government guidance evolving on a day-by-day basis, reasonable and proportional decision making can prove difficult.

Where a force majeure clause has not been included in a contract, parties may be able to rely on the concept of frustration. Frustration is a narrow doctrine which only applies where events occur that make the performance of the contract impossible, illegal or radically different from that originally envisioned by the parties.

It is not enough for a contract to become more expensive or onerous than originally contemplated for it to be frustrated, and therefore will require parties to seek alternative routes or source from different suppliers even if the costs involved are significantly higher.

In the context of facility agreements or other finance documents, material adverse change (MAC) or material adverse effect (MAE) clauses permit a lender to cease performing its obligations where there has been a material adverse change to the borrower’s financial position, but which falls short of insolvency. These types of clauses have not however been extensively tested before the courts, and there is therefore significant uncertainty as to the likely judicial approach in the event a lender invokes such a clause.

A range of other legal implications are likely to arise as a consequence of COVID-19, many of which are yet to be discovered. As mentioned above, companies are starting to consider whether loss of profit clauses in insurance contracts can be invoked, however protection under most types of business interruption insurance cover is triggered by damage to property resulting in partial or total closure of the business, which itself leads to loss of profit.

Certain extensions to cover may apply to circumstances where there is no physical damage, such as denial of access to premises, and some policies may specifically cover infections or contagious diseases. These are not however market standard, therefore as with force majeure clauses the wording of the policy must be checked in order to ascertain whether such circumstances are covered.

Other legal implications include employment issues (both health and safety of workers and considerations arising from agile working, absence and redundancy), data protection and business continuity planning.

Conclusion

As governments and economies commence planning for the most suitable exit strategy for each nation, the extent of disruption to businesses and households is yet to be fully understood and measured. How businesses will deal with the consequences of the pandemic on their cash flows and contractual obligations will unfold in the months and years ahead of us. The debate over the likely shape and form of economic recovery is endless. While it may be a V-shaped revival for some nations, others may take longer to revive their economies and stabilize thereafter (following a U-shaped curve).

The late Austrian economist and Harvard professor Joseph Schumpeter considered disruption critical for economic growth and societal advancement. While the pandemic is far from over, the question is are we ready to embrace it? Indeed, over the past few weeks humans across the world, regardless of their race, origin or social status, have all come together and displayed an act of solidarity and demonstrated the human need for connection even in the worst situations.

Lockdowns have resulted in new social norms and acceptances that may continue beyond the crisis. Technology has enabled employees to work from any location with minimum travel and daily commute. This may increase overall work efficiency, improve work-life balance and reduce fixed costs of office infrastructure resulting in long term benefits for the businesses and the overall climate and environment.

Digital education and learning may become the new norm. It is also expected that lessons learnt from this pandemic would enable parties to use contract provisions and risk management strategies effectively to manage and minimise disputes in future.