In the wake of financial pressures that businesses across the country are facing, many have tapped unused lines of credit to provide extra liquidity. Yet, for certain companies the current pandemic may raise a question as to whether or not they, as borrowers, can permissibly draw down on available lines of credit. Putting aside for a moment the financial performance covenants and other metrics borrowers must regularly achieve under their loan agreements, the current situation also raises the question of whether COVID-19 has put certain businesses into automatic default under their existing loan agreements. Businesses should be cognizant of these provisions as they make business decisions that could impact their rights and obligations under their loan documents.
What Is an MAE?
Many financing agreements have material adverse effect (MAE) provisions that come into play in two situations. First, the borrower is frequently required to make a representation that, as of the date of each draw under a loan, the borrower has not experienced an MAE. If the borrower has experienced an MAE, the draw is not permitted. Second, some loan agreements also provide that if a borrower experiences an MAE at any time, then an event of default has occurred. Whether the COVID-19 pandemic has caused an MAE to a business depends on how MAE is defined.
For example, the following is one common definition of MAE:
“Material Adverse Effect” means, with respect to any event, act, condition or occurrence of whatever nature that has, or is reasonably expected to have, a material adverse effect on (i) the business, results of operations, financial condition, assets or liabilities of the borrower, (ii) the ability of the borrower to perform any of its obligations under the loan documents, or (iii) the rights and remedies of lender under the loan documents.
Arguably, a business that must close for one or two weeks as a result of COVID-19 may not experience an MAE under this definition, but what if the shutdown continues for three months At what point does the business experience an MAE or have a reasonable expectation that the COVID-19 pandemic will have an MAE on its business or ability to pay? The answer may impact whether a business is permitted to draw on its line of credit or is otherwise in default under its loan agreement.
Another variation of an MAE definition sometimes included in loan agreements looks similar to the definition above but also incorporates carveouts (i.e., exceptions) in the definition. For example, the definition may include language stating that an MAE will not include any change arising out of:
- general economic or political conditions;
- conditions generally affecting the industries in which the borrower operates;
- changes in financial, banking or securities markets in general;
- acts of war;
- changes in applicable laws; or
- natural or man-made disaster or acts of God.
If this type of carveout language is included in the loan agreement, a borrower may have a good argument that the COVID-19 pandemic has not caused an MAE because of COVID-19’s general economic impact, or impact on conditions that generally affect the industry in which the borrower operates.
Impact on Acquisition Agreements
Financing agreements are not the only place where MAE provisions potentially impact a capital transaction. MAE provisions are often present in agreements related to mergers and acquisitions (M&A) of companies. MAE provisions are present in M&A agreements in two instances – 1) in the seller’s representations, where the seller will represent that, since a specific date, there has been no MAE to its business and/or that an MAE is not reasonably likely to occur; and 2) in the closing conditions, where a buyer can refuse to close the deal if there has been an MAE within certain timeframes prescribed in the agreement.
The definitions often seen in M&A agreements are similar to those outlined above with respect to loan agreements. Most pressing would be the interpretation of the MAE provision for anyone who is currently under contract to acquire a business but has not yet closed. If that is the case, a buyer may try to terminate the purchase agreement and refuse to close, by asserting that the COVID-19 pandemic has caused an MAE.
Is COVID-19 an MAE?
The question as to whether or not COVID-19 is an MAE is not easy to answer. Much of the difficulty stems from the fact that MAE definitions don’t define what “material” means. Although material will depend on the specific facts and circumstances, arguments about whether an MAE has occurred tend to focus on whether the adverse event has been material enough. In the M&A context, case law from Delaware, New York and other states generally suggests that where “material” has not been further defined, an MAE must be a very significant event that is not limited to a matter of weeks. As a result, courts in Delaware and New York (whose laws typically serve as the governing law for many larger credit facilities) have rarely found an MAE to exist. Not all states may follow Delaware and New York, however. Because some definitions of MAE also include events that are “reasonably expected” to have an MAE, a borrower may have an MAE based on anticipation of what events will transpire over the coming months.
Anecdotally, we have not yet seen much discussion from lenders about invoking an MAE event of default or otherwise blocking access to credit lines. At the present time, most lenders seem concerned with how a borrower’s cash flow will look in the near-term, as well as the borrower’s ability to meet its financial performance covenants under the loan agreement.
Not all loan agreements have financial performance covenants, however, and not all borrowers are immediately impacted by the various state and local shutdowns. It is possible that as the pandemic continues, lenders may look to the MAE definition to begin to exercise remedies under loan agreements or to refuse to fund a credit request. If you believe that your business will be particularly adversely affected by the COVID-19 pandemic, it may be time to discuss loan modifications to provide extra liquidity or relief in the near term. These modifications are supported by the interagency statement released on March 22, 2020 from the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Consumer Financial Protection Bureau, and the State Banking Regulators. The interagency statement encourages lenders to work with borrowers who may be unable to meet their contractual payment obligations because of the effects of COVID-19, and the agencies will avoid categorizing any loan modifications meeting certain guidelines (such as a six-month or less payment deferral) as a “troubled debt restructuring.”
Our Mergers and Acquisitions and Financing Practice Group is available to assist businesses in reviewing financing agreements to determine what options may be available for modifications or otherwise.
The Hirschler Recovery Team: It may soon be a rare business enterprise that is able to insulate itself from the negative economic effects of the COVID-19 pandemic. While we hope the economy will rebound once the pandemic begins to abate, until then, the Hirschler Restructuring and Creditors Rights Group stands ready to assist clients in addressing the financial challenges of these economically unsettled times. Whether you are facing the loss or interruption of business, challenging financing relationships, the need to downsize or restructure, or other creditors’ rights issues, the Hirschler team will work with you toward a successful outcome. Contact us to understand your options and devise a recovery strategy that protects your business and financial health.
Luis F. Ruiz