The Supreme Court of New South Wales has dismissed proceedings1 commenced by the lenders of collapsed mining and steel giant Arrium (Lenders) against the treasurer, CFO and three other employees (Employees).
The Lenders commenced these proceedings alleging that several drawdown and rollover notices issued on behalf of Arrium as borrower in the months prior to the administration contained false representations. The Lenders claimed the Employees as signatories were liable for the false representations that had led them to provide further financial accommodation. The false representations claimed by the Lenders were that there had been no change in Arrium’s financial position constituting a ‘material adverse effect’ and that Arrium was solvent at the relevant times.
The first in our series of articles concerning the decision (link found here) explained why the Court found Arrium was not insolvent at the relevant times.
This article explains the Court’s findings about whether there had been a material change in Arrium’s financial position.
Material adverse effect representation
The facility agreements required Arrium to confirm there was:
“…no change in the Group’s financial position since the end of the accounting period for its most recent Accounts…which constitutes a Material Adverse Effect;”
The drawdown notices signed by the Employees repeated this warranty at each drawdown.
The Lenders argued there had been a change in Arrium’s financial position that did constitute a ‘Material Adverse Effect’ during the critical period from December 2015 through to February 2016.
‘Accounts’ was defined to mean:
- consolidated balance sheet;
- income statement;
- cash flow statements; and
- statements, reports (including, without limitation, any directors’ reports and auditors’ reports) and notes, if any, attached to, or intended to [be] read with any of them prepared in accordance with Australian Accounting Standards.
‘Material Adverse Effect’ was defined to mean “any thing which has a material adverse effect on a member of the Relevant Group’s ability to perform the obligations under a Transaction Document”.
In short, the representation was true if either of the following two limbs were satisfied:
- There was no change in Arrium’s ‘financial position’ between the relevant drawdown dates and either 31 December 2012 (in the case of one loan) or the date up until when Arrium’s last published accounts were prepared, being 30 June 2015 (in the case of the other loans); or
- If there was a change in Arrium’s ‘financial position’, that change did not have a ‘material adverse effect’ on Arrium’s ability to perform its obligations under the facility agreements which included its obligation to repay outstanding amounts when they were due to mature approximately 18 months in the future, in July 2017.
Critically, the second limb was not drafted to depend, as is generally the case, on the lenders’ reasonable opinion; it was to be assessed objectively.
What is a ‘change’ of ‘financial position’?
A key question for the Court was what exactly the parties intended the expression ‘financial position’ to mean in the context of the representations.
The Employees argued Arrium’s financial position should be assessed by looking at the balance sheet only, i.e. assets versus liabilities. This is consistent with the recognised technical accounting meaning of ‘financial position’ and would also enable the comparative exercise to be undertaken. In other words, has the balance sheet changed between the two relevant dates?
The Lenders said ‘financial position’ is intended to refer to the entire financial circumstances of a company requiring a review of all the financial information contained in the ‘Accounts’. The Lenders claimed ‘financial position’ has a broad ordinary meaning encompassing any change relating to Arrium’s business that had an impact on its ability to comply with its financial obligations, including obligations under the relevant facility agreements.
The Court held that any dispute concerning a word or phrase which has both an ordinary meaning and a recognised technical meaning is to be resolved in accordance with ordinary principles of contractual interpretation, namely what a reasonable businessperson would have understood the phrase to mean. This requires consideration of the language used, the surrounding circumstances and the commercial purpose of the contract.
Notwithstanding the lack of precision in the drafting of the relevant clauses, in circumstances where Arrium was obliged to provide the Lenders with half yearly and end of year accounts, not just a balance sheet, the Court concluded the reference to ‘financial position’ meant more than just the information contained in a balance sheet.
The Court’s interpretation of the expression ‘financial position’ was complicated by the use of the phrase ‘financial condition’ when referring to Arrium’s financial circumstances more broadly. The Court commented that the “far from perfect” drafting suggested the drafter had not paid close attention to the way the clauses fit together and undermined the argument that the expressions were intended to have different meanings.
Ultimately, the Court rejected both sides’ arguments and preferred its own intermediate interpretation of ‘financial position’. The Court determined that ‘financial position’ meant the information contained in the ‘Accounts’ and given the Lenders received those documents on a 6-month basis, the ‘change’ would have had to have occurred in the period between the last time those accounts had been provided to the Lenders and the time the drawdown notice was issued.
A ‘material’ ‘change’?
The parties made extensive submissions on the meaning of ‘material’ in the context of a material adverse change clause by reference to other cases.
Whilst it was common ground that ‘material’ in this context meant significant or substantial, the Court held the expression must be construed in the context in which it appears, and that other cases are of limited assistance.
As mentioned above, the Court needed to conduct an objective assessment as to whether the changes in Arrium’s ‘financial position’ between December 2015 and February 2016 identified by the Lenders had a ‘material adverse effect’ on Arrium’s ability to perform its obligations under the facility agreements. Which, most relevantly, included an obligation to repay all outstanding amounts when the loans were due to mature approximately 18 months in the future, in July 2017.
The Court considered four categories of changes in Arrium’s financial position from the information contained in its ‘Accounts’:
- changes in net assets;
- changes in profitability;
- changes in the gearing ratio (the ratio of consolidated net financial indebtedness to consolidated net financial indebtedness plus consolidated net worth) and interest cover ratio (ICR) (the ratio of EBITDA to debt service for any rolling 12-month period ending on a reporting date); and
- the board’s decision on 11 February 2016 to include a note in the ‘Accounts’ expressing doubt about Arrium’s ability to continue as a going concern (Going Concern Disclosure).
The Court found that the substantial changes in net assets and profitability had already been reflected in the July 2015 accounts and the changes from July 2015 to December 2015 were not as significant in comparison. As the Lenders had been provided with the July 2015 accounts, they already knew about those changes and had not raised the issue of a material adverse change in Arrium’s ability to meet its obligations under the facility agreements. In fact, they instead continued to advance money in response to the drawdown notices.
The changes in the gearing ratio and ICR were also not deemed to be material because they were not significant enough to constitute a breach of the relevant covenants under the facility agreements. Critically, the Court found the Lenders failed to prove that any of the first three categories of changes actually had a material effect on Arrium’s ability to comply with its obligations under the facility agreements.
In respect of the last category, the Court held that the Going Concern Disclosure was a change in Arrium’s financial position which had a ‘material adverse effect’. This was because the note indicated the board had formed the view there was a material uncertainty concerning whether Arrium could continue as a going concern, which did not exist as at 31 December 2012 or 30 June 2015.
According to the Court, if Arrium’s financial position had reached the point that warranted the inclusion of that note, it was reasonable to infer there was a material increase in the risk that the Lenders would not be repaid in full as compared with the position as at 31 December 2012 and 30 June 2015. As such, at least in respect of drawdowns and rollovers that occurred before 11 February 2016, the material adverse effect representation was true.
Alternatives for a better outcome
The benefit of hindsight is a powerful thing, but with so much value arguably lost as a result of Arrium’s collapse it begs the question: If Arrium was not insolvent and there had not been a material change in its financial position, why did the board feel it was in a position where it had to appoint voluntary administrators?
As the decision showed, some clearer drafting may have gone some of the way to clarifying what the parties intended in respect of reporting obligations. Lenders should give proper consideration to which changes (if any) in the borrower’s financial position pose the greatest risk to repayment of the loan and ensure those changes are provided for explicitly in the facility agreement.
Even so, there was no allegation that Arrium committed an event of default under the facility agreements at the relevant times, not least because no notice of a potential or actual event of default was given, and Arrium had provided the required financial information to its Lenders. The Lenders were actively monitoring Arrium’s credit risk. If there was a default or a concern, the Lenders should have raised it directly, and in accordance with the terms of the facility agreements.
Arrium had tried to do the right thing – it had engaged a small army of reputable advisors and undertaken a strategic review. Remembering this was all approximately two years before the bulk of the money under the facility agreements would become due for repayment. It had reported on that process to the Lenders. It tried to sell the mining consumables business. It sought alternative financing. It was actively managing cash flow and obtaining updated, more regular financial reporting.
Yet, when the crunch time came, the parties were unable to effect a consensual restructuring. There is no doubt that tremendous value was lost. Lengthy and costly litigation (some estimates are in excess of $100 million in costs) has ensued, for no result. A critical issue throughout the litigation was that insufficient evidence was produced to prove the Lenders’ claims.
One wonders, and doubts, whether this would have happened if the parties had engaged in accordance with INSOL’s Statement of Principles for a Global Approach to Multi-Creditor Workouts II (INSOL Principles). The INSOL Principles advocate a standstill period, a moratorium on enforcement and no action which might adversely affect the prospective return to creditors, co-ordination and information sharing, and priority status for additional funding, among other things. A free flow of information and exploration of all available restructuring options between lenders and the company reduces the risk of unacceptable surprises being presented as done deals.
Perhaps, with the benefit of a consensual approach and clear air to assess, those involved may have seen Arrium’s position for what it was: the temporary effects of the lowest point in the price and demand cycle for iron ore and steel – a position that has since recovered. The sobering lesson for all is that the presentation of a restructuring proposal can matter as much as the substance – particularly where the proposal requires lenders to provide ongoing support and agree to a significant haircut on their debts.
- Lenders should give proper consideration to which changes (if any) in the borrower’s financial position pose the greatest risk to repayment of the loan and ensure those changes are explicitly provided for in the facility agreement.
- Material adverse change and event of default clauses must be drafted precisely and clearly to give effect to their intended purpose; circularity or redundancy in language must be avoided.
- Unless drafted to cover objectively identifiable facts, material adverse change clauses can be difficult to enforce.
- Precisely define words or phrases which have both an ordinary and recognised technical meaning e.g. by reference to accounting standards.
- Subtle differences in language and context can have a substantial effect on the meaning the words convey.
- Pay attention to whether a material adverse change or event of default clause is intended to be judged objectively or on an opinion formed by the lender.
- Lenders who receive accounts under the terms of their facility agreements may be expected to make their own assessment of whether a borrower’s financial circumstances have changed such that any further advances should be refused, and to ask for additional information if they want it.
- If the contractual terms require it, events of default must be acted upon to be relied upon.
1 Anchorage Capital Master Offshore Ltd v Sparkes (No 3); Bank of Communications Co Ltd v Sparkes (No 2)  NSWSC 1025.