Material adverse change in light of falling oil prices

June Ho and Joe McGladdery from Wikborg Rein discuss a clause we may hear a lot more about as oil prices remain depressed.

The topic taking centre stage is undoubtedly the recent sharp decline in oil prices. It is undisputed that a prolonged decline will most certainly adversely affect businesses and cause widespread financial distress cutting across all industries and economies. Anecdotes about contractual and loan defaults are consequently inevitable in such climate. Generally, if an event of default materialises, the lender will have the right to accelerate the repayment of the loan and in a depressed economy, lenders may look to acceleration to get their monies repaid soonest possible. While some events of default in financing arrangements are clear (such as outright non-payment, breach of financial covenants and insolvency of the borrower), one area is still riddled with ambiguity – what constitutes a “Material Adverse Change” and does it allow the lender to accelerate?

MAC definitions and related provisions are usually extensively negotiated, and there are some important points to consider. An MAC clause is typically defined as “a material adverse change in the business, results of operations, assets, liabilities or financial condition of the borrower”. At first glance, the typical MAC clause may seem like a convenient avenue a lender to accelerate payment in a depressed market. In practice however, it is actually difficult to prove that even a sharp decline in oil prices constitutes a MAC, unless the particular MAC clause is drafted in more detail.

Under English law, where there is doubt about the meaning of the contract, the words will be construed against the person who put them forward. Therefore, a MAC clause is only as good as its drafting. For a lender to rely on the MAC clause to accelerate payment, it would have to ensure that the clause is drafted accurately. This article aims to provide a quick overview of the ambiguities of a typical MAC clause and some suggested changes for consideration.

Actual change vs expectation of change. If the event of default is defined absolutely as “no MAC has occurred”, then an actual change will be needed before the clause can be invoked. By this time, it may be too late for the lender. Therefore, if the lender is minded to take action sooner, the event of default should instead be defined with respect to an expectation of change, for example “there has not occurred any MAC or any event or circumstances that would reasonably be expected to result in a MAC”. If your current MAC clause does not include such expectation of change, then it is likely that it will take some time before the dip in oil prices becomes capable of being established from the annual/interim financial statements or management accounts of the borrower – until such time, it is arguably pre-mature to accelerate payment (unless the prevailing circumstances provide sufficient grounds under which to invoke the MAC clause).

By whose standard do you determine the “material adverse change”? Borrowers may look for an objective test of whether or not an event has a material adverse effect, while lenders will want the test to be subjective. If acting for the lender, it would be prudent to include wordings such as “a MAC as determined in the lender’s opinion”. The borrower then will most certainly try to narrow this down by including a reasonableness qualifier (because the narrower the definition of obligations, the more favourable it is to the borrower. Conversely, lenders will want the provision to be as broad as possible and cover all obligations, whether material or not) and so the clause will likely end up to read “a MAC as determined from the perspective of a reasonable person in the lender’s position”. In addition, the lenders will want to apply the material adverse effect test to any member of the borrower’s group and any other parties with obligations under the loan documentation. The borrower will wish to narrow the scope of application to the ‘borrower’ or the ‘borrower’s group taken as a whole’, allowing the group to benefit from the resources available to it from other members of the group.

Is the field of change (eg business, results of operations, assets, liabilities or financial condition) exhaustive? While there is a need to be specific in listing the field of change (in case the court holds that a certain event is not contemplated if the field of change is too vague), it is also risky to be overly exhaustive as the court may then hold that a certain event is not contemplated since it is not included in the exhaustive list. This can be dealt with by including the usual “including without limitation” language when describing the field of change. Also, it would be prudent if the borrower is part of a group of companies for the lender to also include MAC of not just the borrower but also its subsidiaries in order to widen the net (especially if the assets of the borrower are held by special purpose subsidiaries).

Did parties intend for a party to be able to walk away from the deal due to a MAC caused by one or more specific industry wide development? Courts are usually not inclined to include industry wide or general factors as constituting a MAC. Therefore, in the context of falling oil prices affecting the industry as a whole, the lender will need to expressly incorporate this concept into the MAC clause which is difficult primarily because in order for the change to be material, it must not merely be temporary – and at this moment, no one is certain how long the decline in oil prices will continue and it is unlikely that a court will take into account this industry development at the moment to say that the borrower will be unlikely to fund its prospective liabilities/obligations. If the current decline continues for a longer period that it is arguable (especially for the offshore industry) that the depressed market is materially affecting the business of the borrower and hence triggering a MAC. In addition to the duration of such change, change is only material if it can be proven that it would significantly affect the ability of borrowers to perform their obligations, or of lenders to exercise their rights under the transaction documents. The wider the scope of the obligations, and the more essential their nature, the easier it should be to determine their materiality.

Challenging a MAC default. One of the strongest arguments which the borrower can use to challenge a MAC default, however widely drafted, is to show evidence that the borrower remains able to comply with its other obligations under the agreement, particularly the financial covenants. Moreover, if the borrower has strong profit and loss, balance sheet and cash flow statements, it may be difficult for lenders to establish that the effect or change in question is material and adverse. But one should also note the 2013 English High Court case Grupo Hotelero Urvasco v Carey Value Added drew a distinction between a MAC clause referring only to the ‘financial condition’ of a company as compared to one that referred to the company’s ‘business or financial condition’ – as the term ‘business’ (being the company’s operations, performance etc.) covered a broader scope than merely its financial condition. Therefore, depending on how the MAC provisions are drafted, a financier may still be able to invoke a MAC default even if a borrower can prove its strong financial capability.

Tool of last resort. It is likely that using MAC to accelerate payment will be a tool of last resort as it is far easier to argue breach of financial covenants than a generally worded MAC (since loan agreements for the offshore industry will have more definite financial covenants in relation to ratio of loan and value of assets). At all times, due care and attention must be exercised when relying on the MAC clause to invoke a default. The cost to lenders of getting the decision wrong could be expensive in both monetary and reputational terms.

As seen from above, it is not easy to use MAC due to the oil price decline as a ground for acceleration. Perhaps an alternative (and arguably a better approach) to think about when drafting new facilities is to specifically incorporate this concept of a continual oil price decline into the contract as a separate provision for acceleration rather than trying to expand the definition of MAC.

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