- Lenders should consider the potential of lender liability claims when addressing disruption to their borrowers’ business due to COVID-19.
- Refusing to finance a loan application or claiming a default solely on the basis of a “material adverse change” clause should be done with caution and caution, only after careful consideration of the wording in the loan agreement and, above all, the specific factual circumstances surrounding the loan agreement affect borrowers.
- Measures to reduce the risk of the lender are subject to the contractual and legal obligations of the lender to act in good faith.
The ongoing uncertainty about the business impact of COVID-19 is leading many lenders to assess the potential for adverse effects within their loan portfolio and assess what can be done to minimize the potential risk of loss. Given the speed of cancellations, suspensions, and other extraordinary efforts made on a daily basis in all aspects of daily life, it would be understandable that a lender would instinctively want to make quick and extreme decisions when managing their loan portfolio as well. Instead, more than ever, a lender should exercise caution in formulating a plan of action and be careful not to inadvertently expose themselves to lender liability for their actions.
Effects of COVID-19
COVID-19 has the potential to cause a wide variety of negative impacts across a wide range of industries. The virus could cause significant disruption to global supply chains, especially for companies that depend on goods made in China, where COVID-19 has already restricted production and shipping operations. Borrowers may also face declining demand for goods and services due to travel restrictions, event cancellations, quarantines, or the reluctance of their customers to engage in normal commercial activities. Ultimately, borrowers may face non-performance from contracting parties who are unable or unwilling to meet their obligations due to disruptions in their own business.
Determining the extent of the potential negative impact COVID-19 has on a borrower’s business requires careful analysis of management’s current financial statements, material contracts, insurance policies, and projections. In relation to borrowers with significant business disruptions, lenders must carefully develop a strategic plan that will reduce credit risk while reducing legal liability risk.
Invocation of MAC clauses to stop funding or seek legal redress
One way lenders can use to address disruptions caused by COVID-19 is to invoke the material adverse change (“MAC“) In their loan agreements. The specific definition of a MAC will vary from deal to deal, but in many loan agreements, failure to pass a MAC is a condition precedent to funding additional advances on a revolving loan, and the occurrence of a MAC is a default. As a result, a MAC -Clauses grant a lender extensive powers to refuse funding or start legal remedies.
While a MAC clause might appear to be an effective tool for a lender to protect against unforeseen circumstances like COVID-19, lenders should proceed with caution. The suspension of funding often puts a borrower in financial distress or bankruptcy, and history is rife with examples of lenders being held liable in cases where a borrower has successfully enforced a breach of contract because the lender refuses to meet its obligation to meet funding. In many jurisdictions, it is up to the lender to prove that a MAC actually occurred, and without a carefully crafted MAC definition and, more importantly, the facts on which a MAC relies, a lender may have trouble getting the hang of it Provide justification for refusing funding (or similar action). Evidence of a MAC is a very factual investigation that depends on the specific circumstances that affect the borrower and their business. At the very least, a lender should expect to have to prove that COVID-19 had a real impact on the actual and material financial position, business operations or creditworthiness of the borrower and not just abstract or prospective effects.
Previous published court rulings give little to no indication of whether an outbreak (like the SARS epidemic in 2003, the swine flu pandemic in 2009, or multiple outbreaks of MERS from 2012) constitutes a MAC. However, the current COVID-19 pandemic may prove to be greater, duration and severity than previous outbreaks. In general, the greater the disruption to a borrower’s business, financial condition, and prospects, the stronger a lender’s justification for relying on such disruption to exercise discretion in using the MAC for a particular purpose. The more significant the lender’s proposed action, the more critical it is that the disruption to a borrower’s business or financial condition is factual, objectively measurable, and correlates with an economically reasonable need to protect the lender’s identifiable credit risk.
Because of the high bar for proving a MAC and the possibility of substantial liability on the part of the lender if a court or jury determines that no MAC has in fact occurred, a lender should understand the language of the applicable loan documents and the specific factual circumstances surrounding the change very carefully before relying on a MAC to seek redress, expedite the loan, or withhold funding. Lenders should also consider reputational risk when relying on MAC regulations to warrant material decisions.
Lender discretion permitted and implied duty of good faith
Many loan agreements offer additional options to mitigate the effects of unforeseen circumstances affecting the borrower. This applies in particular to asset-based lending (“OJ“), In which lenders are usually at liberty to reduce the availability of credit or limit funding in various ways, including by declaring certain accounts or holdings ineligible, reducing the value of the credit base, or applying reserves against the credit base. ABL loan agreements often include a definition of “legal discretion” which governs the lender’s ability to make such decisions. More generally, most loan agreements require the lender to exercise “reasonable,” “commercially reasonable,” or some other similar standard. The first step a lender takes in assessing whether a particular discretionary response to COVID-19 is allowed on the loan documents (e.g. the applicable language of the loan agreement to determine if there is an applicable contractual limitation on the lender’s discretion.
However, it is important to note that even if the loan agreement specifies that the lender “alone and absolutely“Discretion in making a decision, a lender must consider its obligations outside the four corners of the document. Regardless of the terms of the loan agreement, a lender is bound by the Uniform Commercial Code (“Uniform Commercial Code”) to act in good faith (“UCC“) And in certain legal systems also according to common law. The exact contours of this fiduciary duty are shaped by the applicable state law to the loan documents, but the UCC definition of “good faith” is illuminating. UCC §1-201 (20) defines good faith as “actual honesty and compliance with appropriate commercial standards for fair dealings”. In this wording, good faith is determined both subjectively (based on whether the lender actually believed he was acting honestly) and objectively (based on whether the action taken was related to what an economically sound lender would do).
To avoid liability for breach of good faith, a lender should verify that their decisions regarding COVID-19 stand up to scrutiny by both the UCC’s subjective and objective tests. A lender should, whenever possible, notify the borrower of likely changes directly and with sufficient advance notice. Decisions should be based on objective data (such as current financial statements or a third party review of collateral) or information provided directly by the borrower, and a lender should be careful not to deviate too far from the practices of other lenders in a similar position. Particularly with a view to responding to COVID-19, it is important for a lender to have an up-to-date and accurate insight into whether a proposed action they are considering later deviates as material from their competitors’ “market” behavior during this uncertain phase Period. It is also possible that courts and juries may have a particular understanding of the impact of COVID-19 on borrowers, which further increases the importance of lenders in making measured and strong judgment in the exercise of discretion.
In summary, lenders should carefully review and monitor the effects of COVID-19 on their loan portfolio and, if necessary, take measures to protect themselves. However, we recommend that the matters discussed in this warning be carefully considered as part of any decision-making process.
Footnotes to this warning are available in the formatted PDF file accessible below.