06 Feb 2014
Another look at material adverse effect clauses: the Grupo Hotelero case
by Maria Ratner
Material adverse effect clauses are prevalent in Australian loan documentation. However, lenders should be mindful that, given some recent UK authorities, such clauses are likely to be interpreted narrowly and not every material adverse effect clause, however drafted, will suffice to protect their interests.
Most loan agreements in Australia will have multiple clauses referring to the occurrence of a "material adverse effect" or "material adverse change" (the MAE clauses), with most lenders viewing them as an essential and powerful protection of their interests from any unexpected deterioration in the borrower's condition.
However, there is very limited Australian legal authority on how "material adverse effect" clauses are to be applied in the lending context.
A recent decision by the English High Court in Grupo Hotelero Urvasco S.A. v Carey Value Added S.L.  EWHC 1039 sheds some new light on how the courts may interpret an MAE clause if a lender tried to rely on it to require repayment of the loan.
How is a material adverse effect clause intended to work?
Usually, a loan agreement would include at least an event of default triggered by the occurrence of any event or circumstance which has a "material adverse effect". Further, many representations, warranties and covenants in loan documents are qualified to only constitute a breach of the document if the relevant event "has, or is reasonably likely to have, a material adverse effect".
Interpreting a material adverse effect clause
While the MAE clause in Grupo Hotelero was a very simple version of the provision, the Court outlined the following key principles which may assist in the interpretation of MAE clauses:
Materiality: The Court stated that, in order to be material, the event or change needs to significantly affect the borrower's ability to perform its obligations under the loan documents, in particular its ability to repay the loan. The Court emphasised the word "significant", stating that any other interpretation may allow the lender to call a default or suspend lending when the borrower's financial condition does not fully justify it, propelling the borrower into insolvency.
The Court supported the view of a number of commentators that a material adverse change is a change that would have caused the bank not to lend at all or to lend on significantly more onerous terms.
Financial condition: Where an MAE clause refers only to the financial condition of the borrower, as was the case in the Grupo Hotelero, the Court concluded that financial condition would involve assessment of the financial statements of the borrower as at the relevant date and would not include other matters such as the prospects of the company or external economic or market changes. A lender seeking to demonstrate a material adverse change will therefore need to show such change based primarily on the financial statements of the borrower, although the Court agreed that other information may provide compelling evidence to show a material adverse change, even if such change is not evident in the financial statements.
Pre-existing circumstances: The Court further indicated that if the lender was aware of an event or the state of affairs at the time of entry into the loan documents, such event cannot constitute a material adverse change. Similarly, an event that is likely occur at the time the loan was entered into cannot be relied on for the purposes of an MAE clause.
The Court mentioned that any lender that conducted a significant amount of due diligence on the borrower before signing the loan documents may not be able to rely on an MAE clause in respect of any matter that it could have discovered in such due diligence at the time, but didn't.
Duration of adverse circumstances: As a final point, the Court in Grupo Hotelero mentioned that any adverse change to the borrower's condition needs to be "not merely temporary". When it is clear that the effect of an event on the borrower is short-term, the lender will not be able to rely on an MAE clause, presumably as a short-term change is unlikely to cause a significant impact on the borrower's ability to repay the lender.
Key takeaways for lenders
While an MAE clause remains an essential protection for lenders, a lender should not be complacent in negotiating such clauses in loan documentation. Some key points for lenders to take away from the Grupo Hotelero decision are:
MAE clauses are interpreted narrowly, so the wording of the clause should cast the net as wide as possible. Ideally, you should refer expressly to the borrower’s financial condition, its business, operations and prospects, and, if relevant, the prevailing economic and market conditions.
Lenders should be mindful of allowing specific provisions in the document (such as representations, warranties and undertakings) to be qualified by "material adverse effect" as a proxy for materiality since such a qualification may make the provision difficult to rely on. A better approach would be to introduce a specific materiality requirement, such as a numerical threshold.
If a lender introduces an element of subjectivity into an MAE clause (by adding words along the lines of "in the opinion of the lender, acting reasonably"), the court's focus will switch to whether the lender has formed its opinion acting reasonably, which will assist in enforcing the provision.