The impact of COVID-19 on MAC clauses and lending transactions: A lender’s perspective

To mitigate the financial fall-out of the COVID-19 pandemic, many lenders are reviewing their existing loan portfolios, assessing their obligations to continue funding under loan commitments, and taking affirmative steps to protect their portfolios. A lender’s first thought may be to invoke the Material Adverse Change (“MAC”) clause. This blog offers a bird’s-eye view on the impacts of COVID-19 on MAC Clauses, and other key issues for lenders to consider at this time.

1. What are the prevailing legal standards for a MAC Clause in lending transactions?

The courts have predominantly dealt with MAC clauses in the M&A context, and even then, there is no definite threshold. In the trend-setting jurisdictions, a MAC is deemed to have occurred if there is a prolonged material decline in the operations of the party the MAC clause is invoked against. The cases are fact-specific and include a review of the entire agreement (including the text of the clause and lesser covenants and remedies available to the parties). Based on the case law, the duration and severity of the decline in operations are key factors in assessing whether a MAC was rightly invoked.

The absence of a MAC is typically a condition to funding initial advances and/or continued revolving or term advances, in which case the factors discussed above apply. A MAC is sometimes also listed as a default, entitling the lender to cancel its commitment and accelerate the loan or pursue other remedies. Where so, it is usually at the lender’s discretion, the exercise of which sometimes expressly requires reasonableness. Even where the discretion is “absolute,” the courts may be involved to determine whether the lender’s actions meet the UCC’s standards of good faith and fairness.

2. Does the COVID-19 Outbreak constitute a MAC that could trigger a MAC termination right?

At this time, probably not. But this may change depending on how long the crisis lasts, and the extent to which it affects particular companies and industries. The longer the outbreak persists, the more likely that its effects on borrowers’ financial health will meet the standard of materiality that permits a lender to invoke a MAC. Again, this will be largely influenced by the text of the MAC clause in question and the totality of the relevant facts.

Where invoking a MAC, a lender should be prepared to prove it because the courts place a heavy burden on the invoking party. In practical terms, a lender should consider having certified current and historical financials, information about the borrower’s vendors and sources, short and medium term operating and capital plans, defaults on other obligations, and as appropriate, work force stability, etc.

3. A borrower’s financial health is often tested at fiscal quarter-end dates and its (in)ability to meet obligations may only become clear many months after the crisis is over. Could a lender refuse to fund for breach of obligations (other than MAC)?

Probably, yes. Most businesses are losing revenue because of this pandemic. Although a borrower may meet its debt service obligations in the near future, the revenue loss caused by COVID-19 may take its toll as late as 2021. Where a debt service obligation is breached, loan documents entitle a lender to cancel its commitment and accelerate the loan, or pursue other remedies. Courts will be more likely to approve of a lender’s remedial action where the borrower has clearly breached an obligation or covenant.

That said, a lender should consider that where it is already exposed, ceasing to fund may lead the borrower to liquidation and leave the lender in an even worse position. It may also negatively affect a lender’s reputation, cause a liability for damages (where a court is not convinced), or at least, cause the lender to be subordinated in a bankruptcy. It may therefore be prudent for a lender to leave communication lines open and consider “working” with the borrower. This could involve a modification, forbearance or restructuring.

4. What other aspects of loan documents should a lender pay close attention to in this climate?

Broadly speaking, a lender’s decisions in this time of crisis will be influenced by financial covenants, events of default, and representations and warranties.

Financial covenants

A material drop in a borrower’s earnings will have an adverse impact on its cash flow and may drive it to be more reliant on revolving facilities for future liquidity needs. Lenders should scrutinize financial covenant-related definitions such as “consolidated net income” and “consolidate EBITDA” to determine if add-backs (such as for cost savings, holding remote training sessions, the cost of upgrading IT infrastructure, synergies or other permitted initiatives) could be utilized to limit the amount of covenant impact resulting from decreased net income or EBITDA. Lenders also need to review the equity cure provisions as borrowers may attempt to pre-emptively inject equity to ensure covenant compliance, and designate the same proceeds as cure amounts to equity cure a covenant breach.

Events of default

In the wake of the COVID-19 pandemic, lenders should consider customary defaults as indicators of a borrower’s health. In addition to MACs, other indicative EODs include payment defaults and cross-defaults, etc. Lenders should note the relevant terms and thresholds across their loan documents and their borrower’s other debt instruments. Some loan documents contain business specific cross-defaults relating to defaults or suspension in respect of performance under material third party contracts.

Representations & warranties

Lenders will be well advised to review the truth and timing of the borrower’s representations and warranties on an ongoing basis. Key representations in a time of financial crisis include those relating to “no litigation,” and “no default” which typically pertains to defaults under other material agreements. There may also deal-specific representations that need to be reviewed.

Timing of borrower’s representations will also be relevant in determining whether the borrower is in compliance at the relevant time. These include timing for the delivery of certificates, making of borrowing requests, etc. Lenders should make a note of which representations are continuing and which are only relevant at the time the representation is made.

Please look out for the second series of this blog post which focuses on a borrower’s perspective.

Vicky Gilbert is an attorney in Thompson Coburn’s Banking & Commercial Finance group. For more information on Thompson Coburn’s Banking & Commercial Finance group, please contact Ruthanne Hammet, Vicky Gilbert or Vic Des Laurier.

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