As lender’s counsel in commercial loan transactions, we care about the material adverse change clause (aka the “MAC” clause) in the loan documents because we want to preserve flexibility for the lender if the unexpected occurs.
It is important to a lender that a material adverse change be an event of default. While a lender, absent some other event of default, will not ordinarily accelerate a loan solely on the basis of the MAC clause, such a default can provide a lender with other helpful remedies upon the occurrence of unforeseen reversals not covered by events of default typically included in loan documents. Such remedies include restricting advances under revolving or non-revolving lines of credit and the ability to impose the default rate of interest (if, for example, the lender determines that the loan has become riskier).
Borrower’s counsel will often try to remove the MAC clause as an event of default under the loan arguing that it is unfair to the borrower, that it gives the lender too much discretion or that a lender is sufficiently protected by other financial covenants governing the loan. While these arguments have some merit, the absence of a MAC as an event of default still operates to restrict the flexibility of a lender to address issues which may come up unexpectedly.
We have seen the following examples of the occurrence of such unexpected circumstances where the lender relied entirely on the MAC clause to protect itself:
(a) a borrower in the medical/pharmaceutical field had a negligent and disastrous situation arise due to tainted products, which included the likelihood of criminal charges and massive civil liability. At the time of these developments, the company was still operating within its financial covenants and was still making all required loan payments. But for the MAC clause, the lender would have been prevented from taking immediate defensive steps such as restricting advances under the line of credit; and
(b) senior management of a borrower, whose revenues derived primarily from government contracts, made very negative, inappropriate and highly publicized statements on behalf of the company. These statements created publicized pressure on government officials to no longer do business with that company. In the absence of a separate default, unless protected by a MAC clause, a lender may not have been able to take protective measures against the inevitable and imminent financial reversals the borrower faced.
The MAC clause permits a lender to “pump the brakes” with a borrower and proactively take steps to protect itself when problems arises. Without the ability to rely upon a MAC clause, a lender is forced to be reactive and wait until the consequences of the problem are reflected in a borrower’s quarterly or annual financial statements thus potentially indicating a violation of a financial covenant. If forced to wait for a covenant default, the lender may have fewer options available to address the default and the likelihood of a full recovery of the outstanding loan may be diminished.
While loan documents containing a MAC clause may technically permit a lender to accelerate solely on that basis, doing so is rarely advisable, especially if based solely on a generalized perception of insecurity (i.e. no actual, dramatic adverse circumstances). Depending upon the factual situation, courts may very well be skeptical of defaults based on the MAC clause. The determination by a court as to whether a change is truly adverse and material such that a creditor is justified in deeming itself insecure and entitled to declare a default under a loan will always be a fact-based question leading to the possibility of hotly contested legal proceedings and potentially expensive adverse court determinations.
The UCC expressly states that acceleration based on “subjective” determinations of insecurity or the existence of a material adverse change are only permitted if made in honest good faith. For example, Section 1-309 of the UCC provides that a party with the power to accelerate a loan when it “deems itself insecure,” has “the power to do so only if that party in good faith [emphasis added] believes that the prospect of payment or performance is impaired.” Fortunately for lenders in this situation, “the burden of establishing lack of good faith is on the party against which the power has been exercised.” Other UCC provisions also mandate good faith. Section 1-304 provides “Every contract . . . imposes an obligation of good faith in its performance and enforcement.” Good faith is defined as “honesty in fact and the observance of reasonable commercial standards of fair dealing,” UCC Section 1-201 (20). Thus, although borrowers often object to MAC clauses in their loan documents, they can take a certain amount of comfort that the lender must abide by a good faith standard.
The MAC clause is an important provision which should be included in the recitation of events of default in loan documents. Inclusion of the MAC clause should not be relinquished casually by the lender when loan terms are negotiated. However, a default under a MAC clause should never be invoked lightly and when doing so it should be used only to the extent absolutely necessary to protect the lender’s legitimate interests.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.