Whilst the world reels from the impact of the COVID-19 coronavirus and rightly focuses on preserving lives, many businesses will nevertheless need at the same time to fight to stay afloat as the repercussions of the virus hit hard. Many will have existing financing arrangements in place, and the loan agreements for those arrangements will contain provisions impacting what rights their lenders have in reacting to this crisis.

It will be unusual to find a provision that is directly triggered by COVID-19 itself (albeit in recent years there has been an increase in business disruption clauses which may cover pandemics of this kind, and if so, may offer some relief for the borrower in particular in the testing of compliance with financial covenants). Nevertheless, there will be a significant number of provisions which could be breached as a consequence of the ongoing impact of COVID-19. These include:

• payment obligations;
• financial covenant compliance;
• material contract provisions;
• cessation of business; and
• creditor action clauses.

There will also likely be a number of permission or restriction controls which will now be actionable by a lender and will affect the business activities of borrowers.

MAE CLAUSES AND THEIR USES

This said there remains one specific direct trigger which borrowers do also need to pay attention to – Material Adverse Change/Effect (“MAE”).

MAE provisions have been a feature in loan agreements for many years. They differ from their use in M&A and commercial contracts, and to some extent have fallen into almost a boilerplate type category regarded by market participants as having little teeth in all but the most extreme of circumstances. Even the 2008 global financial crisis and the fallout from that did not give rise to many instances of these provisions being called. However, as we have all witnessed in the last few weeks, COVID-19 is breaking new ground, and so MAE clauses will now be very much back under scrutiny.

MAE clauses in loan agreements arise in various places, but the key ones are:

1. MAE as a qualifier – many representations and undertakings provided by the borrower will be qualified by MAE, meaning that they are only breached if the MAE threshold is attained. This can attach to drawdown restrictions when representations are repeated, to measure the impact of litigation or lost contracts, undertakings or as to whether or not restrictions on the borrower’s business should come into effect.
2. MAE as an Event of Default – almost all loan agreements (in addition to including MAE as a threshold against which to test the impact of particular representations and covenants) will also include a specific standalone MAE Event of Default which does not attach to a particular action, but applies on a generic basis to the business of the borrower.

Where MAE is triggered, the lenders can usually accelerate and start enforcement action if they choose to. Even if acceleration and enforcement are not an immediate option, the Event of Default would give the lenders leverage in discussions around what happens next. The key then is to understand what teeth the MAE provisions have in any given situation.

MAE – THE DEFINITION AND ITS APPLICATION

Any analysis of MAE provisions will be specific to the relevant circumstances and the precise drafting in any particular loan agreement, and as such it is not an area to make generic assumptions about. However, a good starting point is the LMA-recommended form for leveraged finance facility agreements, as these have wide usage throughout the corporate loan markets.

The LMA drafting and interpretation leaves a lot for the parties to agree between themselves, but has some key elements:

Standard LMA MAE definition:

"Material Adverse Effect" means [in the reasonable opinion of the Majority Lenders] a material adverse effect on:

(a) [the business, operations, property, condition (financial or otherwise) or prospects of the Group taken as a whole; or

(b) [the ability of an Obligor to perform [its obligations under the Finance Documents]/[its payment obligations under the Finance Documents and/or its obligations under Clause [ ] (Financial condition)]]/[the ability of the Obligors (taken as a whole) to perform [their obligations under the Finance Documents]/[their payment obligations under the Finance Documents and/or their obligations under Clause [ ](Financial condition)]]; or

(c) the validity or enforceability of, or the effectiveness or ranking of any Security granted or purporting to be granted pursuant to any of, the Finance Documents or the rights or remedies of any Finance Party under any of the Finance Documents.]

Standard LMA MAE Event of Default:

“Any event or circumstance occurs which the Majority Lenders reasonably believe has or is reasonably likely to have a Material Adverse Effect.”

Now these broad propositions have of course become the subject of much refinement, and as mentioned earlier, have been watered down in many loan agreements – such that they are often considered highly unlikely to be triggered. This is because sophisticated borrowers have negotiated significant mitigation around these provisions.

For example, in relation to the definition itself, the interpretation is almost always objective and not subject to lender opinion. It will restrict limb (a) of the definition to the business or financial condition of the Group (and on this specifically carves out a financial covenant breach in itself from being an MAE), whilst limb (b) will be made specific to payment obligations only, and limb (c) will often be subject to significant remedy periods.

The definition will also often require a number of other factors to be taken into account before a determination can be made as to whether something has an MAE or not, including taking account of the availability and use of insurance proceeds, warranty claim proceeds, access to other sources of revenue and/or funding, and of course, cost-saving initiatives which may mitigate the particular issue.

Then its interpretation within the loan agreement itself (and in particular in the Event of Default) will be made as narrow and certain as possible to “has” or maybe “will have” a MAE, so as to take out as much of the look-forward element of its application as possible.

HOW MAY MAE CLAUSES APPLY IN THE CONTEXT OF COVID-19?

So, in the context of COVID-19, how will all this play out, and how have the courts historically interpreted such provisions?

There have, in fact, been relatively few English court decisions on MAE clauses, perhaps because where an MAE has genuinely occurred, other defaults swiftly follow on which it is easier to rely.

The leading English cases on the subject do however, provide the following guidance:

• 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. Where the clause refers instead to an MAE on the borrower’s “business”, the scope is broader, potentially taking into account other matters such as prospects and external or market changes.
• When assessing the borrower’s “financial condition”, the starting point must be its financial information. The financial condition of a company over the course of a financial year will usually be capable of being established from interim financial information and/or management accounts.
• The assessment is not, however, limited to the company’s financial information. There may be wider compelling evidence to show that an MAE has occurred, even where an analysis of the financial information might suggest otherwise. More generally, the English courts have been swift to take a step back from complex and conflicting evidence on a company’s finances and ability to pay, in favour of real world evidence such as the suspension of payments on the company’s bank debts.
• In the context of a loan agreement, materiality must be measured by reference to the borrower’s ability to pay interest and repay principal. A change in financial condition should be assessed on the basis of the changes in the borrower’s cashflow and balance sheet position, which are relevant to its ability to meet those obligations. Does the change in question significantly affect the borrower’s ability to repay, or increase the risks assumed by the lender? The emphasis here is on “significantly”; not every increase in lender risk will be “material”.
• The adverse change must not be only temporary. The event giving rise to it may be short-lived, as we all hope the COVID-19 pandemic will be, but the impact must have a more lasting impact on the borrower and its ability to meet its obligations under the loan.
• Where the clause allows the lender to rely on its own opinion as to whether an MAE has occurred, it is in a strong position. Where no reasonableness qualification is included, the lender will likely have to prove only that it has not taken account of irrelevant factors, and has not arrived at a determination that no other lender, acting reasonably in the same circumstances, could have reached.

Another thing to remember is that lenders should consider their options carefully before relying on an MAE. The consequences of refusing drawdown on a facility, for example, could have dire consequences for a borrower, particularly in a stressed market. A lender could be on the wrong end of a substantial damages claim if it is found to have breached its obligations.

CONCLUSION

As ever the “devil is in the detail”, and no more so is this the case than in relation to how MAE clauses will be interpreted in the context of COVID-19.

It is the devastating impact of COVID-19 on certain businesses which is likely to give rise to renewed scrutiny of MAE clauses. The speed and extent of the impact will lead to immediate liquidity issues. There are likely to be cases which appear, on their face, to be relatively clear-cut (such as where a borrower in the hospitality industry have been forced by government decree to close their doors) and the lender knows the intention is to generate the cash for repayment through trading. Even here, however, questions will arise as to the likely length of closure and other income sources available to the borrower.

Not only will the drafting of the relevant provisions in each loan agreement be crucial, but also the sector the business operates in, its financial strength before the crisis hit and what access it has to shareholder or other financial support.

What is clear is that the once-perceived “toothless” MAE clause may yet have a bite, and it is one that all borrowers need to be aware of. It is safe to say that one guaranteed impact of COVID-19 going forward will be the desire by some parties to have express carve-outs from MAE of COVID-19 and related or other pandemics.