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LEVERAGED FINANCE SPECIAL(3)

Material adverse change clauses are in demand. Increasing tension between borrower and lender is the likely result, Mark Vickers points out.

The turmoil in the leveraged and acquisition finance markets is causing lenders to take a renewed interest in whether material adverse change (MAC) clauses in commitment letters and credit agreements can be invoked. Can they be relied upon to get the bank out of an existing lending commitment? From the sponsors' perspective, the flip side of course is how vulnerable is the borrower to not having access to a committed funding line because of the occurrence of a material adverse change.

Whether or not a MAC clause can be invoked will always depend on the exact wording of the clause itself and also the factual situation to which it is being applied. To that extent it is dangerous to try and make comparisons with previous examples of how MAC clauses have been successfully used. Special considerations apply to MAC clauses in the context of UK public company takeovers which are not immediately applicable to MAC clauses in UK financing documentation.

The onus will be on lenders to demonstrate that a material adverse change has occurred. The practical difficulty this presents is that almost invariably it is the borrower and not the banks which have the detailed information necessary to determine whether a material adverse change has in fact occurred.

What does “material” mean for these purposes? There are very few English cases on the point. In the context of business acquisition agreements, a reduction in net assets of 20 percent from that warranted was held to be material; and a reduction in profits of 16 percent was held to be a material adverse change in the financial position of the business.

There are also a handful of US cases – with IBP v Tyson (2001) as the leading authority. Again these relate to MAC clauses in business acquisitions and show the US courts setting a high hurdle. In Tyson, the court indicated a purchaser would need a “strong showing” and that a MAC clause was designed to protect a purchaser from “unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner”. While an English court may reflect on such examples and the views expressed in such decisions, US cases have no precedent value in the English courts.

What issues do the banks face in relying on MAC clauses? The more general the circumstances causing the material adverse change, the more difficult it will be for the lenders to rely on the MAC clause – particularly if the banking documentation has financial covenants. This is because if the credit agreement contains contractual protections for the lenders, the courts will not use the MAC clause in effect to allow the bank to re-write them. The courts

are unlikely to be impressed by an argument based on the general deterioration of lending markets, or property values, or economic outlook. They will be more persuaded by “bolt out of the blue” events or circumstances that demonstrably have a permanent and identifiable, causational impact on the borrower which are not otherwise contemplated in the finance documentation.

If the wording of the MAC (as in the LMA leveraged loan agreement) imposes a test of materially and adversely impacting on the obligors ability to perform its payment obligations, does the lender in effect have to prove that the borrower is insolvent? Not always easy.

The consequences for the underwriter of mis-calling a MAC can be catastrophic for the banks – not only in terms of damages for breach of the obligations of the finance documents but also in terms of reputational fallout. As big deals have got bigger in the leveraged finance world, over recent years the stakes have become even greater. And as the continuing credit crisis pressurises bank sentiment, we are likely to see a bruising virility test between the lenders' demands for more specific and therefore more reliable MAC clauses, and borrowers' exasperation that tighter MAC clauses undermine the commercial substratum of the very deals they are trying to consummate.

Mark Vickers is European head of banking at international law firm Ashurst.