COVID-19: Does the Current Crisis Threaten Borrower Access to Credit Facilities?
On March 11, 2020 the World Health Organization (WHO) declared the COVID-19 outbreak to be a pandemic. At a briefing in Geneva, WHO Director-General Tedros Adhanom Ghebreyesus explained the decision: “In the past two weeks, the number of cases of COVID-19 outside China has increased 13-fold, and the number of affected countries has tripled.” Many countries have imposed measures to combat the pandemic, including travel restrictions, mandatory quarantine for newcomers, and, at the most extreme, the complete lockdown of non-essential business and social activity.
Mandatory restrictions on travel, urgent calls for “social distancing,” the implementation of mandatory “work-from-home” policies (see our Coronavirus Readiness Checklist for the Workplace), country-wide lockdowns and widespread public concern regarding the pandemic are causing extreme stress to the global economy, with an outsized impact on some industries. For any particular business, the ripple effects of this pandemic may include severe operational constraints and supply chain interruptions caused by a labor force that is ill or under quarantine, the loss of contracted revenues or the cessation of essential contracted services due to alleged force majeure or the inability of counterparties to perform due to their own financial stress and/or a precipitous drop in demand for the products and services of the business.
The COVID-19 crisis could fundamentally alter the near and medium term financial outlook for many businesses. As a result, lenders are reviewing their portfolio of loans to ascertain those borrowers who are materially negatively impacted, and borrowers are assessing their access to liquidity and existing financing commitments under their credit facilities. In connection with those assessments, lenders and borrowers alike will need to consider whether the COVID-19 pandemic and attendant economic disruption have caused a “material adverse effect” or “material adverse change” (“MAE”) under their credit facilities.
Credit facilities vary a bit in the particulars of how MAE is defined. While the typical credit facility definition of MAE is negotiated, and often vigorously so, it is typically far less elaborate than is customary in the M&A context. A typical credit facility might define “MAE” as a material adverse effect on (a) the business, assets, results of operations or financial condition of the borrower and its restricted subsidiaries, taken as a whole, (b) the ability of the borrower and its restricted subsidiaries, taken as a whole, to perform their obligations under the credit documents, or (c) the rights of or benefits available to the lenders under the credit documents.
Many committed revolving credit facilities and delayed-draw term or construction credit facilities contain a condition to drawing, whether as an express condition precedent or through a requirement to “bring-down” representations and warranties of the borrower, that no MAE has occurred since a certain past date — often the date of the last annual audited financial statements. For borrowers under these credit facilities, the purported occurrence of an MAE could result in the loss of access to essential liquidity or to necessary financing for essential capital expenditures, in either case with potentially catastrophic results for the affected borrowers. In some credit facilities, the occurrence of an MAE is itself an event of default giving lenders the ability to accelerate the loans and exercise remedies. At minimum, the assertion of an MAE by lenders will bring the borrower and the lenders to the negotiating table to discuss restructuring and/or repricing the impacted credit facilities.
However, there are good reasons for lenders to exercise caution in asserting that an MAE has occurred.
Litigation surrounding the interpretation of MAE clauses has largely taken place in the M&A context. As discussed in our note on the potential impact of COVID-19 in M&A transactions, prior to Akorn, Inc. v. Fresenius KABI AG, etc. (DE Chancery Court, October 1, 2018), no Delaware court had determined that a particular set of facts was sufficient to support the assertion of the occurrence of an MAE. While the relevant analysis is highly fact-specific, and the specific wording of the MAE definition at issue will be considered by the court, it is the generally settled principle in Delaware in the M&A context that the events underpinning the assertion that an MAE has occurred must “substantially threaten the overall earnings potential of the target in a durationally-significant manner.” (Akorn.)1 The court in Akorn noted that durational significance is more likely measured in years than in months.
In the absence of relevant case law to the contrary, lenders must assume that courts will apply similar reasoning to the interpretation of MAE clauses contained in credit facilities. While “durational significance” for a credit facility with a fixed maturity date might be argued to be shorter than that for an acquisition, and there is some case law in other contexts to support this argument, there is no clear objective standard for calculating the appropriate amount of time required to elapse to achieve “durational significance.” Current estimates by the White House of social and economic disruption resulting from the pandemic go as far out as August, 2020, but at the time of this note, no reputable authority has predicted anything far beyond that.
Historically, most lenders have been reluctant to assert the subjective MAE as a bar to funding or as an event of default. Lenders are cognizant that potentially dire consequences for borrowers who no longer have access to liquidity or whose essential capital expenditures are no longer funded increase the risk that a borrower (or in the event of a resultant bankruptcy proceeding, a trustee, or creditors with proper standing) will sue its lenders for refusing to fund or exercising remedies based solely on an asserted MAE when other objective tripwires, such as financial or other covenants, have not been triggered and debt service is otherwise current. Furthermore, given the rarity with which lenders have asserted MAE in the past, many lenders will want to give due consideration to the effects such an action will have on their reputations in the market after the inevitable conclusion of this pandemic.
Given the currently anticipated short term nature of the COVID-19 pandemic, all but the most aggressive lenders will probably continue to be cautious in making the highly subjective determinations required to assert an MAE under a credit facility.
Please visit our Coronavirus: Preparation & Response series for additional resources we hope will be helpful.
1 This principle has been consistently applied in Delaware and New York courts, see e.g. Hexion Specialty Chemicals, Inc. v. Huntsman Corp., Frontier Oil Corp. v. Holly Corp. and In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (2001).
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.