Covid-19 and MAE: avoidance of contractual obligations in financial arrangements during the pandemic

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Vincent Lau
MinterEllison, Melbourne
vincent.lau@minterellison.com

Introduction

Credit facilities contain clauses which provide the financier with rights where an event or change in circumstances occurs that could have a material adverse effect on the financier or the underlying transaction. These are known as ‘material adverse effect’ (or sometimes ‘material adverse change’) (MAE) clauses.

On the one hand, MAE clauses are intended to capture material risks not specifically contemplated at the time of contracting and so derive their use from being inherently non-exhaustive and broad. On the other hand, financiers are often reluctant to rely on these clauses as their sole basis for enforcement given the uncertainty of their scope.

In that context, this article considers whether Covid-19 (and the associated deterioration of the economy or the borrower’s financial condition) can trigger MAE clauses in financing arrangements in Australia.

What is an MAE clause?

‘Material Adverse Effect’ is typically defined broadly to mean a ‘material adverse effect’ on any one or more of the following:¹

• the ability of an obligor to perform its obligations under the finance documents;

• the remedies or rights of the lenders; or

• the financial condition or business of an obligor.

Despite this arguably uncertain scope, the MAE concept is frequently deployed throughout the finance documents either:

• to provide a threshold to other representations, warranties, undertakings and default events (eg, a warranty that there has been no breach of environmental law capable of having a material adverse effect); or

• as an event of default in its own right (ie, an event of default occurs if an event or circumstance occurs that has a material adverse effect).

Where an MAE causes an event of default (either directly or indirectly), lenders typically gain the power to (among other things) accelerate the obligors’ repayment obligations and commence enforcement action. Further, even if enforcement of an MAE clause is not immediately permitted by the agreement, an MAE can provide financiers with leverage in negotiations with the borrower. In other words, the occurrence or the potential occurrence of an MAE carries serious consequences for all parties to a financing arrangement.

Enforcement of an MAE clause depends heavily on the wording of the clause itself along with the carveouts or exceptions negotiated. During the negotiation process, financiers are incentivised to draft MAE clauses which are ambiguous in scope in order to provide maximum protection. Borrowers, depending on the strength of their borrowing capacity, would be better placed to push for an all obligor test and narrow MAE events.

Are financiers likely to enforce based on an MAE breach?

Financiers considering whether an event will trigger an MAE need to consider a variety of factors. Financiers should consider all the financial statements of individual companies to assess whether the event resulted in a significant decline in revenue. Other considerations are whether deferred debts or payments will be sufficiently covered by the current cashflow of the borrower. If the conclusion is that these assessments by the financier determine that a borrower is distressed, an MAE clause can likely be triggered.

In addition to the considerations above, the courts will also consider, and financiers are well-advised to consider, certain factors such as insurance, warranty cover or any commitment from shareholders of the borrower to provide equity support to mitigate the effects of these adverse events. The purpose behind this is due to the courts seeking to narrow whether there has been a material adverse effect on the financial arrangement. However, determining the scope of an MAE clause is uncertain and vague. Whilst the considerations surrounding enforcement of an MAE are objective, the vague thresholds surrounding the clause make it difficult to determine on the sole basis of an MAE, that the threshold has been surpassed.

In assessing whether or not to call an MAE, financiers will need to consider the broader (and any unintended) effects of triggering an MAE clause, including any reputational impact it may have on a financier and the financial consequences on the group (and its business) that may result from early triggering an enforcement process.

In practice, there is little Australian case law on parties triggering MAE provisions absent of any other defaults. The downside (including damages) for a party in making an incorrect MAE call can be substantial. Instances of global instability which have affected global markets and where MAE clauses were triggered are rare, even accounting for cases in the United Kingdom and United States jurisdictions. For instance, during the 2008 global financial crisis (GFC) and resulting downturn, financiers rarely relied on triggering these clauses; presumably, this is because usually there were other specific defaults financiers could rely on, the most obvious being a financial covenant breach.

While the GFC and other instances of global instability did not result in a spike in MAE litigations, Covid-19 presents a unique challenge to the Australian business environment. The response by the Australian Government, which is discussed below, has the potential to delay and impact the difficulty financiers have in enforcing MAE clauses.

Could an MAE clause be triggered by Covid-19 in Australia?

Australian financiers have rarely enforced solely on the basis of an MAE. They will often wait until a borrower tips into some other formal default (eg, a non-payment default), and then add an MAE to the list of defaults justifying their default action. However, the Covid-19 pandemic may be the ‘black swan’ event that leads financiers to take a more aggressive approach in this respect.

When comparing the case of Covid-19 being the trigger of an MAE to other instances of global instability, Covid-19’s uniqueness makes it stand out. Although the GFC resulted in the tightening of financial supply chains, the government mandated closures to multiple industries including air travel and entertainment have drastically altered the economic landscape. The ripple effect of these closures has resulted in major supply chain disruptions and downward pressure on the demand for otherwise stable industries. Due to the crisis, the Australian Government has implemented a vast array of schemes, including a substantial wage subsidy and a moratorium on insolvent trading, in order to minimise the impact that the pandemic has had on businesses. These schemes make it difficult to assess the impact Covid-19 has had on businesses as these businesses are being artificially propped up by these arrangements. While providing assistance to ensure the economy does not collapse, some businesses have relied on such schemes to prevent them going into insolvency or receivership. While Covid-19 has had a drastic impact on the Australian economy, the monetary support measures implemented by the government have stabilised businesses. However, the question looming over financiers is how to treat MAE clauses once government support programmes have ceased.

Where businesses supported by government programs can maintain the principal and interest payments on their loans, it would be unlikely that a bank would enforce an MAE clause. Furthermore, where a financier views Covid-19 as only having a temporary impact on a business, they are unlikely (and ill-advised) to call an MAE. In addition, the continued fallout from the Banking Royal Commission will likely cause Australian financiers to be more hesitant on enforcing against borrowers on the arguably vague grounds of an MAE due to the potential reputational risk. On the other hand, private financiers and foreign banks in syndicated agreements potentially have less at stake when taking enforcement and other action based on their MAE clauses.

Caution is essential when considering whether to trigger these clauses as mismanaging stakeholders in the Covid-19 environment can have magnified repercussions on the parties.

What can borrowers do?

To the extent businesses can access them, the placeholder schemes implemented by the Australian Government may be cushioning how ‘material’ an adverse effect the Covid-19 pandemic is having. Borrowers should update cashflow models with a view to the market and economy following expiry of the government assistance programmes and restructure businesses to the extent necessary as, with the expiry of these schemes, financiers may have a stronger case to be able to call an MAE.

To prevent a potential MAE clause being enforced, there are a few factors which borrowers should address. The factors that borrowers should consider include, but are not limited to:

• reviewing their existing credit facilities and consider whether waivers are required;

• maintaining open communication with their bank, particularly when circumstances change as early notification allow for potentially more flexibility when sourcing solutions;

• increased attention to maintaining records and data demonstrating the financial impact of Covid-19 if those records are required;

• update cashflow models to with a view to the market and economy following expiry of the government support; and

• when entering into new facilities, seek to include Covid-19 MAE carveouts or holidays.

Conclusion

Regardless of whether these clauses have an immediate impact on borrowers, it would be prudent to understand the wording of the MAE clause within the financing arrangement. It is necessary for financiers and borrowers to find certainty within their own financing arrangements now more than ever, especially during these unprecedented times.

Note

¹ These are substantially the elements of both definitions of ‘Material Adverse Effect’ in the Asia Pacific Loan Market Association standard facility agreement, which is generally considered the market standard for investment grade lending.

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