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Coronavirus: will the crisis trigger a material adverse change default?

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As it becomes increasingly apparent that the effects of COVID-19 will be long-lasting. With few, if any, sectors unaffected, borrowers and lenders alike will need to understand what the potential consequences are for their respective rights and obligations under loan agreements. 

Borrowers will be keen to ensure that they can continue to access undrawn facilities, particularly where needed for cashflow purposes, and lenders will be cognisant of the increased risk that a borrower may be unable to repay its loans or keep trading in the long term.

Material Adverse Change – the possible consequences

It remains commonplace for loan agreements to include an event of default which applies where there has been a 'Material Adverse Change' (MAC) to the borrower and its business. This serves as a "catch-all" protection for lenders against unforeseen events or changes in a borrower’s circumstances.

In the event that a MAC provision is triggered, a borrower will likely lose its right to utilise any undrawn commitments from its lender, for example, the utilisation of a revolving credit facility needed for working capital purposes. In addition, a lender would have the right to place a facility "on-demand" and ultimately to demand repayment and, in the event of non-payment, enforce any security held by them in respect of the loan.

Additional consequences may also include an increase in the applicable rate of interest, for example where there is a margin ratchet which applies when an event of default is continuing.

Material Adverse Effect

In most loan agreements there will be an event of default along the lines of "any event or circumstance occurs which the [lender/majority lenders] reasonably believe(s) has or is reasonably likely to have a Material Adverse Effect." 
What constitutes a Material Adverse Effect (MAE) will often be heavily negotiated but will generally be expected to include events which have a material adverse effect on (i) the business, operations, condition (financial or otherwise) or prospects of the borrower, any obligors or the borrower’s group (taken as a whole) or (ii) the ability of a borrower, any obligors or the borrower’s group to perform their obligations under their financing documents (this is often negotiated to compliance with payment obligations and agreed financial covenants). 

It is also usual for such agreements to include a repeating representation that there has been no material adverse change in the assets, business or financial condition of the borrower and its group since it last provided accounts to the lender.

MAC clauses in practice

Whether or not a MAC/MAE has occurred or will occur will largely turn on: 

  • the specific drafting in the loan agreement; 
  • the intentions of the parties when they entered the agreement; 
  • the circumstances of the borrower; and 
  • the specific facts surrounding the purported MAC.

It is therefore important to ensure that up-to-date information is made available (whether that’s for a lender to determine whether a MAC has occurred or for a borrower to make representations to its lender that a MAC has not occurred).  This information will stem mainly from the borrower's knowledge of the business and the financial information the borrower has to provide to the lender.

Who decides?

The decision as to whether a MAC has occurred may be a subjective one for the lender to reach. This decision may be subject to requirements for the lender to "act in good faith" or to have a "reasonable belief".  The agreement may explicitly give a lender a broad discretion to determine whether a MAE has occurred. 

A stronger borrower, on the other hand, may have negotiated a purely objective standard, which would make it less likely to be triggered in practice.

The risk of the wrong decision

Invoking a MAC clause is often viewed as a last resort and generally speaking, lenders will not, and cannot, do it lightly. The consequences of improperly exercising MAC rights are serious – the lender could be in breach of contract and potentially be liable for the losses of the borrower which resulted from this breach (which may include the ultimate failure of the borrower’s business). This inherent uncertainty and risk also explains why such clauses are rarely invoked in isolation and why previous global events, such as the global financial crisis, terrorist attacks and previous pandemics, have not generated much significant case law on the matter. 

In one of the few cases on the point, Grupo Hotelero Urvasco SA v Carey Value Added SL and another [2013] EWHC 1039 (Comm) (the Carey Case), the UK High Court stated, in finding against a lender which had sought to invoke a relatively standard MAC clause, that, in order to be material, a change must not be temporary and must significantly affect the party’s ability to perform its obligations under the contract. 

The court also stated that a lender could not invoke MAC provisions where they relate to circumstances which they were aware of at the outset and found that where reference is to be had to the "financial condition" of a party, this should primarily be determined by reference to their financial information and their ability to comply with its financial obligations under the loan agreement in question.

Furthermore, if the MAC clause includes a degree of lender discretion, the lender may, in some circumstances, also be subject to a duty to exercise that discretion in a manner which was not irrational, arbitrary or capricious (known as a Braganza duty). 

If the facility is syndicated, the specific decision making thresholds in the loan agreement will need to be considered however, this will most likely require the majority of lenders (usually those funding at least two-thirds of the debt) to be in agreement.

Will COVID-19 trigger MAC clauses?

In the context of COVID-19, whether a change is temporary should be viewed by reference to how long the effects and consequences of any disruption will be felt by the borrower (and, where included in the MAE definition, its wider group), rather than whether the virus itself is temporary. 

In light of the Carey Case, lenders undertaking new transactions may also wish to consider whether specific provisions should be included to provide them with additional protection if the event the situation worsens further. 

What to do now?

Given the uncertainties which surround COVID-19 and the responses to it, some corporate borrowers may be considering whether they should utilise their available commitments now to avoid the risk that, in a worsening situation, they may cease to be available (for example if it becomes clearer that a MAC may have occurred). This, of course, needs to be weighed up against a number of factors including, the additional interest costs the borrower would incur and the impact on financial covenants. Directors also need to consider their wider duties and assess whether the borrower is likely to be able to repay the additional monies if required to do so. 

Borrowers should also be mindful of the potential impact a sudden request for additional, unexpected, loans may have on their relationship with their lender. It is likely to act as a 'red flag' triggering further enquiries as to the financial prospects of the borrower group. Lenders faced with a sudden or large drawdown request may feel pressured into seeking to invoke their MAC rights earlier than they otherwise might.

COVID-19 will be affecting many, many businesses and lenders are aware of this.  Parties should seek to engage in an active dialogue. Our experience to date has been that lenders are supportive of their customers and generally responding positively to requests to fund working capital needs in these testing times.  The Chancellor's announcement of support for small businesses and the related Bank of England funding scheme have helped set the tone for how financial institutions are expected to react. 

With quarter end dates imminent (31 March and 30 June), lenders are also being sympathetic towards requests for waivers of financial covenants which are due to be tested. Engagement is key. 

Lenders who find borrowers are reluctant to engage should consider their rights to require a borrower to provide additional financial information at the lender’s request. This will help ensure that they have the best information available for making any decisions and will assist them in best supporting their customers through this crisis. In addition, if really necessary the existence of MAC rights may serve as a useful means of getting the borrower to engage in an active dialogue about any need to restructure existing loans.

Ultimately, whilst it is hoped that the impact on businesses and their employees will be short-lived, we remain ready to assist our borrower and lender clients in addressing the issues raised by COVID-19. 

Need more infomration?

Ultimately, whilst it is hoped that the impact on businesses and employees will be short lived, we remain ready to assist you in addressing the issues raised by COVID-19, please contact one of our experts, listed below, for more information.

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