Covid-19: How adverse is materially adverse? 


The concept of ‘Material Adverse Effect’ or ‘Material Adverse Change’ is used for protection from the unknown: events of magnitude which cannot be anticipated in due diligence and risk assessment.

The COVID-19 pandemic has had an enormous impact on every sector of economies across the world which (i) before December 2019 could not have been foreseen; and (ii) is still impossible to predict.

Both the extent of the spread of the virus itself and its economic effect will depend on the duration of our “significant period” of strict social distancing restrictions. In an effort to mitigate the economic fallout, the UK Government has mounted a multi-billion “fightback” and many businesses are innovatively adapting their models for our new social circumstances.

Whether a MAC/MAE provision can be invoked in relation to an event will depend on how the provision is documented. Whilst MAC/MAE provisions are routinely included in facility agreements, in times of previous market disruption lenders have been cautious to rely on MAC/MAE alone as an event of default. COVID-19 has provided a novel series of repercussions and consequences which go beyond previous market crises. This Law-Now considers an initial analysis, following discussion in our recent webinar, “Risk Essentials: The impact of COVID-19: contractual obligations under the microscope”.

Lenders use the MAC/MAE concept in most types of financing:

  1. initially, the absence of a MAE will be a representation/condition precedent to funding; and then
  2. should an event or circumstance which has a MAE occur during the term of the loan, this may be an event of default to allow the lenders to demand repayment and enforce security.

MAC representation

The LMA precedent “MAC representation” is usually a condition to any drawdown of a facility, and is repeated at the start of every interest period. This requires the borrower to represent that “there has been no material adverse change in its assets, business or financial condition (or the assets, business or consolidated financial condition of the Group, in the case of the Parent) since the date of the “[Accountants Report/Original Financial Statements]”. If this cannot be confirmed, the lenders are not obliged to lend and the misrepresentation could give rise to an event of default.

Grupo Hotelero Urvasco SA v Carey Value Added SL & Anor [2013] provided limited guidance on MAC representation (see further our Law-Now of August 2013) as follows:

  1. “financial condition” should be assessed primarily by looking at the company’s financial information, and other compelling evidence, such as failure to make repayments;
  2. the change is only ‘material’ if it affects the company’s ability to perform its obligations in the underlying agreement;
  3. the change must not be merely temporary, it must have a long term impact on the company and whether it can meet its obligations under the facility; and
  4. evidence of external economic or market disruption would not of itself constitute a material adverse change.

The MAC representation is this case was limited to financial condition only and extremely briefly worded so this may not necessarily be influential in relation to a more extensive clause.

MAE Event of Default

The LMA’s precedent event of default is “Any event or circumstances occurs which the Majority Lenders reasonably believe has or is reasonably likely to have a Material Adverse Effect”. This allows the lenders to look forward as to the future potential impact rather than just whether the MAE has occurred already.

“Material Adverse Effect” is often defined to be both wide and vague in scope, and whilst generally negotiated, it usually has as its base the LMA precedent leveraged facility agreement definition which is:

“[in the reasonable opinion of the Majority Lenders]1 a material adverse effect on:

  1. [the business, operations, property, condition (financial or otherwise) or prospects of the Group taken as a whole; or
  2. [the ability of an Obligor to perform [its obligations under the Finance Documents]/[its payment obligations2 under the Finance Documents and/or its obligations under clause [●] (Financial condition)]]/(the ability of the Obligors3 (taken 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
  3. 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.]4]

By way of commentary:

1 many negotiated provisions will remove the subjective determination, however where the lenders’ decision remains the trigger, case law has set a low threshold requiring that the lenders rationally and honestly believe that the event gives rise to a MAE, disregarding whether that is the case objectively (see Cukurova Finance International Ltd & Anor v Alfa Telecom Turkey Ltd (British Virgin Islands) [2013]). This case however did not consider the “reasonableness” of opinion which should impose a higher bar on the lender to prove objectively that their view is reasonable;

2 borrowers will often seek to limit this limb to the fundamental payment obligations and possibly financial covenants, and other material obligations;

3 on specific asset or real estate financing, the lender may narrow this to asset owning entities, but a borrower may resist this where the lender has recourse to the covenant strength of a wider group;

4 this seeks to protect the lender against the disruption to the legal effectiveness of the recourse and security package which is not relevant to the current crisis.

Use in practice

Lenders are generally cautious about calling an event of default based solely on a Material Adverse Effect. Whilst the subjective determination is more robust for lenders, if an objective test is required, there is rarely legal, factual and causal certainty as to whether a Court will determine the circumstances to constitute a MAC or MAE.

The novel circumstances of COVID-19

We have no tested cases where a lender has looked to invoke MAC as a result of an epidemic/pandemic. Additional issues now are the uncertain proliferation of COVID-19, whether the consequences are temporary or permanent, the widespread global effect and whether there may be any pre-existing circumstances affecting the borrower’s position, such as Brexit, extreme climate, weather conditions and disruption in the oil markets.

Grupo Hotelero suggested that general economic disruption is not of itself a MAC in a company’s ability to service a loan and this point was also considered by the Takeover Panel in 2001 when it said that to meet the material significance test "requires an adverse change of very considerable significance striking at the very heart of the purpose of the transaction in question analogous… to something that would justify frustration of a legal contract” (see our Law-Now of April 2002).

We have seen the initial COVID-19 shock, and the effects of our current lockdown on the economy and businesses are evident, but we cannot predict how long these effects will last nor how successful the Government’s relief measures will be in mitigating the economic impact (see our recent Law-Nows which discuss the CCFF, CBILS, tax relief measures, business rates relief and wages support).

Caution and consideration

Lenders will usually want the comfort of an alternative cast-iron Event of Default prior to taking any action – non-payment, failure to meet financial covenants, cessation of business, cross-default under another facility or an insolvency event are all provisions that may be triggered as a result of the current crisis are less open to interpretation and debate.

The UK Government and the regulatory authorities have made clear their expectations of lenders in their recent CEO letters: the Government noting the need for “willingness to maintain and extend lending despite the uncertain economic conditions” and the Prudential Regulation Authority urging lenders to “consider carefully their responses to potential breaches of covenants airing directly from the COVID-19 pandemic and its consequences…” (see further here and here).

An unsuccessful MAC/MAE claim in the Courts could lead to a lender incurring reputational damage and significant damages liability to make good the borrower’s losses. A preliminary Court ruling would be time consuming and may still lead to negative publicity and damage to a lender’s relationship with its customers and the borrower’s wider business.

In the absence of any other definite event of default, lenders are more likely to consider renegotiation and interim options such as short term waivers, consents, standstill agreements, alternative security and/or reviewing the pricing arrangements mechanism or encouraging the borrower to apply for the CBILS, CCFF or new Coronavirus Large Business Interruption Loan (CLBILS) schemes (depending on the borrower’s circumstances). These suggestions for caution and consideration for business that were already distressed are more nuanced. Ahead of the next interest payment date and financial covenant test date (likely to be imminent), borrowers will assessing their financial position and financial covenants in preparation.

Whether a lender may feel more comfortable calling a MAC to stop further drawing of a revolving facility than calling a MAE event of default may depend on whether the borrower is looking to fully draw a sizeable facility from fear of a liquidity crisis rather than a genuine attempt to front run possible default concerns down the track.

Determining whether or not an MAE has occurred now as a result of COVID-19 does not necessarily make it unreasonable to call the MAC/MAE in the future. Borrowers usually have an ongoing obligation to notify the lenders of any Default and there are likely to be fixed dates a MAC representation must repeat or a no Default representation is required for the rollover of an existing loan.

As for any new deals, borrowers may need to consider the exclusion of COVID-19 and its consequences from any MAC/MAE provision but the exact scope of those exclusions will require careful review and negotiation, and may be difficult for lenders to accept.