Update | Insolvency: Material Adverse Change

Many loan agreements provide a lender with the opportunity to call in the loan and enforce security where there has been a material adverse change (MAC) in the position of the borrower. Often the MAC only has to have occurred in the opinion of the lender.

This means that a borrower may have breached the terms of a loan without realising it and could be served with a demand for payment, no doubt followed by the appointment of an administrator with no inkling that this would occur.

For some lenders this clause is a means of putting pressure on a borrower, where default is suspected or anticipated, to provide information and generally cooperate with the lender by providing information. However, the clause can be used in a more draconian fashion and bring a borrower's business to its knees.

So what is an "MAC"? Until recently there has been no guidance as to what that might mean. This can be as big a problem for a lender as for a borrower since the enforcement of security against a company when it is not enforceable is likely to lead to a large claim for the loss to the business and a potentially invalid appointment ?of administrators.

Welcome guidance

The case of Grupo Hotelero Urvasco SA v Carey Value Add SL and another [2013] EXHC 1039 (Comm) is therefore welcome guidance as to how the courts may view such a clause.

Carey had agreed to loan funds to a group of companies, Grupo Hotelero Urvasco (GHU) for the development of ?land at a prime location in London but, less than a year after the loan agreement was entered into, withdrew funding and claimed back €55.4m. One of the grounds relied upon was that GHU had breached a representation that there had been no MAC in GHU's finances. GHU argued that the withdrawal of funds was a breach of the loan agreement and counterclaimed losses of £71.38m allegedly caused by the withdrawal of funding and the consequent failure of the project.

At the time that Carey came on board with GHU, in 2007, the group and the development was already suffering serious issues. GHU was one of the main real estate developers in Spain and the Spanish property market had collapsed. It was highly geared with lending obtained through syndicated loans and from BBVA. It was dependant upon such finance, which was readily available before the property market crash but not afterwards. It was also tied into derivative contracts at the behest of lenders and the decline of sterling caused heavy losses on those contracts. In 2007 more finance was needed by GHU but BBVA would only consider lending if the group itself invested more funds into the project, which it was not prepared to do.

Carey agreed to lend funds and entered into a financing arrangement with GHU. This involved the transfer of shares to Carey to enable it to acquire the development at an agreed price which would be set off against the loan debt and a lease to GHU with an option for GHU to re-acquire ownership of the development. The Loan Agreement was entered into on 21 December 2007, though funds weren't advanced immediately.

In March 2008 contractors started to suspend services due to non payment. GHU claimed, at trial, that this had not stopped progression of the development since, while structural work could not progress, work was being carried out in other areas. In any event, funds were obtained through further alternative lending and contactors were paid. Carey's agents reported to them in March confirming that the project was "on programme".

At this point Carey advanced its first tranche of funds, not all of which was used in the development. In April another application for payment was made and further funds were advanced.

The timetable for works then started to slip. Carey were not informed of this. Their agent became aware of the issue in May 2008 by which time it appeared that the slippage would be at least three months. It also became apparent that the works would cost £10m more than had been budgeted.

GHU was, by now, receiving bad press regarding its financial situation. A third application for payment was made to ?Carey in June 2008 for works. Carey withheld payment without notice to GHU of its intention.

On 9 June 2008 Carey wrote to GHU, explaining the withdrawal of funding, relying upon an MAC based upon a comparison of GHU's accounts as at 31 December 2006 and 31 December 2007 and doubt as to the ability of GHU to fund the development even if funds were advanced.

GHU paid interest due on the loan ?until September when construction ?works stopped. Carey then cancelled ?the agreement.

GHU submitted that the change in the financial condition of the company was as shown in its accounts and would not encompass matters such as the company's prospects or the effect of external economic or market conditions. In this case, the accounts to December 2007 were not relevant as these only showed the position as at the date of the loan. GHU argued that the change had to be material in the context of the ability of the borrower to meet its obligations under the loan agreement. It also argued that there would not be an MAC if the circumstances were in existence and known to the lender at the date of the loan agreement or if the lender knew that the circumstances were likely to occur.

Carey's case was that the term "financial condition" was of unlimited and general application. It argued that the enquiry into the borrower's financial condition was not limited to its ability to meet its obligations under the loan agreement. While the position at December 2007 was not determinative of the position at the date of withdrawal of funds, it maintained that the position had deteriorated by then. As to the issue of pre-existing circumstances or those that are likely to occur and are known to the lender, Carey argued that the mind of the lender was not relevant to the question of whether there had been an MAC.The court had little case authority to rely upon in deciding whether there had been an MAC.

'Financial condition'

In BNP Paribas SA v Yukos Oil Company [2005] EWCH 1321(Ch) the court held that certain events had a material adverse effect on the ability of the borrower to repay a loan and therefore there was an MAC. The facts of this case were, however, extreme and will not be of general application, as the borrower had suffered a tax liability of $3.3bn and most of its assets were frozen. The borrower argued that there were sufficient unfrozen assets to allow it to continue to repay the loan and therefore there was no MAC. Arguments were raised as to the meaning of MAC but were based upon the drafting in the agreement so were particular to the facts of the case. In any event, the court considered that it was unlikely that the borrower would be able to demonstrate that it was unreasonable for the lender to conclude that there had been an MAC, in circumstances where the borrower was subject to a freezing order whether or not the loan could be funded from other sources. The court's judgment was based on two events of default and the court concluded that, if it was wrong in respect of the MAC issue then the lender could succeed on the other event of default.

The court looked to the US for case authority but there were no US appellate decisions to rely on. Decisions in lower courts were not consistent. The Delaware Court considered MAC clauses to subject to the particular facts of the case and had never found that such a change had occurred. However, in the case of IBP Inc v Tyson Foods Inc 789 A2d (Del Ch 2001) Delaware concluded that such a clause was merely a backstop protecting a party from the occurrence of unknown events. The court in the GHU case noted that this view was supported by academic authority.

In its judgment, the court considered that the issue would turn on the construction of the terms of the clause.

By way of general application, the court agreed that the term "financial condition" would suggest an emphasis on the position as shown in company accounts. Further support was found for this argument since the relevant clause referred to the position "consolidated if applicable", which the court considered referred to consolidated accounts. It appears that the court would have found this to be the case even without that reference. However, the court also considered that enquiry would not have to be limited to the accounts, as there may be compelling evidence of an MAC that is not shown in them.

The court considered that the change would be material if it affected the ability of the borrower to repay the loan.

Finally, the court found that the clause cannot be triggered due to circumstances that the lender was aware of at the time of the agreement. The parties had agreed that any change must not be temporary.

There was an issue as to the date at which the breach of the MAC clause had occurred. It had to have occurred before the date that Carey had relied upon the breach. The court determined that it had not occurred as at that date but did find that there were breaches of other terms of the loan agreement upon which Carey could rely.

In conclusion, lenders should use ?caution before exercising enforcement rights on the basis of a MAC alone. The onus is upon the lender to prove the breach and ?so it should be certain of being able to do so before causing losses to a lender's business by its actions. Lenders should also ensure that the wording of such a clause reflects precisely what is meant by an MAC in ?order to avoid the court having to interpret its meaning.