In the first part of this round up, a “reasonable endeavours” clause case was examined.
Minumbra Lancewood Pty Ltd v AM Lancewood Investment Nominees Pty Ltd  NSWSC 1929 concerns a material adverse change (MAC) clause. These are also common in commercial agreements and, similar to reasonable endeavours clauses, are also infrequently litigated on. The discussion of the Court of MAC clauses and the decision are therefore of considerable value.
Interests associated with the plaintiffs and defendants purchased an accommodation village (Lancewood Village) in Queensland for mine workers as a joint venture. The defendants sourced the funds for the venture and loaned the funds to the plaintiffs. The judge, Justice Robb, referred to the plaintiffs as the “borrower” and the defendants as the “lender” and that will be followed here.
The lender and the borrower entered into a number of agreements. Of relevance were:
A loan agreement
- The principal sum was $11.785 million. Most of this was drawn down on 4 July 2012.
- The borrower was to provide evidence of occupation agreements (“take or pay” contracts) which would generate $4 million revenue in the first 12 months of operation.
- Clause 6.1: Interest was payable monthly. Unpaid interest was automatically capitalised.
- Clause 7.1: The borrower was required to repay the principal sum 30 months after the date of the first drawdown. No regular repayments were prescribed though.
- Clause 9.1(a): If an event of default occurred, the lender may declare as due part or all of the money then owed.
- Clause 9.2(a): “Material Adverse Change: any situation occurs which in the opinion of the Lender gives it grounds to believe that a material and adverse change in the business or financial condition of the borrower has occurred or that the ability of the borrower to perform its obligations under this Agreement has been or will be materially and adversely affected or that any other Event of Default is likely to occur.”
- Clause 11.2: The borrower was to provide information to the lender about the business in a manner that compared actual results with budget.
A company associated with the borrower (Transpac) was appointed as manager of Lancewood Village. Transpac was set a number of key performance indicators and was required to provide monthly progress reports.
At the time of the joint venture, Lancewood Village provided accommodation for mine workers under either “take or pay” contracts or on a casual basis. Take or pay contracts were lucrative. Mining companies paid for the occupation for a fixed term whether or not it was used.
The expectations of the parties regarding profitability were very high (at ) and this was expected to continue, fuelled by mining growth. The numbers in the business plan and budget were eye-wateringly attractive. Unfortunately for the parties, the bottom fell out of the accommodation market soon after the agreements were entered into:
- Big mining companies did not renew their take or pay contracts and severely reduced their bookings.
- From the second half of 2012 occupancy rates plummeted and never recovered. Lancewood Village offered 324 rooms at the time of the joint venture, all of which were booked. By August 2013 only 24 rooms were occupied.
- Competitors entered the market. This forced Lancewood Village to cut its rates.
- Forecast income plummeted.
In June 2013 Ashe Morgan, on behalf of the lender, prepared an analysis. It was concluded that the analysis of the borrower’s financial status “indicates dramatic underperformance compared to budget, including all key financial metrics (occupancy, revenue, expense ratio, net income), which has been exacerbated by the management failures identified above” (at ).
On 24 June 2013 the lender served a notice of default on the borrower. The notice relied on an event of default having occurred and demanded repayment of $10,644,426.20.
The borrower sues the lender
The borrower sought orders in the NSW Supreme Court preventing the lender from acting on the notice of default. The main grounds were:
- There had been no MAC to the borrower’s financial condition as it still continued to operate the camp.
- Failure to meet budget is only a failure to meet an expectation. It does not constitute a change in the condition of the borrower.
- Failure to obtain new and/or replacement occupancy contracts could not be a MAC. Overdue interest was capitalised, and clause 7.1 meant that repayment of the principal sum was “at large”.
The Court noted that there had been relatively few decisions in which MAC clauses had been considered (at ).
The decision of Justice Blair in Grupo Hotelero Urvasco SA v Carey Value Added SL  EWHC 1039 was cited. In that case there was a summary of some authorities and legal writing on MAC clauses (at  – ). However, the judge said it was difficult to draw general statements of principle from them.
The judge went on to make his decision under four headings:
The subjective approach of the lender in forming its opinion
The borrower challenged the good faith of the lender. The lender disputed this, but accepted that there had to be a reasonable basis for its opinion on a MAC. The Court endorsed that. It then held there was no indication of bad faith on the part of the lender.
An objective basis for forming the opinion
The MAC clause simply required grounds to believe that a MAC has occurred (at ). This is materially different from a clause that requires there to have been a MAC (eg, Grupo Hotelero). As His Honour put it: “An opinion that there are grounds to believe in the existence of a circumstance is not the same as an opinion that the circumstance exists” (at ).
The judge further found that on the wording of clause 9.2(i) of the loan agreement, it was not a requirement that the opinion be objectively based on facts (at ).
The Court noted a number of difficulties in the way of accepting the borrower’s contention that there must be facts that objectively prove that the opinion was valid (at  – ). It was concluded that the preferable construction was that if the lender forms the opinion honestly and not capriciously, it will be effective unless no reasonable person in the position of the lender could form that opinion (at ). The opinion by the lender satisfied this requirement.
The ability of the borrower to perform the obligations
There were two aspects of the borrower’s performance that were to be considered under the MAC clause:
- the business or financial condition of the borrower; or
- the ability of the borrower to perform its obligation under the loan agreement.
The fact that the business of the borrower was part of the MAC clause as well as the financial condition of the borrower was important. It widened the scope of the considerations that the lender could take into account. MAC clauses that focus only on the financial condition of the borrower are more difficult to enforce.
The judge also held that, even though items 1 and 2 above were contained in the same clause, the considerations were separate and not dependent on each other as they were separated by the word “or” not “and”.
The MAC clause was to be construed as encompassing all material and adverse changes which would include changes which would undermine the lender’s original decision to lend or would cause the lender to lend on significantly different terms (at ).
Material and adverse change
The parties agreed that it was necessary for the lender, in forming its opinion, to compare changes between date that the loan agreement was entered into and the date that the notice of default was served (at  – ). The judge proceeded on that basis.
The argument that there had been no MAC because the business continued to operate was rejected as being too simplistic and misstated the very high profitability expectations that the parties had when they entered into the venture (at ).
The argument that a failure to meet a budget or business plan did not constitute a MAC was also rejected. This was a matter of degree (at ). Here, the differences between budget and performance were glaring and spoke for themselves.
The Court also did not accept the argument that the capitalisation of overdue interest, and no repayments being required within 30 months or drawdown, meant that failure to generate revenue to pay these could not be a MAC.
This argument ignored the reality that Lancewood Village was never going to be able to generate revenue to make any repayments during the 30-month period, nor probably after that time.
The Court added: “With all due respect, the plaintiffs’ argument is tantamount to a submission that a person who falls out of an aircraft has not suffered a material adverse change until the person hits the ground” (at ).
The claim by the borrower was dismissed.
I support the decision.
The quote of the Court above, while harsh, was justified. There was an air of unreality to the borrowers’ submissions. Each of the points may have had some technical merit looked at in isolation. However, when one looks at the circumstances in the round, it is difficult to see how a lender to a business that was rapidly deteriorating on the scale of Lancewood Village would not have had grounds to form a belief that there may have been a MAC.
There are some noteworthy points from the decision:
- The drafting of the MAC clause in this case favoured the lender significantly. The lender only had to have grounds for a belief that there had been a MAC. The importance of this cannot be overstated and is a clear drafting tip.
- Cases on MAC clauses are rare. The Court cited only a handful of authorities and none of them had wording that was the same as the MAC clause in this case. Authorities (even if you can find one that applies to the wording of your clause) will only be of limited use.
- MAC clauses based on an opinion being formed on objective facts will be particularly difficult to litigate.
It was noted in Grupo Hotelero in relation to MAC clauses that “the interpretation of such provisions may be uncertain, proof of breach difficult, and the consequences of wrongful invocation by the lender severe, both in terms of reputation, and legal liability to the borrower” (at ).
This comment is clearly borne out in Minumbra. What appeared to be a straightforward situation triggering a MAC clause still took a three-day hearing and 62-page judgment to resolve in favour of the lender. Grupo Hotelero shows this even more graphically; 34 hearing days and a 173-page judgment.
Minumbra is a useful authority. Commercial parties would be advised to take extra care when drafting MAC clauses rather than simply relying on litigation to resolve any difficulties. Litigation of MAC clauses can be a very expensive exercise.
Michael Lenihan practices as a barrister specialising in civil and commercial work. Michael formerly worked at Henry Davis York in Sydney, Jones Fee in Auckland and Russell McVeagh in Wellington before going to the bar. Michael also teaches guarantees at the Auckland University Faculty of Law. Michael’s website is www.lenihan.net.nz.