Anticipating defaults under existing contracts
In our first alert in the present series, we considered practical steps that can be taken now to anticipate and prepare for potential counterparty defaults under existing contracts. These include:
- Identifying and collating key contractual documents in one place;
- Identifying, where possible, common provisions running across existing contracts that may offer assistance – for example, contractual rights to seek performance assurance, credit support, and so forth;
- Identifying the necessary tests and notice requirements for invoking such provisions; and
- Maintaining discipline around communications with counterparties across different internal functions to avoid the risk of an inadvertent waiver of contractual rights.
Negotiating and drafting commercial contracts to anticipate potential counterparty defaults
When it comes to the negotiation of new contracts, a number of steps can be taken contractually to anticipate potential adverse changes in a counterparty’s creditworthiness, breaches of contract, or actual insolvency. In this alert, we consider best practices in the drafting of such contractual provisions, focusing on (1) material adverse change clauses, (2) contractual rights of termination, and (3) specific insolvency-related provisions.
A. Material adverse change clauses
Material adverse change (MAC) clauses give one party specific rights upon the occurrence of events which have impaired or may impair the counterparty’s ability to perform the contract. MAC clauses may therefore be used to allow protective steps to be taken where a potential insolvency-related default by a counterparty is anticipated, but before it has occurred, such as suspending deliveries or requiring the counterparty to provide additional credit or performance assurance. Having such rights is particularly important where credit is extended to the counterparty. As a matter of English common law, in the absence of an express MAC clause in the parties’ contract, there may be little or nothing that can be done prior to the counterparty’s actual default to minimise exposure to the counterparty. A number of considerations arise when drafting MAC clauses.
Defining the trigger: It is important to define adequately what events or circumstances would need to occur in order to be able to rely on the MAC clause. The trigger for MAC may be objectively determinable by reference to the counterparty’s financial position, such as failing to maintain a specific credit rating or financial metric. This approach gives both parties the benefit of increased certainty as to whether the MAC has arisen, but gives the MAC a narrow scope.
A more common approach to the trigger is the more subjective approach where, in the relying party’s opinion, the counterparty’s ability to perform its obligations under the contract has been materially impaired. This allows the party invoking the clause to take into consideration all external and internal issues that might affect the counterparty’s creditworthiness, and may provide grounds for invoking the clause in response to any general market turmoil caused by COVID-19. However, in order to counterbalance such wide discretion, counterparties may insist that the relying party’s belief that a MAC has occurred must be reasonably held. Even where a ‘reasonableness’ qualification is not included expressly, the relying party’s discretion to invoke the MAC clause will not be completely unfettered, and it will still be necessary for the relying party to demonstrate that its opinion was genuinely held, honest, and rational.1
Materiality: By definition, a MAC event should be material. Consideration of materiality may include durational significance, and short-term disruptions or difficulties caused by COVID-19 and its effects may not be enough to trigger the MAC clause.
Change: Since MAC clauses require there to have been some ‘change’, a party will typically not be entitled to rely on the MAC on the basis of circumstances which already existed when the parties entered into the agreement. This will be of special importance to new contracts entered into after the COVID-19 outbreak started. However, parties should in principle still be able to rely on MAC clauses where COVID-19 has an unexpectedly serious effect on the counterparty, beyond what the parties might reasonably have expected at the point of contracting.
Defining the effects of MAC: MAC clauses will provide for specific rights if they are triggered. These may include, where the party invoking the clause is the seller, the right to demand additional credit support for the unpaid price of the goods. A MAC clause may also include more generally a right for either party to demand ‘performance assurance’ from the counterparty affected by MAC. Under English law, at least, there is no general right to demand security or performance assurance even where there are real grounds to suspect the counterparty may not be able to perform the contract, although other jurisdiction’s laws may take different approaches.2
Credit support and performance assurance can take the form of cash prepayment, standby letters of credit, on demand guarantees, documentary letters of credit, bank guarantees, and parent company guarantees. When drafting MAC clauses, it will be important to consider which party chooses the form of the performance assurance – cash prepayment and instruments that are easily called upon (for example, standby letters of credit and on-demand guarantees) could result in the counterparty being exposed to significant credit risk on the relying party itself.
Rights of suspension and termination: Where the demanded credit support or performance assurance is not provided, a MAC clause may allow a right to suspend performance and may constitute an event of default giving rise to a right to terminate the agreement.
Practical considerations when asserting MAC: The party seeking to rely on the MAC clause has the burden of proving that the MAC has arisen. An unjustified invocation of the MAC clause may itself be a repudiatory breach of the contract by the relying party, so it will be vital for the relying party to gather all available evidence of the MAC to support its position in any future dispute under the contract. MAC clauses will often include specific notice requirements with which it will be important to comply.