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Can a lender ever rely on a material adverse change event of default?

01/07/2013

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United Kingdom

The inclusion of material adverse change provisions is common in financial documents, including loan agreements.

Finance brief - 1 July 2013

 

The inclusion of material adverse change provisions is common in financial documents, including loan agreements.  It is, however, unusual for them to form a key issue in legal proceedings, and a recent High Court decision has much to say on the subject that is of interest.

A loan agreement is likely to contain a number of provisions based on material adverse change, including a representation that nothing has happened that has or will have a material adverse effect on the borrower's business, financial condition or ability to perform its obligations, and an event of default if such a material adverse change or effect occurs.  The lender's obligation to make advances is likely to be conditional on these provisions (and of course other terms of the documents) being satisfied.  These are often "catch-all" provisions designed to protect the lender against unanticipated events adversely affecting the borrower.  Equally, a material adverse effect qualification may be used to protect the borrower against minor or technical breaches of representation or undertakings.

It is unsurprising that lenders are cautious about invoking such provisions, particularly to trigger a default.  Case law shows that while a demand for repayment made when there has not in fact been an event of default is simply ineffective, a failure to make advances in that situation will put the lender in breach of its obligations, and expose it to a damages claim.  Invoking a material adverse change provision may also carry a reputational risk for the lender.  While each case will turn on its facts and the terms of the documents, the recent decision in Grupo Hotelero Urvasco SA v Carey Value Added SL and another [2013] EWHC 1039 (Comm) provides some useful guidance on what is required to demonstrate material adverse change, and also on an event of default triggered by a proposed rescheduling of debts.

Grupo Hotelero Urvasco S.A ("GHU") claimed damages from Carey Value Added, S.L. ("Carey") for its failure to make advances under a loan agreement to fund the construction of what was to be a prestigious hotel on the corner of Aldwych and the Strand in central London, and for subsequently terminating the loan agreement.  In response, Carey argued that GHU or other obligors had themselves been in breach of a representation that there had been no material adverse change in their condition, and claimed that there were financial defaults and development defaults by the obligors.  It counterclaimed for the repayment of advances already made, and brought its own claim against Grupo Urvasco S.A. ("GU") as guarantor of the facility. 

A key issue was whether Carey could prove that there was a default under the loan agreement at the date it refused to make an advance, being 6 June 2008.  Doing so involved the court in a lengthy and dauntingly detailed assessment.   As Mr Justice Blair remarked, it is unusual for a case in the Commercial Court to involve so many contested breaches, and so many issues both of fact and law.  Just to add to the complications, the loan agreement between GHU and Carey was governed by Spanish law, a related share purchase agreement was under English law, and the court also had to consider the terms of a secured "senior loan" between GHU and another lender, since default under that facility would trigger the cross-default provisions of the Carey loan.  But in fact the court held that for present purposes there was no difference between Spanish and English law in the interpretation of the relevant provisions of the loan agreements.

GHU represented under the loan agreement that there had been no material adverse change in the financial condition of the relevant obligors since the date of that agreement.  The court held that the assessment of a borrower's financial condition should normally begin with its financial information at the relevant time, and would include an assessment of interim financial information and/or management accounts.  A lender seeking to demonstrate a material adverse change should show an adverse change over the period in question by reference to that information.  But the enquiry is not necessarily limited to the financial information if there is other compelling evidence to show that an adverse change is material.  An adverse change is material if it significantly affects a borrower's ability to perform its obligations and to repay the loan, and must not be merely temporary.  However, a lender cannot trigger such a clause on the basis of circumstances of which it was aware at the date of the loan agreement.  It is also up to the lender to prove the breach.

In the event Carey prevailed, but not on the material adverse change ground.  The court held that there had indeed been a material adverse change in the financial condition of GU between 21 December 2007 and 6 June 2008.  The property bubble in Spain had burst, GU's business was highly leveraged, property sales were drying up, and the future was in doubt, to the extent that GU had ceased to pay its bank debts. But Carey was relying on a cross-default triggered by breaches under the senior loan agreement, and the court was not satisfied that GU had made a representation under that agreement on 6 June that there was no material adverse change.  It was also unable to establish a material adverse change in the financial condition of GHU or the other obligor at that date.

Where Carey succeeded was in establishing that GU was in breach of other obligations under the senior loan.  In particular it had entered into negotiations for a rescheduling of debt with another creditor "by reason of actual or anticipated financial difficulties", which triggered the cross-default provisions of the Carey facility.  The result was that Carey had not been obliged to make the advance otherwise due at 6 June, and that its subsequent cancellation of the loan agreement was lawful.  Although Carey had in fact been looking to extricate itself from its commitments to GHU at the time, it had acted lawfully.

That was enough to decide the case, but as regards the "development defaults", Carey could not establish that progress on the development had been such that the long stop date for completion could not have been met, but the court was satisfied it had established a number of other defaults.  The funding shortfall was such that the project would not in fact have got to completion.  This meant that GHU's damages claim would have failed in any event.

The message remains, however, that while it may sometimes be possible to establish a material adverse change, invoking such a provision in the absence of other clear defaults is not for the faint hearted.

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