The comprehensive finance and security documents used by banks and other lenders often make use of the concept of a “Material Adverse Effect” or “MAE”.
The precise definition of what constitutes an MAE, and the consequences if one occurs, will vary depending on the nature and terms of the particular arrangement in question. At a high level, MAE most commonly refers to a negative change in a borrowing party’s business or financial position or to a financier’s rights or security. The occurrence of an MAE can have consequences ranging from a restriction on further drawings or a review of facility terms to an immediate event of default allowing a financier to demand immediate repayment and enforce any security it holds.
Businesses impacted by the COVID-19 outbreak should consider whether any change in their circumstances may have had a Material Adverse Effect for the purposes of their financing arrangements. In this alert Special Counsel, Kim Hinton and Associate, Chris Kamp identify what the consequence may be of a Material Adverse Effect.
What is a Material Adverse Effect?
Not all finance and security documents contain a definition of “Material Adverse Effect”, and those that do define the term in a variety of different ways. In some instances, the term may be defined broadly to refer to an adverse effect on almost any matter relating to the finance documents, the parties to them and any security property. In others, the definition may be narrower, sometimes with a specific focus on changes affecting a particular material contract or project.
The below comments are therefore no substitute for a detailed review and analysis of the terms of your particular financing arrangements. Nonetheless, there are some common features present in most typical definitions of “Material Adverse Effect”.
For example, the definition will commonly include a material adverse effect on:
- the financial condition of the borrower and any guarantors and security providers (or, in some cases, their business, condition or prospects more generally, not limited to financial matters);
- the ability of those parties to perform their obligations in relation to the facility;
- the validity or enforceability of the facility documents; and
- any property subject to security in favour of the financier, or its value or marketability.
What are the consequences of a Material Adverse Effect?
As with the definition, the consequences of an MAE vary substantially from one financing arrangement to another.
The most onerous position from a borrower’s perspective (though not uncommon, particularly in comparatively high-risk lending arrangements) is that the occurrence (or potential occurrence) of an MAE will itself constitute an event of default allowing the financier to demand immediate repayment of the facility and enforce any security it holds.
In other cases, the occurrence of an MAE may give rise to a “review event” allowing the financier to change some or all of the terms of a facility (and, potentially, require early repayment if amended terms cannot be agreed).
Depending on the terms of the facility documents, a default or review event may be triggered simply because something has occurred which could have an MAE.
Even where the occurrence of an MAE is not itself a default or review event, it may give rise to an obligation to notify the financier of the occurrence of the event or circumstance which has caused the MAE. Alternatively, drawdown notices or regular compliance certificates may require the borrower and other parties to state that whether an MAE has occurred. Failure to comply with those reporting obligations, or any untrue statement, may in turn give rise to a default.
Has the COVID-19 outbreak had a “Material Adverse Effect”?
Whether recent circumstances have had a “Material Adverse Effect” for the purposes of your financing arrangements will, of course, depend on the terms of those arrangements and your particular circumstances.
It is certainly possible that changes to the financial condition, prospects and asset values of businesses heavily impacted by COVID-19 may have (or may have had) a “Material Adverse Effect” as commonly defined.
While a failure to satisfy payment obligations or to meet required financial covenants and performance metrics is usually not difficult to identify, determining whether a Material Adverse Effect has occurred is not always as straightforward and can involve matters of subjective judgement.
Circumstances such as these serve as a timely reminder of the dangers of entering into financing arrangements without a clear understanding of their terms. While many of those terms may relate to eventualities that seem unlikely at the time of signing, a borrower who has negotiated appropriate carve-outs, grace periods and general softening of onerous facility terms at the outset may be in a better position when the unexpected does happen.
Businesses concerned about the impact a change in circumstances may have on their financing arrangements should consider the terms of those arrangements carefully, and seek appropriate advice.