Banks tolerate credit-line draws in coronavirus crisis — for now

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If the economic shutdown meant to curb the spread of COVID-19 persists longer than expected, it’s feared that banks would use certain clauses in their contracts with business borrowers to prevent massive drawdowns on credit lines.

These so-called material adverse effect clauses, which are common in merger agreements as well, give the bank the ability to refuse a request to draw down a loan commitment if there is a significant deterioration in the borrower’s business. According to analysts, banks have enough liquidity for now to meet the growing demand for cash from hard-hit businesses, but banks could begin to invoke these clauses if the situation worsens.

“We are not aware of any bank calling" a material adverse effect clause to date, said Richard Spehr, who leads the global litigation and dispute resolution practice at the law firm Mayer Brown. “However, as severe economic dislocation continues, banks will certainly focus on whether an MAE is available to them.”

Drawdowns of C&I credit lines

There were $139.9 billion in commercial and industrial loan draws as of March 25, up from $29.2 billion on March 18, according to estimates compiled by Janney Montgomery Scott. Observers expect to get a clearer picture of the level of activity when banks report earnings in April.

Bankers contacted for this story did not comment.

Christopher Maher, chairman and CEO of OceanFirst Financial in Toms River, N.J., said during a recent conference call that commercial clients had recently drawn down $11 million from existing lines of credit. He said 104 business clients of the $10.2 billion-asset company had temporarily shut down to preserve cash.

Nationally there remain roughly $1.2 trillion in revolver credit lines that could be drawn by corporate clients, and about $800 billion of that is available to companies with debt ratings one notch above junk, according to Barclays Capital researchers.

“It’s too early to tell what kind of opportunistic behavior might unfold as this crisis rolls along,” said Andrew Glenn, a lawyer at Kasowitz Benson Torres. “We have some private-equity clients who started publishing recommendations to portfolio companies to draw down out of concern that liquidity might not be there.”

Glenn’s firm successfully compelled banks to reverse their decisions to use the clauses during the recession that followed the 2008 financial crisis. Lenders then were looking to get out of financing merger and acquisition deals that suddenly soured. Previous court rulings on the issue have shown that banks wanting to use these clauses have a high bar to reach in order to do so.

One of the most commonly cited cases came in 2001, when a Delaware trial court ruled that Tyson Foods had to carry out its acquisition of IBP even after trying to use a material adverse effect clause to get out of the deal when IBP’s earnings suddenly started to wane.

The judge in the case, Leo Strine, who sat on the Delaware Supreme Court from 2014 to 2019, ruled at the time that a company trying to use the clause to back out of a deal had to show adverse effects over time. The precedent could now give lenders pause if the economic shutdown from the new coronavirus pandemic is a short-lived one.

“A short-term hiccup in earnings should not suffice,” Strine said in his ruling. “Rather the Material Adverse Effect should be material when viewed from the longer-term perspective of the acquiror.”

Sartaj Gill, a finance partner at the law firm Davis Polk, said case law suggests that a lender alleging an material adverse effect has occurred will have a “high burden.”

“It is generally accepted that for there to be an [material adverse effect] the impact must, among other things, have had or be expected to have a material adverse effect for a durationally significant period,” Gill said. “Since we are still in the early days of the pandemic and the long-term impact on most businesses is not yet clear, this may be challenging or at least uncertain.”

If a bank desperate to get out of honoring a credit facility draw pulls the lever too quickly, a swarm of litigation is almost certain, attorneys said.

“No well-advised lender will call an MAE lightly,” Gill said.

Barclays Capital researchers said in a March 19 note to clients that “the banking system has the liquidity to meet potential revolver draws,” especially as the Federal Reserve uses an unprecedented number of maneuvers to backstop the financial market.

The Senate passed legislation Wednesday night that would send $2 trillion to struggling consumers and businesses to help in the near term. But the economic damage from the new coronavirus spread is already hitting some industries like hotels particularly hard, sending jobless claims to a record high on Thursday.

If the toll from the virus worsens and shutdowns linger longer than expected, the question over whether banks will test the limits of the material adverse clauses would become more pressing.

“At first it looked like this would be a very short-term thing and that maybe the entire world wouldn’t shut down,” Glenn said. “It really has closed down so many businesses that this looks like it would be a more extended affair."

Paul Davis contributed to this article.

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