Loan agreements: Political risk default trigger needed?
The recent coup attempt in Turkey is causing lenders to think about including in loan agreements a political risk clause that allows the lenders to call an event of default in case of political unrest.
The Loan Market Association suggests wording in its developing markets template loan agreement, but there is no universally accepted version of this. Many variations are possible, but two fundamental variants can be identified.
One is an unqualified political risk clause.
The other is a political risk clause that is qualified by materiality, for example, by being subject to the risk event having a “material adverse effect” on the borrower.
The unqualified clause has the advantage that the mere occurrence of a political risk event triggers an event of default, entitling the lender to stop funding the borrower, placing the facility on demand or demanding immediate repayment of all disbursed loans. Risk events that are typically covered include war, hostilities, invasion, armed conflict, revolution, and insurrection or insurgency. So an attempted coup d’etat by force of arms will trigger the clause, even if the coup is put down swiftly.
By contrast, the qualified clause requires the effect of the risk event on the borrower to be assessed. The lender must wait and assess the consequence or, depending on the wording of the qualification, the reasonably likely consequences of the risk event, before it becomes entitled to take any action, although certain rights may be triggered earlier, especially the right to request enhanced reporting or information from the borrower. It will depend on the wording of the qualifier how long the lender must wait and what assessment is required to trigger the event of default.
Borrowers usually resist inclusion of political risk events of default, since political events are not within a borrower’s control.
Lenders are tempted to concede the point either by agreeing to a qualified clause or by dropping the requirement altogether. Unless the decision is made on the basis of a principled risk assessment of the relevant jurisdiction, lenders tend to convince themselves with the following argument: “If there were to be political unrest, first, we will have other problems altogether and, second, we would be protected by our material adverse change clause anyway.” Let’s analyze these considerations in turn.
It may be true that incidents of political unrest cause wider problems that will affect the lender’s activities in the relevant country. However, it is not obvious that such impacts will be immediate, even though they may be foreseeable.
Broadly, the possible ramifications of political unrest fall into three categories.
The first is contractual breach. The political unrest means the borrower cannot perform its obligations under the loan agreement or other finance documents, like the security agreements, cease to be enforceable or otherwise lose value. This can take many forms: for example, the borrower’s business may be interrupted, and currency regulations may be imposed so that payments cannot be made.
Another potential ramification is illegality. After the political unrest has played out, the lender is no longer permitted to do business in the country of the borrower or with the borrower. For example, there is a regime change and sanctions are imposed by the lender’s home government.
Another possible ramification is strategic withdrawal. The affected country is no longer a place where the lender is comfortable conducting business. A strategic commercial decision is made in the bank to withdraw from that market. This could be the case, for example, if the result of political unrest is that the reliability or impartiality of the civil administration or judicial services in a country is eroded.
The “other problems” claim holds up only for the first two categories: contractual breach and illegality. Strategic withdrawal is not a reason for terminating a loan agreement. Thus, lenders would have to seek a buyer for their engagement to exit the investment and, following the political unrest, this may be difficult.
Also, contractual breaches or changes in the law leading to unlawfulness may not manifest themselves immediately. For example payment default may not become apparent until a payment milestone is reached and the borrower fails to pay. In other words, the lender will have to wait until breaches actually occur or become inevitable before being able to take action.
So, the political risk clause has real value, because it allows the lender to take swift action, effectively placing the facility on demand, as soon as an event of political unrest has occurred. This increases the options available to the lender and adds protection, in case the fallout from the political unrest is such that the lender wishes to withdraw from the engagement for reasons not otherwise captured in the facility documentation.
The limitations of the material adverse change or “MAC” clause are well known, and a full discussion of why lenders tend to be reluctant to invoke it is beyond the scope of this article. Suffice to say that the main limitation of the MAC clause is that it requires the bank to make a decision about whether the political risk event has a material adverse effect on the borrower as stipulated by the specific wording of the MAC clause itself.
Unless a breach of another representation or covenant occurs in the meantime, whether a material advance change has occurred may not become clear until the political risk event has moved into a more advanced stage, at which point matters may be worse for the borrower or the lender. Thus, the MAC clause cannot give the same comfort as a political risk clause.
Further, when negotiating any qualifications to the political risk clause, it should be borne in mind that a qualification by reference to material adverse effect can result in the political risk clause collapsing into the MAC clause, so that its value is eroded.
The bottom line is there is value to a lender in an unqualified political risk clause.
It offers protection that goes beyond the standard repertory of covenants and events of default. A MAC provision is not a substitute. The decision not to insist on a political risk clause should be made on the basis of an assessment of the degree of political risk to which the relevant country is exposed and the lender’s appetite for that risk.