Recent Developments: (A) The “Material Adverse Change” Clause (Part II); and (B) Changes to the Small Business Bankruptcy Debt Limit

Posted on by Neil E. McCullagh in Corporate and Business, Creditors' Rights, Bankruptcy and Insolvency, Litigation


Two years ago, as COVID began to take its toll on the economy, our firm received inquiries about “material adverse change” (“MAC”) contract clauses. So, in these pages we surveyed some of the case law on MAC clauses in the lending context and provided some principles that a lender can take away and apply to emerging situations. That article can be found here. Surprisingly, COVID did not generate a lot of reported cases on MAC clauses, but two recent cases provide more insight into how to think about MAC clauses and when they may be invoked. We review those cases below.

Also, in bankruptcy-related news, the debt limit for Subchapter V small business bankruptcy cases has changed again, and March 2022 saw a significant surge in bankruptcy filings. We provide details below.

I. The Material Adverse Change Clause

a. Bank of China v. L.V.P. Associates

In Bank of China v. L.V.P. Associates, which was decided in December 2021 by New Jersey’s intermediate appellate court, the bank won its case on summary judgment based in part on its MAC clause. The bank had made commercial mortgage loans to three LLCs that were owned by the same individual. The loan documents provided that a default by one of the LLCs constituted a default by the others. The bank invoked its MAC clause, alleging that one of the LLCs (the “Debtor”) was in default based on negative changes in its “financial condition or results of operations…or…the value of [its] Property”. In particular, the value of the Debtor’s building securing the bank’s $14.35 million loan had fallen from almost $16 million to approximately $8 million from 2009 to 2017, and the vacancy rate had increased consistently from roughly 27% in 2010 to 62% in 2016.

The bank filed foreclosure lawsuits against the other two LLCs (the “Co-Debtors”). The Co-Debtors replied by accusing the bank of acting inequitably and violating the loan documents and the implied covenant of good faith, pointing to the bank’s refusal to allow the Co-Debtors to prepay their loans one month before maturity because of the Debtor’s alleged default.

The court started its analysis by rejecting the Co-Debtors’ position that “determining if a material adverse change has occurred involves a subjective standard.” The court wrote that “in deciding if an adverse change is material, we consider what a reasonable lender under the circumstances would deem material.” In this respect, the court echoed the ruling in a case we reviewed in our prior article on MAC clauses, in which the court rejected a subjective “know-it-when-you-see-it” approach to defining “material”.

The court then wrote that “[t]ransitory changes in a borrower’s finances are unlikely to qualify as material” and that an adverse change must be “durationally-significant” to qualify. As to what constitutes “transitory” or “durationally-significant”, the court pointed to “the context in which the parties were transacting” and cited cases stating that in corporate acquisitions, the acquiring corporation presumably sees the acquisition as part of a long-term strategy, such that an adverse change in the target corporation would be “material” only if it will last over a long term. In other words, the court seemed to be ruling that in the context of a loan transaction, whether an adverse change is “material” depends in part on how long it will last in relation to the length of the loan. Also, more specifically, the court wrote that “[t]o be ‘material’ in the ‘context’ of the loan transaction and the Bank’s decision-making, the adverse change had to affect the financial risks associated with making and holding the loan.”

In rendering its decision, the court then wrote that “[h]ere, importantly, the ‘material adverse change’ pertains to [the Debtor], not markets or economic conditions that might impact [the Debtor]”, and that measured against the standards the court had set forth -

“We are satisfied that the vacancy rate rise and property value drop were material adverse changes. Particularly once the property's value dropped significantly below the $14.35 million indebtedness, the loan was significantly under-collateralized. It would have been unreasonable for the Bank to loan $14.35 million secured by a mortgage on an $8 million building. Furthermore, the vacancy rate rise was no transitory blip. It was a consistent trend that played out over several years, which raised reasonable questions about [the Debtor’s] capacity to sustain itself without continued and growing infusions of cash from [its owner]. Consequently, the vacancy rate rise significantly increased the Bank's risk in holding the loan.”

b. Level 4 Yoga, LLC v. CorePower Yoga, LLC

Level 4 Yoga, LLC v. CorePower Yoga, LLC, was decided in March 2022 by Delaware’s Court of Chancery, which likely has rendered more decisions on MAC clauses than any other court in the United States. In Level 4 Yoga, the court ruled, after a week-long trial, that a franchisor of yoga studios breached an asset purchase agreement (“APA”) with one of its franchisees by refusing to purchase the franchisee’s assets due to COVID. In the APA, which was signed in November 2019, the franchisee represented that no “material adverse effect” (“MAE”) - defined as a “material and adverse effect on the business, assets, liabilities, financial condition, property or results of operations of the Seller, taken as a whole” - “has occurred”.

On March 26, 2020, after the franchisor and franchisee had both shut down their respective yoga studios due to COVID, the franchisor declared that the APA was no longer valid based in part on the franchisee’s alleged violation of the MAE clause. The franchisor argued in court that “the effects of the COVID-19 pandemic caused [the franchisee] to breach” the MAE clause. The court rejected the franchisor’s argument and ruled that there had been no MAE.

The court noted that the franchisor’s own actions in March 2020 indicated that “it did not believe the COVID-19 pandemic would persist for any durationally significant period.” Specifically, on March 19, 2020, the franchisor certified to its own lender that it had neither endured nor expected to endure an MAE, and on March 20, 2020, the franchisor’s management forecast to its board that COVID-19 studio shutdowns would last only six weeks.

Also, the court pointed out that even though “the concept of material adverse effect is inherently forward looking” because “the value of a company is determined by the present value of its future cash flows”, the MAE clause in the APA did “not contemplate that the parties will undertake a forward-looking analysis when assessing whether an MAE has occurred.” Specifically, the APA referred to whether a MAE “has occurred”, not whether, for example, one “is reasonably expected to” occur.

Further, the court ruled that regardless of whether COVID ultimately had an adverse effect on the franchisee’s business, “at the time [the franchisor] purported to invoke the No-MAE Representation [i.e., in March 2020], there was absolutely no basis for [the franchisor] to conclude that the business effects of COVID-19 were then, or later would be, significant.” (emphasis added) The court noted that none of the franchisor’s witnesses testified that they had analyzed whether the franchisee had experienced a MAE in March 2020, when the franchisor declared the contract invalid.

c. Takeaways

We think these cases provide the following lessons:

1. In determining whether a borrower has experienced a MAC, the focus should be on whether there are measurable changes to the borrower’s financial condition that jeopardize the bank’s position, not on (as stated in the Bank of China case) changes to “markets or economic conditions that might impact” the Debtor. In other words, it is not prudent to assume that changes in the economic environment by themselves - even ones as dramatic and negative as the COVID economic shutdown - constitute a MAC.

2. Read the MAC clause carefully. In the Level 4 Yoga case, the MAE clause clearly was not forward looking - it referred to only whether a MAE “has occurred.” Yet the franchisor went to trial without a witness who could testify that a MAE had occurred when the franchisor invoked the MAE clause. The franchisor might have assumed it was on solid legal ground because COVID was likely to harm the franchisee’s business in the future, but the language of the MAE clause did not support that assumption.

3. Before invoking a MAC clause, consider whether the purported MAC is unique to the borrower and, if not, whether the MAC will be invoked against other similar borrowers. In the Level 4 Yoga case, the franchisor’s clear hypocrisy - invoking the MAE clause against the franchisee while at the same time telling its own lender that it had not experienced a MAE (even though the franchisor and franchisee both operated yoga studios) - made it easy for the court to rule that there had been no MAE. However, if a lender has done the right analysis before invoking a MAC clause - i.e., an analysis focused on whether there are measurable changes to the particular borrower’s financial condition that jeopardize the bank’s position - that should help to neutralize any argument that the MAC was not fairly invoked based on how the lender dealt with other similar borrowers.

II. Bankruptcy News

On March 28, 2022, the debt limit for Subchapter V small business bankruptcy filers reverted from $7.5 million to $2,725,625. Then, on April 1, 2022, it increased to $3,024,725 pursuant to regular adjustments that are prescribed by the Bankruptcy Code.

We have written about Subchapter V small business bankruptcy before, and those articles can be found here and here.

In March 2020, in response to COVID, Congress increased the debt limit for Subchapter V from $2,725,625 to $7.5 million. Congress renewed that increase in 2021, with a sunset date of March 27, 2022. On March 14, 2022, Senator Grassley introduced a bill to make the $7.5 million debt limit permanent. However, due to other matters on the legislative calendar, Congress was unable to address Senator Grassley’s bill by the sunset date. Nonetheless, Senator Grassley’s bill has wide bipartisan support, and a permanent increase to $7.5 million is likely to become law in the near future.

Subchapter V continues to be popular, comprising almost 40% of all Chapter 11 filings in 2021, and 55% of all Chapter 11 filings in the quarter of 2022.

Chapter 11 bankruptcy filings increased to 292 in March 2022, from 203 in February 2022, with much of that increase attributable to a late-March surge in Subchapter V filings that was due to the impending decline in the Subchapter V debt limit. Nonetheless, both business and consumer bankruptcy filings saw a significant surge in March 2022 relative to February 2022, with business filings up 26% and consumer filings up 34%. This month-to-month surge comes, however, amid a year-to-year decline in bankruptcy filings, with first-quarter 2022 business filings down 25% from the first quarter of 2021, and first-quarter 2022 non-business filings down 16% from the first quarter of 2021. March often sees an increase in bankruptcy filings, so it remains to be seen whether the significant jump in bankruptcy filings in March 2022 is actually a harbinger of a longer-term increase in filings.

Neil McCullagh works with banks on a wide variety of issues, including lending, insolvency, workouts, creditors’ rights, bankruptcy, and collections.

About the Author

Neil E. McCullagh is an attorney who works with banks on a wide variety of issues, including lending, insolvency, workouts, creditors' rights, bankruptcy, and collections.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.