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Financial Services FLASHPOINTS December 2018

December 14, 2018Print This Post Print This Post

Michael L. Weissman, Levin Ginsburg, Chicago
312-368-0100 | E-mail Michael L. Weissman

This month we consider what exactly is a material adverse effect (MAE), what must be shown to evidence a violation of the Equal Credit Opportunity Act, and what happens when London Interbank Offered Rate (LIBOR) disappears.

What Is a Material Adverse Effect?

Search virtually any loan agreement and you will find a reference to default that includes (as an example) the following:

Any event shall occur that, in Lender’s opinion, has a material adverse effect on the collateral, or Borrower’s financial or business conditions, operations or prospects.

Or that reads as follows:

The entry of any judgment, decree, levy attachment, garnishment or other process and such judgment or other process would have a material adverse effect on the ability of Borrower to perform under this Agreement.

Or, if it is related to periodic disbursement of loan proceeds, reads as follows:

The obligation of the Bank to disburse or make all or any portion of the Loans is subject to satisfaction of all of the following conditions:

( ) There shall not have occurred any event having a material adverse effect on Borrower.

But just what is a material adverse effect (or material adverse event)? Even though the phrase repeatedly appears in loan agreements, there typically is no definition of the term, and, when questioned, lending officers, borrowers and their respective counsel are unable to provide one.

That is why the decision in Akorn, Inc. v. Fresenius Kabi AG, No. 2018-0300-JTL, 2018 WL 4719347 (Del.Ch. Oct. 1, 2018), is important even though it does not involve a financial institution. For the first time, a Delaware court, where much financial litigation occurs, has put some meat on the bones of the phrase.

Fresenius Kabi AG, a German pharmaceutical company, signed an agreement to merge with Akorn, Inc., a U.S. pharmaceutical company on April 24, 2017. Closing was to occur in 2018. The acquisition was conditioned on (1) the truth of Akorn’s representations at closing, (2) Akorn continuing to operate its business as it had in the past, and (3) the nonoccurrence of a MAE.

During the preceding five years, Akorn had experienced healthy growth. That continued during the first quarter of 2017. But then the roof caved in — quite suddenly. Akorn lost a major contract and regulatory issues were raised by the FDA.

For the entirety of 2017, Akorn’s revenue declined by 25 percent, operating income dropped by 105 percent, and earnings before interest, taxes, depreciation, and amortization fell by 86 percentage. Obviously, the three quarters of 2017 that followed the execution of the merger agreement were disastrous.

In addition, the FDA received letters from whistle-blowers complaining about Akorn’s data security system. The FDA investigated and found that after signing the merger agreement, Akorn had canceled its regularly scheduled audits of its data security systems, failed to cure deficiencies, and made a misleading presentation to the FDA.

Faced with that, Fresenius elected to terminate the agreement. When Akorn sued to force Fresenius to adhere to the contract, the Delaware Chancery Court ruled in favor of Fresenius.

Although the court bolstered its conclusion by finding Akorn had breached the representations it made in the merger agreement and failed to continue to operate its business as it had in the past, the crux of the decision was premised on its finding that a MAE had occurred. The court said that a MAE must “substantially threaten the overall earnings potential of the [borrower] in a durationally-significant manner” and that the relevant period of the MAE should be “measured in years rather than months.” 2018 WL 4719347 at *53. Applying those criteria, the court had no difficulty in ruling for Fresenius. The financial data told the tale.

What is notable about this case is that it is the first time a prestigious court has articulated what a MAE is. However, an appeal is likely, so there is more to come.

What’s the point? Lenders faced with an unanticipated significant long-term earnings slump by a prospective borrower after executing a commitment letter now have a way to reject the transaction based on a MAE. The same would apply to a multi-advance loan in which each advance is based on the absence of a MAE. But the Delaware court did state that it was not establishing a bright-line quantitative test. Other surroundings, circumstances are not to be disregarded.

Equal Credit Opportunity Act Lawsuit Failed for Want of Issue of Material Fact

In a per curiam opinion, Sims v. New Penn Financial LLC, No. 18-1710, 2018 WL 5076136 (7th Cir. Oct. 18, 2018), the United States Court of Appeals for the Seventh Circuit sustained a lower court’s ruling that claimants had not produced adequate evidence of racial discrimination to maintain an action under the Equal Credit Opportunity Act (ECOA), 15 U.S.C. §1691, et seq.

Mario and Tiffiny Sims, an African-American couple, purchased a home in South Bend, Indiana, from John Tiffany in October 2008 for $185,000. They made a $12,000 down payment and paid $1,400 per month for approximately one year thereafter. Apparently, the purchase was on a contract for deed.

Then, in December 2009, they were surprised to receive a notice of intent to foreclose from Bank of New York Mellon. The seller, John Tiffany, had ceased making mortgage payments in May 2009 when the mortgage balance was $126,000.

To avoid foreclosure, the Simses undertook to assume the unpaid mortgage debt beginning in January 2010. By the terms of the mortgage, purchasers of the property could assume the debt so long as they provided information necessary for the lender to evaluate them “as if a new loan were being made.” 2018 WL 5076136 at *1.

The Simses alleged that they tried to assume the debt for four years but were never provided with the questions they needed to answer for their evaluation.

In 2012 the Simses obtained a quit-claim deed from Tiffany, but in 2013 the bank commenced foreclosure proceedings.

A new loan servicer, Shellpoint, entered the scene in March 2014. Nine months thereafter, the Simses were told what information they had to provide in connection with their application to assume the mortgage debt. Foreclosure was postponed.

The Simses alleged they sent the requested data to Shellpoint three times, but Shellpoint’s position was that the data submitted was incomplete. And Shellpoint advised the Simses they needed to bring the loan current in order to assume it. That was a sticking point.

A conversation occurred subsequently that led to the Simses’ allegation that they were not being permitted to assume the loan because of their race. In a conversation with a Shellpoint employee, believed to be African-American, they allegedly were told, “These people, you know how they treat us.” 2018 WL 5076136 at *2.

The Simses filed suit, claiming, among other things, a violation of the ECOA because Shellpoint had discriminated against them due to their race by delaying their efforts to assume the debt and insisting they pay all of Tiffany’s past due debt, a requirement they allege that was not in the recorded mortgage.

The Seventh Circuit ruled against the Simses because they had not produced sufficient evidence to establish a dispute of material fact. As to the telephone conference, the court said it was too “vague and requires too much speculation to conclude that their race motivated Shellpoint to require them to satisfy Tiffany’s outstanding loan payments.” 2018 WL 5076136 at *2.

What’s the point? The Seventh Circuit’s decision makes it clear that a claim of racial discrimination under the Equal Credit Opportunity Act cannot stand solely by implication but requires proof of an unequivocal act of discrimination.

What Happens When LIBOR Disappears?

Stewart Bishop wrote:

A Citigroup Inc. unit has agreed to pay $100 million to 41 U.S. states and the District of Columbia for manipulating its U.S. Dollar London Interbank Offered Rate submissions in order to dodge bad publicity, prosecutors said [in June of this year]. Stewart Bishop, Citi To Pay States $100M For Libor Rigging, Law360 (June 15, 2018).

Barbara D. Underwood, the Attorney General of New York, said the $100 million deal will resolve allegations of LIBOR-rigging against Citibank NA. It is matters such as this, in the United States and elsewhere, that have caused the forthcoming demise of LIBOR.

According to Fran Garritt and Frank Devlin,

[LIBOR] has had a long and influential run. Devised in 1969 as a method to price a syndicated loan deal with the Shah of Iran, Libor, which is an estimate of the interest rate that London banks would pay to borrow from each other, was later formally published by the British Bankers Association and grew to become an international go-to benchmark.

Today, an estimated $160 trillion of U.S. dollar exposures is tied to the swings of Libor.

* * *

But now Libor’s days of influence may be numbered. Fran Garritt and Frank Devlin, Closing the Door on Libor, RMA J. (June 2018).

If things go according to plan, LIBOR will be replaced by alternative risk-free reference rates based on transactions that include overnight funding and repurchase agreements.

[In July 2017], Andrew Bailey, chief executive of the U.K. Financial Conduct Authority (FCA), the agency that oversees Libor, announced that the 20 rate-submitting banks have agreed to contribute to Libor until the end of 2021. While banks may voluntarily submit rates thereafter, Bailey has said that the FCA will not compel them to do so. Most in the industry agree that the FCA’s announcement sounded the death knell for LIBOR.

Libor came under scrutiny with coverage of the manipulation scandals emanating from the financial crises. To either downplay their credit problems or enhance their market gains, some banks participating in Libor-setting were gaming the rate by understating or overstating their perceived borrowing rates.

In response, the FCA stepped in to oversee Libor regulation. In 2014, Libor underwent the transition to a new administrator, the [Intercontinental Exchange] Benchmark Administration, which has taken steps to formalize the rate submissions process and establish an oversight committee. However, despite these efforts to professionalize the rate and the submission process, Libor has continued to lose the industry’s confidence.

* * *

Federal Reserve Chairman Jerome Powell has said that “LIBOR may remain viable well past 2021, but we do not think that market participants can safely assume that it will.”

* * *

For U.S. dollar transactions, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) has recommended replacing U.S. Libor with the secured overnight funding rate, or SOFR [a rate based on the overnight cost of borrowing cash collateralized by U.S. Treasury securities].

* * *

The end of 2021 may seem distant, but many in the industry believe that achieving the switch to new benchmarks in less than four years is an aggressive goal. To be sure, many say, market participants and regulators must begin acting now to be able to ensure a smooth transition.

* * *

Transitioning to SOFR will necessitate adjustments. Whatever those may be, industry groups are stressing that they should be simple, transparent, fair, and minimize “winners and losers.”

* * *

Some industry watchers fear that banks will feel pressured to sacrifice spreads and reprice transactions to the benefit of borrowers rather than face their wrath. Any such losses would be on top of the millions of dollars the transition will cost banks and the industry.

* * *

Many transactions include language regarding fallback rates should Libor become unavailable. Id.

Examples of these fallback rates are the federal funds rate, the prime rate, or a rate that a lender will, in its sole discretion, select in the future. But some don’t. Phillip W. Field of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., proposed:

A simple, if vague, solution is to require the lender to use “good faith” in determining a “reasonable” substitute rate, instead of allowing the lender to select a rate in its sole discretion. Borrowers preferring more specificity can reference the post-LIBOR prevailing industry standard or the rate adopted by a specific banking authority or trade organization . . . . Another option is to adjust the spread so that the “all in” rate on the date that the interest rate converts to a substitute is equal to the “all in” rate on the last determination date LIBOR was available. This avoids a sudden jump in interest expenses, with the caveat that the borrower still needs to be careful in negotiating the underlying substitute rate.

These are just a few examples of the options available to lenders and borrowers. Whatever language they may agree upon, [lenders] should take care to at least raise LIBOR’s phase-out with their [clients] and [discuss] the best approach. The transition away from LIBOR promises to be orderly, but it is best not to be caught unaware. LIBOR Phase Out: Important Considerations for Negotiating Loan Documents, Mintz Insights Center (May 24, 2018).

What’s the point? If existing fallbacks in loan agreements fail to provide parties with a rate, and the parties fail to agree on an alternative rate, contracts will be terminated or end up in litigation.

For more information on Financial Services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION — 2018 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.

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