COVID-19 as a “material adverse effect” clause in loan agreements under English law

Since the end of 2019, the spread of coronavirus and the disease created by it (the “COVID-19”) have generated fear in the population and are directly affecting the economy worldwide. In an attempt to avoid closing down and to reduce their losses, some businesses are relying on law and contracts. In the sphere of the loan industry, many existing agreements contain provisions that can be actionable by the lender as consequence of this crisis and, which, as result, may affect the borrower’s business. An example of such provision is the material adverse effect (“MAE”) clause. This article focuses on the links between MAE clauses and the ongoing impact of COVID-19 on loan agreements.

MAE CLAUSE’S DEFINITION AND USES IN LOAN AGREEMENTS

A MAE clause can be trigged whenever there is a material change in the circumstances in which the parties, at first, have decided to enter into an agreement. Until now, such clauses have been considered by market participants of little use and only called in extreme circumstances. However, due to the COVID-19 impact on some businesses, it is very likely that the use of such clauses will be considered under thorough evaluation.

The key uses of MAE clauses in loan agreements are as:

  • a qualifier: many representations and covenants provided by the borrower will be qualified by MAE, meaning that they will only be breached if the MAE threshold is reached; and
  • an event of default: in addition to a MAE as a threshold, as above, loan agreements may also include a MAE as a standalone event of default, which applies on a generic basis to the business of the borrower.

When a MAE is trigged as above in loan agreements, lenders may be allowed to start or accelerate enforcement action against the borrower. Sometimes, even if such enforcement action is not immediately permitted by the agreement, a MAE can give the lender leverage in negotiations with the borrower on the next steps to be taken.

MAE CLAUSE’S APPLICATION IN THE CONTEXT OF COVID-19

The following guidance can be extracted from the leading English law cases on MAE clauses:

  • Where the MAE provision is limited to effects on the borrower’s “financial condition”, the emphasis will be on the company’s own, specific finances. While, where the clause refers instead to the borrower’s “business”, the scope will be broader, in order to take into account matters such as external or market changes;
  • When assessing the borrower’s financial condition, the starting point will be its financial information (cashflow and balance sheets) and/or management accounts in order to access the borrower’s ability to pay. However, English courts can also take into consideration real world evidence, such as the suspension of payments on the borrower’s bank debts;
  • In order to access the change in the ability of the borrower to pay as above, the question that needs to be done is “does such change significantly affect its ability to repay or increase the risks assumed by the lender?” English courts focus on the “significantly” threshold;
  • When a MAE is trigged upon the borrower’s breach of its obligations under a loan agreement and such agreement provides that the borrower will pay a certain amount to the lender for such breach, that payment will only be enforced by an English Court if the amount in question resemble as the actual damage that the lender suffered as a result of the breach;
  • The adverse effect must not be only temporary. In relation to COVID-19, even if it turns out to be a short-term event, the emphasis will be on the impact that such event will cause on the borrower’s ability to meet its obligations in the long-term; and
  • The MAE clause may allow the lender to rely on its own opinion as to whether a MAE event has occurred. In this case and where no reasonableness qualification is included, the lender only needs to prove that it has not taken account of irrelevant factors and that it reached the same conclusion that any other lender, acting reasonably in the same circumstances, would have reached.

NEXT STEPS TO CONSIDER

In the COVID-19 scenario and its devastating impact on businesses, MAE clauses, which in the past seemed to be of little of no use, will now be subject to a renewed scrutiny. More than ever, the “difference will be in the detail” and whether MAE events will be triggered will mostly depend on how this clause has been drafted.

To this extent, it is crucial for borrowers to be aware of such scrutiny and to start getting ready in case lenders decide to execute this clause under their loan agreements.

Additionally, lenders should bear in mind other available options, before relying solely on MAE clauses. The MAE trigger and the consequent enforcement of actions against the borrower (for instance, acceleration of repayments to the lender) could have a huge impact on the borrower’s wealth, particularly in a crisis scenario. Besides, borrowers can always seek damages in courts against excess taken by lenders or in case lenders breach their obligations under the agreement.

For more information, and any guidance on COVID-19 as a MAE event under loan agreements and how this can impact your business, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.

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