COVID-19 as "Material Adverse Change" in German law loan facility agreements?

Loan facility agreements for businesses typically include the concept of “material adverse event” and “material adverse change”. This concept is not only common in the U.S. and in the UK but – not least due to the influence of the standard forms of the Loan Market Association (LMA) – all accross Europe including Germany. In loan facility agreements, the occurrence of a Material Adverse Event is regularly defined as an Event of Default, giving the lender the right to accelerate the loan and claim repayment as well as to refuse further drawdowns. Moreover, as in the case of every Event of Default, the borrower is obliged to inform the lender without undue delay if a Material Adverse Event arises.

A Material Adverse Event (or an event having a “Material Adverse Effect”) is in German loan facility agreements often defined as follows (slightly simplified): an event having a material adverse effect on (a) the business, operations, property, condition (financial or otherwise) or prospects of the group of the borrower taken as a whole, (b) the ability of the borrower (and other obligors) to perform its obligations under the finance documents, or (c) the validity or enforceability of, or the effectiveness or ranking of any finance document, including security.

But that is only the rough definition. Important details are often negotiated, for example the following points:

  • Is a short term adverse effect required or is a long term adverse effect sufficient?
  • Does the adverse effect have to be a certainty or is a certain degree of likelihood sufficient (“will have …” or “might have …” construction)?
  • Is there an objective test or is the opinion of the lender relevant?

However, just like in the English language standard forms, the core of the definition, i.e. the meaning of “material adverse effect” itself, remains undefined. In German jurisprudence, this would be called an open legal term (unbestimmter Rechtsbegriff). When applying this open legal term to the economic situation of many businesses in the current COVID-19 pandemic, the story of the blind men and the elephant comes to mind. Everyone can touch and feel a different characteristic but all agree: this must be an elephant.

Of course, the current situation is still in flux. In particular, the duration of the shutdown is still unclear. Also, much will depend on the special circumstances of each business, on the diversification of the business model, on the reserves, on the cost structure, etc. But, for example, a fashion business which cannot open its shops and sits on its summer collection, a hotel business which following a missed-out Easter holiday season now anxiously awaits bookings for the summer, or a trade fair organizer which cannot hold trade fairs, is likely confronted with a Material Adverse Event.

There is to date no German case law interpreting the term “Material Adverse Event” or shedding more light on the legal consequences of a “Material Adverse Event” in the context of loan agreements. However, there are established German legal concepts, partly developed in previous times of economic crisis, which do not use the exact terminology of “Material Adverse Event” but which in essence deal with the same set of circumstances. There is on the one hand the legal concept of the “disruption of the contractual basis” (Störung der Geschäftsgrundlage, similar to the English law doctrine of “frustration of contracts”). On the other hand, there is the statutory extraordinary termination right of the lender in the case of a “material deterioration of the economic condition” of the borrower according to section 490 para. 1 of the German Civil Code (BGB).

COVID-19 as a disruption of the contractual basis?

The legal concept of disruption of the contractual basis was codified in Germany as recently as 2001 (in section 313 BGB) but it is much older. It was established by legal academics and the courts roughly a hundred years ago as a response to the manifold repercussions which the First World War, the revolution of 1918 and the following times of hyperinflation brought on contractual relationships. According to section 313 BGB, an adjustment of the contractual terms can be requested if circumstances which have formed the basis of the contract materially change following the conclusion of the contract and if, firstly, the parties would not have concluded the contract, at least not with these terms, had they foreseen this change, and if, secondly, having due consideration of all individual circumstances and of the contractual or statutory allocation of risks, it cannot be reasonably expected of a contracting party to be bound to its unchanged terms.

One could now, from the perspective of the borrower, think of section 313 BGB as a kind of antidote against the effects of a “MAC” clause. The argument would run: There may well be a “MAC” according to the standard definition. But the current pandemic is such a severe disruption of the macroeconomic situation that the parties to the loan agreement would have reasonably qualified the “MAC” concept in such a way that it does not give the lender a unilateral termination right in this general situation of crisis.

But German courts have clarified over many decades that borrowers cannot use the concept of disruption of the contractual basis in such a way. To point to a development like the COVID-19 pandemic as a case of a disruption of the contractual basis would be what is called in German legal literature pointing to the “general” or “overall” contractual basis (große Geschäftsgrundlage), i.e. a disruption of the general expectation which normally underlies every contract that the economic, political and social framework as a whole will not fundamentally change.

This general expectation is currently no doubt disrupted. But the German courts pursue the restrictive approach that contractual problems caused by a general emergency or by a social and economic general disaster cannot be solved with section 313 BGB, i.e. with the instrument of “disruption of the contractual basis”. Moreover, the right to claim a contractual amendment based on a disruption of the contractual basis requires an analysis of who bears the contractual risk in question. Thus, the German Federal Supreme Court (Bundesgerichtshof, BGH) decided in a judgement of the year 1952 (BGHZ 7, 360), in the light of the destruction of the Second World War, that payment obligations under loan agreements cannot be modified on the sole basis of a disruption of the “general” or “overall” contractual basis (große Geschäftsgrundlage). Rather, such modifications of contractual relationships would require a legislative act (and such legislative acts to modify contractual relationships were indeed introduced at the time).

Also today, the German legislator reacted on the current disruption of the “general” contractual basis, by introducing changes to contract law, see the Gesetz zur Abmilderung der Folgen der COVID-19-Pandemie im Zivil-, Insolvenz- und Strafverfahrensrecht vom 27. März 2020 (Mitigation of COVID-19 Pandemic Consequences for Private Law, Insolvency Law and Criminal Procedure Act of 27 March 2020). This leads to certain relaxations of payment obligations for consumer credits, which may yet be extended to small businesses. But there currently are no further statutory measures as a reaction to COVID-19 at the contract law level in sight. Borrowers will not likely be able to claim more relaxations than that based on section 313 BGB (i.e. based on the doctrine of disruption of the contractual basis) by simply pointing to the current pandemic situation.

However, loan facility agreements for businesses contain numerous covenants, in particular financial covenants. Financial covenants are individually negotiated and tailor-made with view to the financial situation of the borrower. When agreeing these covenants, the existence and functioning of certain market mechanisms is indeed an underlying contractual basis. If this contractual basis is disrupted, this is not so much a change of the “overall” or “general” contractual basis (große Geschäftsgrundlage) but it is what German lawyers call a change of the individual, the “small” contractual basis (kleine Geschäftsgrundlage). It is therefore conceivable that German courts would see borrowers currently entitled to a financial covenant reset based on section 313 BGB, due to the COVID-19 pandemic, because financial covenants are normally based on financial projections which have been mutually accepted by the borrower and the lender as realistic but which can now, in the light of the COVID-19 pandemic, be scrapped entirely. These deviations cannot be seen wholly as the realization of a risk to be borne by the borrower. While German courts see the risk on the borrower’s side when it comes to the ability to meet payment dates, this cannot with certainty be said also of financial covenants. Financial covenants have the function of an early warning system and therefore have a different quality than payment dates.

This does not mean however that currently agreed financial covenants become irrelevant from one day to the next. Each loan agreement and covenant setup must be analyzed individually. From the practical perspective, an open communication with the lender and negotiations about this topic are advisable. In the current situation, lengthy legal disputes would serve no-one.

So the interim result is that COVID-19 will indeed in many cases mean a disruption of the contractual basis within the meaning of section 313 BGB, but in loan facility agreements for businesses this will only in certain aspects become relevant, for example with regard to certain financial covenants. Section 313 BGB will not help to postpone payment dates, and it will not help to get around the legal consequences of a triggered “MAC” clause.

“Material deterioration of the economic condition” due to COVID-19?

There is an apparent similarity between the standard definitions of “MAC” and the statutory termination right in section 490 para. 1 BGB. Under that provision, the lender is “as a rule” entitled to terminate the loan without notice period if there is or threatens to be a material deterioration in the economic situation of the borrower or in the value of the security which puts the repayment of the loan, also considering the value of the security, in danger.

It is not clear how German courts will analyze the “MAC” Event of Default clause in loan facility agreement in the context of section 490 para. 1 BGB. The “MAC” Event of Default clause could be seen as an attempt to contractually modify section 490 para. 1 BGB or – which seems more plausible – as an additional termination right, i.e. standing next to section 490 para. 1 BGB.

No matter how one analyzes the “MAC” Event of Default in the context of section 490 para. 1 BGB, it is quite likely that in the current pandemic situation a number of borrowers will be suffering from both: a “material adverse change” within the meaning of the “MAC” Event of Default and a “material deterioration of the economic condition” within the meaning of section 490 para. 1 BGB.

But when using this termination right, or the two termination rights, lenders should take caution. It is acknowledged in the context of section 490 para. 1 BGB that prior to terminating and calling a loan without notice period, the lender must take a balancing of his interests against those of the borrower into account. This requirement of weighing of interests is seen to be expressed by the statutory wording that the extraordinary termination right arises only “as a rule”.

Whether in the current pandemic situation there is the same requirement of weighing of interests in the case of the “MAC” Event of Default is not clear. But it is advisable for lenders to comply with the standards of section 490 para. 1 BGB also in the case of the “MAC” Event of Default.

Regardless of the issue whether a “hard cut” of the lender by terminating the loan would be permissible in the context of section 490 para. 1 BGB, it is questionable whether such a step would be of practical use before the background of changes to German insolvency law that were introduced following the outbreak of the COVID-19 pandemic, see the Gesetz zur vorübergehenden Aussetzung der Insolvenzantragspflicht und zur Begrenzung der Organhaftung bei einer durch die COVID-19-Pandemie bedingten Insolvenz (COVInsAG) of 27 March 2020. If the lender terminates the loan, the borrower will not be able to repay. Due to COVInsAG, there is no duty to file for insolvency in this scenario prior to 30 September 2020. So, unless the creditor aims for a security enforcement outside an insolvency – which bears a number of additional risks – it is hard to see what can be gained from calling the loan. A creditor application for insolvency would fail due to section 3 COVInsAG which sets out that creditor applications for insolvency require that the insolvency must have occurred by no later than 1 March 2020.

Practical consequences of a “material adverse event”

We can conclude that “MAC” Events of Default in loan facility agreements are highly relevant in the current situation. But there is not so much the “all or nothing” question at stake, i.e. the issue of a termination of the loan based on a “MAC”, one reason being that the exercise of that termination right is legally complicated. Still, borrowers should seek an active and open communication with lenders about this topic. Borrowers should comply with their contractual notification duty vis-à-vis the lenders if there is indeed a “material adverse event”. In the case of new drawings under the facility agreement, the borrower must make a statement about the presence of a “material adverse event” (and any other Event of Default) in the context of the “Repeated Representations”. The lender can generally refuse further drawings in this situation of a “material adverse event”. However, lenders should treat this possibility of a “draw stop” not as an automatism but they should take an informed decision in each case.

This often difficult decision of “funding into a default” has been made easier to a certain extent by the German COVID-19 legislation. Normally, lenders are faced with a peculiarity of German law which holds a lender accountable vis-à-vis other creditors where the lender provides fresh money to a borrower in a crisis situation if it later turns out that the borrower’s struggle was never realistic (a concept called Insolvenzverschleppung, “wrongful protracting of insolvency”). To protect the lender from this liability, normally an extensive restructuring analysis and due diligence is required. But according to section 2 para. 1 No. 3 COVInsAG, these liability rules are waived with regard to businesses that are struck by the current pandemic situation. New credit and new security transactions with such businesses until 30 September 2020 (which cut-off date may yet be postponed) is expressly exempt from these liability rules.

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