The COVID-19 pandemic and the responses adopted by governments around the world to mitigate its human cost will have a considerable impact on economic activity. We are seeing the forced closures of businesses and restrictions on free movement and working practices, which are resulting in disruption to supply chains, reductions in consumer spending, and, of course, reductions in output as families self—isolate, care for their sick and home-schooling becomes part of daily life. At the same time, governments are announcing unprecedented levels of financial support for businesses and employees and national resources are being diverted to boost production in key sectors. No one can predict how long these measures will be required for or what long-term structural effects they may have on economies.
Against this backdrop, borrowers and lenders are scrutinizing their existing financing arrangements. Lenders are assessing what their exposure is and borrowers are confirming which liquidity lines are available to them. In an economic crisis, cash is king, and access to liquidity will be critical in determining which businesses survive. Under existing loan agreements, access to cash may hinge on whether the current crisis has a material adverse effect on a group either triggering a material adverse change (MAC), event of default or the inability to make a representation that has to be made as a condition to maintaining an existing loan or drawing a new one. Where businesses have been required to close or have decided to suspend certain activities, this may also give rise to an event of default for cessation of business. The drafting of various provisions will be key to determining the outcome.
Under revolving credit facilities certain conditions must be satisfied for the drawdown of new loans and for the rollover of existing loans. The Loan Market Association formulation for use in leveraged finance transactions (the LMA form) provides that an existing loan will rollover if the repeating representations are true and has an option to also require that either no default or no event of default is continuing. While some loans may have one or more of these features, in the loan agreements of financial sponsors it is more common to find that the loan will rollover subject to one condition only: that the lenders have not accelerated the loan. In these loan agreements, in the absence of lenders exercising remedies, borrowers will be able to keep rolling their working capital loans.
For the drawdown of new revolving loans, it is customary that there must be no default and that the repeating representations must be true. Parties evaluating the conditions to fresh cash drawdowns will need to carefully check the scope of the repeating representations and the scope of the events of default. The LMA Form provides for a repeating representation that there has been no material adverse change to the assets, business or financial condition of the borrower since the most recently delivered financial statements. In practice it is rare to see this representation in leveraged finance loan agreements. Where it does exist, the interpretation by the courts of material adverse change provisions, described below, will be pertinent.
With respect to events of default, given the impact that COVID-19 will have on financial performance, lenders and borrowers should focus on financial covenant calculations and on the MAC event of default. However, the TLB generation of English law loan agreements and the super senior RCFs do not all have financial covenants and some have no MAC event of default. Where there is a financial covenant, it is probably a springing covenant that will only apply when the revolving facility has been drawn beyond a threshold percentage of the total commitments, typically in the range of 30% to 40%.
The Material Adverse Effect (MAE) definition is the key component of the MAC event of default. The drafting of the definition varies widely between loan agreements. The LMA Form has three limbs. The first refers to a material adverse effect on the business, operations, property, condition (financial or otherwise) or prospects of the group taken as a whole. The second contains alternatives focusing on a material adverse effect on either the ability to perform obligations under the relevant finance documents or the ability to perform payment obligations or comply with financial covenants. The third relates to the security granted in support of the financing.
In practice, it is rare for these limbs to be retained in their entirety. The first limb often contains references to business, assets and financial condition only and may expressly exclude from its ambit any forecasted breach of a financial covenant. The second limb often refers to payment obligations only, whether or not the agreement includes a financial covenant. Sometimes the two limbs are combined such that the material adverse effect on the business, assets or financial condition must be sufficient to render it unlikely that the group can meet its payment obligations in the next twelve months. This essentially turns the question into whether the event is so significant that it would call into question the going concern of the business. In some documentation, in making the determination as to whether there has been a material adverse effect, one must take into account the resources that are available to the borrower group as a whole. As we will see below, these nuances are important in assessing whether the MAC event of default is in play.
The MAC event of default is generally expressed in one of two ways. In some cases it will be triggered if an event or circumstance occurs which is “reasonably likely” to have a Material Adverse Effect. In others, it will only be triggered if an event or circumstance occurs which “has” a Material Adverse Effect. The latter is the most common in financial sponsor leveraged loan agreements.
While COVID-19 may contribute to a material adverse effect for a group, the threshold required to successfully claim a MAC event of default is high. The existence of a MAC event of default will be a question of fact and degree and, as discussed above, dependent on the drafting of the definition of “material adverse effect” and the MAC event of default itself.
There is very little case law on the interpretation of these clauses. However, the leading case, Grupo Hotelero Urvasco v Carey Value Added , provides the following guidance:
The adverse change must be material. In order to be material, it must significantly affect the borrower’s ability to perform its obligations and in particular its ability to repay the loan. The court will focus on whether the circumstances were such that a lender was justified in suspending lending or calling a default, given that to do so may precipitate insolvency. In the context of COVID-19, government announcements of financial assistance to business may render claims by lenders of the occurrence of a MAC premature. The courts, government and public opinion may also look unfavorably on lenders seeking redress in a time of national emergency.
In order to be material, the adverse change must not be temporary. Will the impact of COVID-19 be temporary or will it have a long-term impact on revenues? Will we see a “V” shaped recession or something of longer duration? The news cycle changes daily as the scientific models are updated and published.
There must have been a change. If a situation already subsisted at the date of the agreement, it will not give rise to a MAC. If an event or circumstance was likely to occur at the date of the agreement, then it will also not give rise to a MAC as the lender will be considered to have taken this into account when determining whether to enter into the transaction and the level at which to price it. However, if conditions worsen in a manner that renders them materially different in nature, then there is scope to invoke the clause.
Where the MAC refers to the financial condition of the borrower, a claim based on a material adverse change in financial condition should start with an analysis of the borrower’s financial information at the relevant times; i.e., a comparison of historical data against current data. However, the analysis is not necessarily limited to this financial information if there is other compelling evidence available. In the context of Grupo Hotelero, the borrower had ceased to pay its bank debts.
The burden of proof will be on the party asserting that the MAC event of default has occurred. If a lender asserts that the event of default has occurred and exercises contractual remedies on that basis but fails to prove it, they will be in breach of contract.
In practice, lenders tend to prefer to wait until there has been a hard breach of another obligation, a representation or a financial covenant before invoking an event of default. For example, it may be challenging to demonstrate a MAC event of default where a borrower is in compliance with financial covenants (if there are any). Given the risk to a lender of incorrectly invoking an event of default, both to its reputation and the risk of liability if they get it wrong, a potential MAC event of default might prove to be more useful to lenders as a tool to opening dialogue with a reticent borrower.
However, COVID-19 clearly presents a unique set of circumstances. For loan agreements that pre-date the current crisis, there will be greater scope to argue that a MAC has occurred. For transactions that have signed during the initial onset of the crisis, there will be scope to argue that deterioration in performance due to the impact of the virus could not have been in the reasonable expectation of the parties at the time that they contracted with each other given the speed with which it has evolved. For example, a European transaction entered into at a time when the virus appeared to be limited to Asia and the outbreak was slowing in China. However, announcements by governments in several countries of extraordinary financial support for businesses and employees will be a useful counterpoint to these arguments for borrowers.
The LMA Form provides, with certain carve outs for permitted transactions, that there is an event of default if any member of group suspends or ceases to carry on (or threatens to suspend or cease to carry on) all or a material part of its business. In practice, rather than refer to any member of the group, this provision will often apply to a “material” member of the group or to the “group taken as a whole.” In the current circumstances where business lines may have been temporarily suspended or temporarily ceased to operate, parties will have to carefully consider if an event of default has occurred. Lenders should also take into consideration reputational issues if they consider taking action in response to a government mandated shut down.