More than just ma­te­rial change

Lo­cal par­ties look to for­eign case law in US and else­where for guid­ing prin­ci­ples

Business Day - Business Law and Tax Review - - BUSINESS LAW & TAX REVIEW - CAREY-ANNE SAL­LIE

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.

Pic­ture: THINKSTOCK

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