Material Adverse Change Clauses: Are They Really Reliable?
We are thinking a lot these days about how the pandemic will affect our industry. One topic that came up is the MATERIAL ADVERSE CHANGE clause (the "MAC"). How does it apply to...this?
A few thoughts:
Before we even start in, we must ask why you are asking. Are we talking about a MAC default? Is it a MAC trigger to withdraw a loan approval? If the latter, is it an approval given to a borrower, or are you a funder who gave an approval to an originator? (BTW, it is a good time to rethink your approval/proposal/commitment letter form).
These questions may make a big difference. We also want to take into account the course of dealing between the parties - how have you and they reacted to changes in the past (not that there could be much similarity)? What industry are we talking about and how sensitive is it to this sort of change? What is the collateral and how is it, as well as the financial condition of the borrower affected?
The cases and commentators indicate that:
a. There must be a present, real change, not some vague idea that one is coming.
b. You must have documentation that the change occurred.
c. The change must be "material" - can you say under oath that you would not make the loan to the borrower if you had initially been approached with these financials and this other information? Here you might be able to include the economy and prospective decline IF there is an actual change that may be material.
d. The change must not be temporary and likely to be reversed before damage to the borrower's financial condition is impaired.
We are still looking at cases, those arising after the 2008 crash in particular, but here is a 10,000-foot view for your consideration:
1. As to calling a default, courts have been very hesitant to allow a lender to call a default only because of an adverse change in the borrower's business or financial condition, even if the loan agreement clearly makes this a separate and distinct default. If you are considering calling a default of this type, it may be a good idea to schedule an inspection, review all records, demand further assurances...do whatever you can to find actual defaults in existence. Are there unpaid liens or taxes? Is the equipment properly maintained and located where it should be?
Nothing is a slam-dunk here and we hate, hate, hate telling clients that they cannot rely on the very language to which the borrower agreed, but the world is messy and it is possible that judges will be even slower to allow a lender to shut down a business that is still making payments now that so many of them (us) are struggling.
2. Lender (lessor) liability is a real thing. We have been involved in one awful case where a lessor faxed out "You're Approved!" notices to a couple of hundred businesses, and tried to back off when a rather foolish contractor went out and committed to buy equipment based on the "approval." The jury loved the contractor and hated the lessor. Big bucks.
That said, consider whether it is better to risk a possible lawsuit or make what you really think to be a bad loan.
What is more, there is actually potential liability, or at least a risk of being subordinated in a bankruptcy, to making a loan to an insolvent borrower, or to a borrower who you have good reason to know cannot repay the loan. "Deepening Insolvency" is one of a few theories under which lending to a weak borrower because you like the collateral even though you don't expect the borrower to perform is a bad idea.
3. Are you sure there has been a MAC? Can you prove it? The cases indicate thinking it is coming is not enough. Demand certified current financials, whether or not the agreement clearly requires them. Get all the information you can.
4. Document that you are actually trying to determine the borrower's condition and willing to listen to whatever the borrower has to say. Good faith is close to reasonableness and reasonableness is what a judge (or, gasp, a jury) may be looking for. In fact, good faith is required by the UCC.
5. If you are the originator, don't wait for the funder to ask - get with your client asap and have information ready for the funder so you remain the borrower's point of contact. Manage expectations while you are at it. Remember that the cover-up is worse than the crime: don't try to assure the borrower there is no problem if one is looming.
6. Be careful what you say, especially in an email or other writing, and save what is said to you. If you are the originator, don't be too eager to assure the funder of the borrower's financial health. If you are a funder, don't lead anyone on or give wishy-washy assurances. Keep an eye on your sales staff - if they exceed their authority you may be in hot water. (And beware of fraud, we saw this in 2008).
7. If you do cancel a commitment, consider what sort of notice you will send. There may be ECOA implications and the wording could be crucial. Say as little as possible and do NOT feel it your duty to explain or listen to explanations.