Pandemic Debt Exemption

Reclined person

Pandemic Debt Exemption, a force majeure like protection for debt contracts in the Hibernating Economy

By June Ma, Rohan Pitchford and Rabee Tourky

In a previous post, we described coordination mechanisms for a private sector solution to the provision of insurance through the hibernating economy. We highlighted the role of banks in providing insurance for businesses during what we termed the economic hibernation period induced by the public health response to the virus. 

We suggested that the government facilitate the transmission of low rates by doing whatever it can to encourage renegotiation of loans, credit lines and debt forgiveness by private banks. In short, we proposed “hibernation through renegotiation” with banks mediated by government encouragement.

In this post, we focus on bankruptcy and insolvency arising due to the shutdowns in the pandemic. The lockdowns put in place to reduce the spread of the virus mean that many small businesses may find themselves unable to repay their debts in coming months.

The Australian Government has already made some temporary changes to bankruptcy and insolvency law. It has increased the debt threshold required for creditors to initiate proceedings against debtors from $2,000 to $20,000, and extended the timeframe for debtors to respond to such proceedings, as well as the period available to debtors to prevent recovery action by unsecured creditors, from 21 days to six months. Additionally, company directors have been relieved from personal liability for insolvent trading for any debts incurred in the ordinary course of the company’s business for six months. These changes provide businesses and individuals with additional time to renegotiate debt arrangements, and could help them avoid the consequences of bankruptcy or insolvency that would require a business to resume from scratch, if at all.

Another form of relief that some businesses may have available to them is the “force majeure” clause contained in some contracts. A force majeure clause relieves a party to a contract from performing its contractual obligations due to an event outside that party’s control. As the WHO has declared COVID-19 a global pandemic, it may be sufficient to trigger the force majeure clause, depending on the terms of each contract.

The consequences of triggering this clause will also depend on the specific terms of a contract, but include the suspension the obligations of the parties to the contract until the force majeure event and its effects no longer prevent the performance of the contract, waiver of liability for non-performance, or renegotiation of contract terms. This would provide businesses with further relief in addition to the government’s temporary changes to bankruptcy and insolvency law.

However, not all contracts contain force majeure clauses, and they are not implied into contracts in Australia. Furthermore, the definition of specific contracts may mean that the pandemic is insufficient to trigger relief under the force majeure clause. While this does not prevent debtors from seeking other forms of relief from creditors (such as the deferral of repayments for up to six months as part of the banking sector’s small business relief package covered in a previous post), debtors without access to relief under a force majeure clause may be disadvantaged, particularly if the effects of COVID-19 persist for longer than six months.

For contracts that do not contain a force majeure clause, the doctrine of frustration may apply if it is impossible for a party to perform their contractual obligations. However, frustration generally does not occur only merely because a party has suffered financial hardship or loss. Moreover, frustration of a contract results in its termination, which is not beneficial where businesses wish to resume operation in the future.

To protect businesses that cannot rely on a force majeure clause for relief from the COVID-19 pandemic, we propose that the government enact legislation providing the force majeure-like protection to persons and businesses with debts to large banks and who are distressed by the hibernation of the economy. This legislation should specifically require the parties to renegotiate debt contracts, which would put small businesses in a better position coming out of the COVID-19-induced economic hibernation. Liquidity for this is provided by the RBA to large banks.

Rabee Tourky is the Director of the Research School of Economics at the Australian National University and The Trevor Swan Distinguished Professor of Economics. His interest has been the operations of markets and market incompleteness.

Rohan Pitchford is a Professor of Economics in the Research School of Economics at the Australian National University. He works on financial stability and securitisation. he has published papers on default, securitisation, and contracts in the leading journals in Economics. He is a graduate from MIT.

June Ma is a pre-doctoral researcher at the Australian National University.