Borrower Beware Series - Part V: Key Commercial Considerations for CARES Act Program Participants

For additional guidance, please refer to Steptoe's COVID-19 Resource Center.

As outlined in earlier installments of our Borrower Beware Series, prospective CARES Act borrowers should tread carefully to guard against unintended consequences associated with accepting those loans. Prior alerts have discussed potential exposure to federal criminal prosecution for bank, wire, and mail fraud (click here), as well as treble damages flowing from government lawsuits filed under the False Claims Act (click here). This alert focuses on the risky intersection where participation in the CARES Act programs may conflict with the contractual rights and obligations of parties to commercial agreements. 

The COVID-19 pandemic has disrupted commercial services across every industry. By way of illustration, factory workers may be unavailable to build machines—because they are sick, or because a state or local government has mandated that they stay home. Even if the workers are able to work, suppliers may not deliver necessary parts to the factory. If another company pre-purchased the finished products, and perhaps promised them to a third party, the chain of disruption goes on. On the receiving end, non-essential businesses that were required to close may now have pre-ordered inventory piling up—unused and going to waste. 

In other contexts, businesses selling services that involve in-person, face-to-face interaction to thrive are not able to perform for clients as contractually promised. Whether "remote" options for the delivery of these services or credits toward performance in a pandemic-free time, will constitute adequate consideration for what was contractually agreed is likely to be heavily disputed. 

These hypothetical scenarios are now playing out in every corner of the domestic and international economy, and companies caught in the crosshairs of their contractual counterparties have limited options for relief. In ordinary times, companies struggling to meet their contractual obligations could raise contractual defenses to performance and possibly seek insurance money, where available. In these unprecedented times, they can also seek funding under the CARES Act. But companies contemplating this new source of funding must understand how accepting it could intersect with their existing contractual obligations, their otherwise available contract-based defenses, and their insurance claims – or risk creating further problems down the road. The urgency with which businesses need financial relief to fulfill their commercial obligations only heightens the risk that they will seek immediate funding without adequate care and caution.  

Below are some of the key issues companies should consider when balancing their need for financial assistance and their rights and obligations under commercial agreements.

Impact on Contractual Defenses to Performance 

When a company fails to perform its contractual obligations, the availability, and ultimate receipt of funds through the CARES Act or insurance could change how that company is able to defend itself against a breach of contract claim filed by its commercial counterparty.    

As Steptoe discussed recently in an alert, companies struggling to perform their contracts in the midst of this pandemic may find relief in various legal theories of defense, including impossibility of performance, frustration of purpose, failure of consideration, impracticability, and force majeure. These defenses have the potential to excuse the performance of a struggling company entirely. 

But the receipt of CARES Act funding or insurance proceeds can materially change a company's circumstances and thereby impact those defenses. For example, an influx of cash can change the practical reality of whether performance is still actually "impossible," which in turn can change a company’s obligations to its contracting counterparty. While the stimulus enacted during the 2008 financial crisis (TARP) did not provide for a private cause of action (see, e.g., Brecker v. 1st Republic Mortgage Bankers, Inc., No. 13-5646, 2013 WL 5729783, *2-3 (D.N.J. Oct. 21, 2013)), and it is anticipated that the CARES Act will not be interpreted as providing one either, that will not prevent parties from arguing under existing contract law that a company's receipt of funding materially changes its circumstances in ways that might nullify otherwise available defenses. 

It can also be anticipated that, even without a private cause of action under the CARES Act, aggrieved counterparties may attempt to file suit against borrowers of CARES Act loans alleging that they are the intended third-party beneficiaries of the CARES Act program. This is precisely what happened in connection with TARP funding. There, numerous troubled homeowners filed suits against banks alleging that they were third-party beneficiaries of the deals between banks and the government, such that banks were required to modify their loans. See, e.g., Clay v. First Horizon Home Loan Corp., 392 S.W.3d 72 (Tenn. Ct. App. 2012) (dismissing third-party beneficiary claim). In the context of CARES Act funding, it can be anticipated that if a borrower does not apply funding in the prescribed manner (for example, by using the required portion of funding to pay employee salaries), the would-be beneficiaries of the funds will file suit (even if those suits ultimately prove unsuccessful).    

On the other hand, if a struggling company is faced with potentially breaching a contract and fails to take advantage of available funding under the CARES Act, an aggrieved contractual counterparty could also argue that the company failed to mitigate its damages by accessing available funding. 

When negotiating with contractual counterparties and contemplating external sources of funding, there are risks associated with however a struggling company chooses to proceed. As a result, it is advisable to consult with in-house or outside counsel early on in that process, so that the consequences of accepting funding or asserting various positions can be thoroughly vetted, and the opportunity for potentially renegotiating those contracts can be assessed.

Impact on Existing Contractual Obligations 

Funding under the CARES Act also comes with enormous strings attached. As outlined in prior alerts, companies accepting direct loans under Title IV of the CARES Act, through programs like the Main Street Lending Program or the Paycheck Protection Program for small businesses, are restrained in numerous respects—including, for example, limits on executive compensation, the ability to pay dividends, and the types of business in which they may invest. Additionally, there is a further amorphous caveat that Treasury has the discretion to set the terms and conditions of the loans, which could impact other business operations normally within a company's own discretion. 

These restraints could conflict with pre-existing contractual agreements, and companies should therefore consult with counsel before accepting such funding. While reliance on a government regulation can be a defense to a contractual obligation under the doctrine of impossibility of performance (see Hampton Roads Bankshares, Inc., et al. v. Harvard, 291 Va. 42, 53-54 (2016)), a business' voluntary choice to apply for a loan and submit to its terms could arguably be viewed differently. It may be advantageous to renegotiate any potentially conflicting contracts early in the process, when the need to do so is readily apparent to all involved, in order to avoid later disputes.  

Impact on Insurance Claims 

The availability of CARES Act funding also is likely to impact insurance claims. Insurance policies often require insureds to provide prompt notice of any potential claim, and failure to do so can lead to the denial of coverage. As a result, it can be anticipated that numerous companies, faced with mounting losses, are quickly filing insurance claims now so as to avoid any undue delay, at the same time as they are seeking funding under the CARES Act. 

Receipt of CARES Act funding may change the scope of damages a company suffers and, as a result, the amount of losses that could be claimed under an insurance policy. Whether the insurance claims being filed today will be deemed covered claims in the future ultimately will depend on the facts of the case and the specific terms of each policy. But the rule against windfall recoveries may affect an insured's potential disclosure obligations to insurers on otherwise covered claims. Consequently, failing to disclose receipt of CARES Act financial assistance, depending on the nature and circumstances of the funding, may expose insureds to civil or criminal liability for fraud. It may also be a basis for insurers to deny otherwise proper claims.  

In the same vein, borrowers seeking funding under the CARES Act are also required to provide information about other sources of funding, such as insurance coverage. It may be that the scope of coverage available is yet unknown at the time of applying for a loan, meaning that a borrower must remain vigilant in updating its certifications where necessary as new information becomes available. For example, the Department of Defense is requiring government contractors seeking reimbursement for employee compensation under Section 3610 of the CARES Act to identify any other claimed or received relief stemming from COVID-19.  

Insurance policies also often require that a policyholder take steps to mitigate its losses. As such, while there is risk in applying for a CARES Act loan, there also may be risk in not doing so. It is possible an insurer could take the position that a company facing the types of business interruption that so many companies are now facing must apply for a CARES Act loan as a way to mitigate its losses. 

Fundamentally, it can be assumed that neither the government nor insurance companies will be sympathetic to businesses who obtain funding for losses from multiple sources, such that amounts received are greater than what was needed for the business to be made whole. To that end, it is also possible that complicated questions of subrogation will arise in the coming months where an insurer first pays a claim, and CARES Act funding arrives thereafter, covering the same loss. Given the current rush to file claims with insurers and applications with the government, overlapping funding—and competing rights arising out it—appears very likely to occur.      

All of the above issues are very much dependent on the specific facts and circumstances a business is facing and the terms and conditions of its insurance policies.

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The COVID-19 pandemic has wreaked havoc on commercial operations worldwide, and businesses understandably want to stop the bleeding as quickly as humanly possible—for the health of their companies and their employees. But as outlined herein, quick solutions could pose long-term risk, and proceeding thoughtfully and cautiously will help mitigate future harm.