The Threshold Question: Negotiating Materiality Qualifiers and Standard of Effort Clauses in Credit Agreements

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1 The Threshold Question: Negotiating Materiality Qualifiers and Standard of Effort Clauses in Credit Agreements American Bar Association Loan Documentation Subcommittee Meeting September 12, 2014 Don Waters McMillan LLP David Shafer Duane Morris LLP

2 Materiality Overview Material Adverse Change Material Dollar Baskets Standard of Effort Best Efforts, Reasonable Efforts, Commercially Reasonable Efforts Knowledge 2

3 Thresholds Purpose of Materiality Thresholds/Qualifiers and Standards of Effort Allocation of risk (lender v. borrower) Timing Unequal access to information Future circumstances (uncertainty) De minimus exclusions Expediency Tension between Flexibility and Certainty 3

4 Materiality Timing Material Adverse Change Applications Commitment letters/closing Conditions Precedent Funding Conditions (subsequent advances) Representations and warranties Covenants Affirmative and Negative Events of Default 4

5 Materiality Timing Material Adverse Change Example Material Adverse Effect means a material adverse effect on (a) the business, assets, operations, [prospects] or condition, financial or otherwise, of the Borrower and the Subsidiaries [taken as a whole], (b) the ability of any Loan Party to perform any of its obligations under the Loan Documents to which it is a party, (c) the Collateral, or the Administrative Agent s Liens (on behalf of itself and the Lenders) on the Collateral or the priority of such Liens, or (d) the rights of or benefits available to the Administrative Agent or the Lenders under any of the Loan Documents. 5

6 Materiality Timing Material Adverse Change Tension: Quantitative vs. Qualitative MAE Thresholds General qualitative MAE clause Flexible, but risk that it may be too ambiguous or vague. Specific quantitative MAE clauses Precise, but risk that if specific events are listed, a court may interpret the MAE as being limited to those specified events. Alternatives: Address specific elements of MAC in representations and covenants 6

7 Materiality Timing Material Adverse Change Whose Determination/Burden of Proof? Objective? Reference to a threshold? Lender discretion/duty to act in good faith Prospects expands by including market/industry conditions Developments and events Retrospective or Prospective Has had vs. would/could reasonably be expected to have 7

8 Materiality Timing Material Adverse Change Judicial treatment Rare to determine a MAC has occurred In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001) Buyer(lender) must make a strong showing to invoke a MAC Best read as a backstop protecting the acquirer [lender] from the occurrence of unknown events 8

9 Materiality Timing Material Adverse Change Applications Commitment letters/closing Conditions Precedent Reference to most recent audited financial statements Reference to MAC clauses in purchase agreements 9

10 Materiality Timing Material Adverse Change Applications Funding Conditions Precedent (subsequent advances) Allows lender to cut off future advances if a MAC occurs (as an alternative to the rights and remedies of an event of default) Should not be based on interpretation of Lender since needs to be brought down 10

11 Materiality Timing Material Adverse Change Applications Representations and warranties/covenants Compliance with Applicable Law Compliance with Environmental Law..except to the extent failure to do so has not had a MAC Avoid Double Dipping Thresholds for determining Material Licenses or Contracts all licenses/contracts, the termination of which would give rise to a Material Adverse Effect Ambiguity cuts both ways 11

12 Materiality Timing Material Adverse Change Applications Events of Default Independent Event of Default Very broad Definitional terms / interpretation will be important Enforcement issues / Lender liability 12

13 Materiality Material/All Material Respects Significant, pertinent, essential, not trivial An objective test but also based on context Tested objectively with a view to the reasonable person Depends upon the facts and context of the particular transaction ie. the nature of the contract, the parties, their knowledge about the subject matter 13

14 Materiality One possible formulation: If a reasonable person relying on the information, in the context of a significant decision relating to the transaction, would have changed or been influenced by the inclusion or correction of such item, then the inclusion or correction of such information is material 14

15 Materiality Applications: Representations and warranties Notice Requirements (e.g., notice of material litigation) Affirmative Covenants Negative Covenants (dollar baskets more common) 15

16 Materiality Applications: Events of Default: Cross Default threshold exclude de minimus debt amounts Material breach of representations and warranties (avoid double dipping) Litigation Judgments 16

17 Materiality Materiality of Compliance Example Each Credit Party is in material compliance with all applicable laws Materiality of Effect Example Each Credit Party is in compliance with all applicable laws except where failure to comply will not have a Material Adverse Effect 17

18 Materiality Dollar Baskets Provides materiality with objective level of certainty Ease of Comprehension v. Inflexibility Straight dollar amounts v. percentage of EBITDA or debt 18

19 Materiality Application: Collateral Package Representations and Warranties Affirmative/Negative Covenants: As a threshold to control leakage of collateral and proceeds: Permitted Dispositions/Permitted Distributions/Permitted Liens/Permitted Cap Ex? Events of Default 19

20 Standard of Effort General Commercial Understanding Absolute Covenant Best Efforts Reasonable Efforts Commercially Reasonable Efforts 20

21 Standard of Effort General Legal Understanding Absolute Covenant Reasonable Efforts Best Efforts Commercially Reasonable Efforts 21

22 Key Provisions of Payoff Letters (cont d) Standard of Effort Best Efforts US judicial consideration: UCC Unclear Best Efforts may be indistinguishable from Reasonable Efforts Canadian judicial consideration is limited and not entirely clear An objective standard a higher obligation than reasonable efforts Taking, in good faith, all reasonable steps to achieve the objective 22

23 Standard of Effort Reasonable Efforts (Reasonable Best Efforts) Distinguishable from Best Efforts? Less developed Canadian judicial consideration Good faith efforts is too subjective can be unreasonable and in good faith if has an honest yet unreasonable belief Application: For third party agreements (landlord agreements/bailee waivers, deposit account control agreements) 23

24 Key Provisions of Payoff Letters (cont d) Standard of Effort Commercially Reasonable Efforts Best Efforts/Reasonable Efforts within a specific industry. An objective standard connected to established commercial practice Prudent standard based on context and established business practice in similar circumstances and industries 24

25 Standard of Effort Limitations US Courts frequently hold that efforts clauses do not require party to: Take every conceivable effort Take unreasonable actions Disregard economic and business considerations or incur substantial losses 25

26 Standard of Effort Avoiding Ambiguity Specify what steps should be taken and when upon Lender s request/reasonable request Timing (dates, promptly/immediately) At whose expense, limited expense (e.g. No material expense or disruption of business, after considering the cost to borrower/benefit to lender) Define Best Efforts Rarely done 26

27 Key Provisions of Payoff Letters (cont d) Knowledge Subjective vs. Objective knowledge Subjective actual knowledge Reasonable person in similar circumstances ought to have known (an implied obligation to investigate?) Knowledge of the corporation? Directing mind and will of the corporation? Senior Management? any employee? Diligence obligations Knowledge after due inquiry? 27

28 Key Provisions of Payoff Letters (cont d) Knowledge Best of knowledge Common perception that sets a higher standard of diligence than just knowledge Due diligence or inquiry not implied Whose knowledge any employee of the Borrower? Senior management? Sponsor? 28

29 Key Provisions of Payoff Letters (cont d) Knowledge Actual knowledge Direct and clear knowledge (not constructive knowledge) However, may Include imputed knowledge based upon surrounding facts and on the basis of recklessness or wilful blindness Investigation and inquiries of persons likely to have knowledge Consider whose knowledge directors and officers? 29

30 Knowledge Purpose To avoid blanket representations related to minor exceptions To allow document to remain a living document Where Borrower also does not have full information Scheduled Disclosure 30

31 Practice Points Knowledge Goal: remove as much uncertainty as possible Use interpretative provisions with respect to references to knowledge Specify what level of investigation/inquiry is required Knowledge qualifier to representation and warranties is generally limited to the absence of threatened claims by third parties (ie. Litigation, threatened tax assessments, union actions) 31

32 Practice Points Knowledge Address knowledge limitations by ensuring that borrower has an obligation to promptly and diligently remedy any defaults In absence of knowledge qualifiers, ensure adequate cure periods. Absence of Litigation: example: schedule/knowledge/materiality/mac 32

33 Questions? Don Waters McMillan LLP David Shafer Duane Morris LLP