As developments surrounding COVID-19 continue to unfold, it could be useful for both lenders and obligors to identify certain contractual terms and clauses that may become relevant for determining the potential impact of a pandemic. Most of these terms form part of Loan Market Association (LMA)-based documentation, but some may be found in other documents. Such terms should always be considered against the background of the specific agreements in a particular situation. The most relevant terms are the following:
Material Adverse Effect
In finance transactions, the equivalent of a material adverse change (MAC) is a material adverse effect (MAE). LMA template documents contain very broadly formulated language, which allows the lender to accelerate the loan and to enforce security rights if "any event or circumstance occurs which the Majority Lenders reasonably believe has or is reasonably likely to have a Material Adverse Effect." An MAE is defined inter alia as "a material adverse effect on the business, operations, property, condition (financial or otherwise) or prospects of the Group taken as a whole".
This template language is optional, so specific wording should be analysed on a case-by-case basis to consider whether the COVID-19 outbreak could meet the definition of an MAE. There is little guidance and precedent as to the precise meaning of this term. It is possible, for instance, that it makes a difference that COVID-19 is now formally declared a pandemic.
As we have seen in previous macroeconomic downturns, such as the 2007-2008 credit crunch and more recently Brexit, lenders traditionally look for easily demonstrable facts, such as non-payment or the breach of a financial covenant, before seeking acceleration or enforcement.
Furthermore, a court could find that invoking an MAE event of default triggered by the COVID-19 outbreak would, in the particular circumstances, be blatantly unreasonable and unfair. This would mean that the court would not allow the lender to exercise its contractual rights on this basis.
Even if a lender is reluctant to seek acceleration or enforcement solely due to an MAE, the event could nonetheless result in the lender refusing to fund new (non-rollover) utilisations under a revolving working capital facility. This could have a significant effect on the company's liquidity, as its working capital needs are liable to increase due to the adverse impact of COVID-19 on its business and supply chain.
Loan agreements are designed to ensure that the lender is aware of any financial distress as early as possible. For this purpose, financial covenants such as a cash flow cover ratio, an interest cover ratio and a leverage ratio, are included in the agreement and tested at set dates throughout the year. The adverse effects of COVID-19 on a business could result in the breach of one or more of these financial covenants which in turn could lead to the lender taking steps to accelerate the loan and enforce its security rights. It should be checked whether the loan agreement requires the borrower proactively to inform the lender of any such developments.
In addition, lenders could consider increasing fees due under the loan documentation owing to the impact of the COVID-19 outbreak on the company's risk profile. If no fees have been agreed for a certain period of time, the Dutch bank's general terms and conditions (Algemene Bankvoorwaarden) grant Dutch banks the right to increase fees if a company's risk profile (adversely) changes.
Cross-default provisions can be found in many financing agreements. The reason for including a cross-default provision in a loan agreement is that if an agreement with another creditor is breached, it is likely that the loan agreement will be affected as well. In other words, an MAE under a given loan agreement could lead to default under other loan agreements.
Whether the COVID-19 situation constitutes an MAE default, remains to be seen. Furthermore, banks and other lenders face difficult policy decisions regarding how to deal with the impact of COVID-19 on the financial health of their borrowers. In any case, we recommend that borrowers and lenders engage early in order to discuss the situation and any temporary waivers.
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