Material Adverse Change Clause: What a Lender Can Prove

Covenants are tested on dates and on historical numbers. A twelve-month earnings figure can take a long time to show bad news, because each new quarter replaces only one old one. In that interval the borrower may have lost a licence, a customer or a plant, and every test it has been set still passes. The clause exists for that interval. It lets the lender respond to substance before the arithmetic has caught up.

It usually appears in one or both of two places. As an event of default, it may allow the lender to accelerate. As a representation repeated on each drawing, that no material adverse change has occurred since the last accounts, it may allow the lender to decline a further advance. The second is the milder form.

Two drafting choices settle most of the argument. The first is the subject: the borrower's financial condition alone is narrow, while business, assets, operations or prospects reach much further, and some clauses instead ask whether the borrower can perform its payment obligations. The second is who decides. Some clauses make the test an objective fact and others turn on the lender's opinion, a form that favours lenders but does not remove all scrutiny.

The leading English decision is [2013] EWHC 1039 (Comm). On a clause about financial condition it held that the assessment normally starts with the company's financial information, though other compelling evidence can count. A change counts as material only where it makes a real difference to whether the borrower can meet its obligations, repayment above all, and it must not be merely temporary. A lender cannot rely on circumstances it knew about at signing, unless they worsen so much that they become different in kind. The lender bears the burden of proof. That decision binds no court in New Zealand or Australia, although courts there may find it persuasive.

Australia adds a limit of its own. Under the Banking Code of Practice, a subscribing bank will not include an event of default based on unspecified material adverse changes in a standard-form loan to a customer within the Code's small-business test. Larger and individually negotiated loans remain a matter for their own drafting.

A contract blender of car-care products, constructed for this page like every figure in it, has a US$9m term loan and US$3m drawn on a US$5m revolving line. Its covenant is net debt to twelve-month EBITDA of no more than 3.50 times, tested half-yearly. Net debt is held flat for simplicity. In April its largest customer, 32% of volume, gives notice that it will move to its own plant in December. The forecast:

The covenant will not fail for some twenty months. In May the blender asks to draw a further US$2m for a new blending line. Each drawing repeats a representation that no material adverse change has occurred. The 3.50 times belongs to the example and is not a market norm.

What can the lender show? The accounts do not yet show any change. If the clause speaks only of financial condition, the English approach makes this difficult: the evidence is a forecast, and the borrower's finances today are as they were. In the English case, the court refused to treat future funding needs that were not yet liabilities as part of the financial condition at the date in question. If the clause also covers business or prospects, the case is much stronger. A customer of that size leaving for good is neither temporary nor trivial.

The lender does not declare anything. It writes to reserve its rights, says the drawing cannot proceed while the effect is assessed, and asks for a revised forecast and a plan to replace the volume. Three weeks later the two sides agree monthly reporting, and the blending line is scaled back and funded partly by the owners. The lender has what it needed: a borrower at the table twenty months early.

A financial covenant is a precise test on a known date: it passes or fails, and a compliance certificate settles it. A material adverse change clause is general and has to be argued. A review event is the same concern, reduced to a specific listed fact, with a negotiation built in.

The label also travels. Material adverse effect is often a defined term used to qualify other clauses, such as a breach of law that counts only if it has that effect, whereas a material adverse change is itself the event. And where funds must be certain, as in certain funds lending, the lender normally gives the clause up for the acquisition drawing.

DEFINED IN ONE PARAGRAPH → · REVIEW EVENT → · LTM EBITDA →

The risk of using the clause falls on the lender. A lender that refuses a drawing or accelerates without being entitled to may be liable for substantial damages, and an acceleration can set off cross-defaults and insolvency that would be hard to undo. So lenders generally invoke it beside something firmer, such as a missed payment or a late certificate, and many will want legal advice first.

Its practical value lies in the letter that mentions it. A borrower knows the clause is there, so a request for information gets an answer. For borrowers, negotiation tends to focus on removing prospects, tying the test to ability to pay, excluding general market and industry conditions, and making the test objective. Those are the words to read in the facility letter.

READING YOUR FACILITY LETTER → · LOAN COVENANTS, EXPLAINED →