More than just material change
Local parties look to foreign case law in US and elsewhere for guiding principles
IN THE face of a material change in political, economic or legal conditions parties to a contract often seek to contractually regulate their obligation to remain bound if such a change significantly reduces the ability of one of them to perform.
This principle finds expression in what is known as the material adverse change regime. However, despite their prevalence — in acquisition and, increasingly, lending transactions — there is no South African case law on how material adverse change clauses are to be interpreted.
The absence of local guidance is somewhat unsettling, given that material adverse change clauses are now a common feature of long-term lending transactions that are brokered within economically important and highly regulated industries, such as energy and financial services. Where, for example, there is a material adverse change in a borrower’s financial position, the lender could be relieved from making further advances on the loan. Clearly, the continued viability of a project could hang on whether a material adverse change can be said to have occurred or not.
While foreign case law on material adverse change clauses is not abundant, there are some principles that have been laid down. Parties should take note of these as they may prove persuasive when the South African courts are called on to decide on the occurrence of a material adverse change and its contractual enforceability. These principles are outlined below.
What emerges from foreign case law, the majority of which is from the US, is that the courts interpret material adverse change clauses restrictively and place a high onus on the party making a claim under a material adverse change clause.
More specifically, in the early 2000s in a US case in relation to a takeover agreement the following principles were established:
In interpreting a material adverse change clause the contractual context and intentions of the parties have to be taken into account.
A material adverse change clause only contemplates a material adverse effect which is of durational significance.
A heavy onus rests on the buyer to show that a material adverse change affected its ability/willingness to close the deal.
Material adverse change clauses should be considered as “catch-all” protection, in that they will not serve to alter risks specifically allocated elsewhere in the agreement nor will they alter risks known to the party alleging a material adverse change.
Risks known to a party and accepted during negotiations cannot later be deemed a material adverse change.
About five years later, a further principle was established in the Canadian case of Doman Forest Products Ltd et al v GMAC Credit Corporation – Canada (2005 BCSC 774, affirmed, 2007 BCCA 88) that broader considerations would have to be taken into account in assessing the materiality of a material adverse change, the test being subjective. The court was open to considering commercial considerations of the lender, such as its appetite for risk on entering into the relevant transaction.
The recent case of Stetson Oil & Gas Ltd v Stifel Nicolaus Canada Inc related to a standard material adverse change provision in the context of an underwriting agreement. The Ontario Superior Court of Justice accepted the view that a material adverse change could be invoked by an underwriter in the “event of a change in the business, operations or capital of the issuer of the securities that would rise to the level of a defined material change, with the change ‘trigger’ being the price or value of the issuer’s securities, without regard to whether the change is permanent or transformational”.
Furthermore, the material adverse change would have to be specific to the issuer, as opposed to being of general application. The court also indicated
It is important such clauses be precisely drafted and that specific concerns are addressed as conditions elsewhere in the agreement
that pre-existing knowledge and acceptance of a risk cannot later be claimed as a material adverse change.
In the recent decision of the England and Wales High Court (Commercial Court) in the matter between Grupo Hotelero Urvasco and Carey Value Added and another, the court was called on to examine a material adverse change clause which had been invoked by Carey Value Added (the “lender”) when it refused to advance further amounts of a loan to Grupo Hotelero Urvasco (the “borrower”).
Accepting the already established US principles mentioned, the court in the Grupo case emphasised the uncertainty around the interpretation of material adverse change clauses and the difficulties relating to “proof of breach … and the [severe] consequences of wrongful invocation by the lender … both in terms of reputation, and legal liability to the borrower”.
In this case the material adverse change clause was set out in the loan agreement as a representation, repeating at the time of each drawdown. It was also used as an event of default (albeit in wider terms linked to the discretion of the lender).
The lender relied on the representation material adverse change, which was limited to the “financial condition” of the borrower, and which the court accepted would be evidenced primarily in its financial statements (although the court said that other compelling evi- dence may be considered).
In essence, the court found that determining a material adverse change in these circumstances does not extend to matters related to the prospects of the borrower, such as “external economic or market changes”.
The court further stated that “unless the adverse change in its financial condition significantly affects the borrower’s ability to perform its obligations, and in particular its ability to repay the loan, it is not a material change”. To interpret it any other way could lead to the untenable circumstance in which the lender withholds an advance or calls a default “at a time when the borrower’s financial condition does not fully justify it, thereby propelling it towards insolvency”.
The court further favoured the borrower and demonstrated a reluctance to find in favour of the lender’s decision to invoke a material adverse change by adding that the lender cannot trigger an event of default on the basis of circumstances of which it was aware of at the outset and that a change that triggers a material adverse change must not be merely temporary.
While the court was clear that the threshold for a lender to invoke a material adverse change was high, the court did not eliminate the ability of a lender to invoke a material adverse change completely. The court acknowledged the importance of material adverse changes, which allow the lender to “be exonerated from what amounts to throwing good money after bad” and indicated that certain external factors could be suggestive of the occurrence of a material adverse change, for example, the fact that the borrower stopped paying its bank debts in 2008.
Case law on material adverse change clauses is limited, but it is clear their interpretation is restrictive. Of course, the general principles of contractual interpretation in each jurisdiction will apply, for example, that the agreement will be considered as a whole and the parties’ intentions will be given effect to. It is thus important such clauses be precisely drafted and that specific concerns are addressed as conditions elsewhere in the agreement.
Because a general material adverse change clause will seldom provide sufficient protection, parties should aim to cover objectively identifiable facts in the clause.
WORD OF LAW