Do the veto rights in your finance agreements really give you an absolute veto?

23 October 2017


In the world of finance, provisions in loan agreements which say that consent is needed to lift a restriction or exercise a right are commonplace.

They are also often negotiated into documents as a commercial compromise. However, as we reported in our insight 'How might private equity and venture capital be impacted if a court implies terms into a contract', the courts are starting to turn a much closer eye to the true meaning of consent provisions and how they should be operated. That could mean that where they appear in loan agreements, intercreditor agreements, guarantees, security documents and other finance related agreements, they may over time, come under closer scrutiny from the courts.

What did the case say?

The case of Watson & Ors v Ltd (Watchfinder) said:

  • a clause in a share option agreement, which said that a share option could only be exercised with the consent of a majority of the board of directors, didn't mean the board had an absolute veto to block the option being exercised;
  • instead, the consent provision had the effect of creating a discretionary power to veto the exercise of the option; and
  • in exercising that discretionary power, the board had to act in a manner that wasn't arbitrary, capricious or irrational and have regard to what it should be considering in the circumstances.

How could this case impact your finance agreements?

Consent provisions are common not only in the key finance agreements mentioned above, but also in important ancillary documents such as amendment letters, waivers and reservation of rights letters. These can be important not only from a day one or increase in lending perspective, but also in the context of restructuring arrangements and protecting lenders' legitimate commercial interests.

For syndicated and club finance deals, requests for consent from a borrower will come under the further scrutiny of the syndicate/club. Depending on the subject matter of a consent, either all lenders or a majority/super-majority of lenders will typically have to consent. For intercreditor arrangements, the layers of approval can become more complex still, often depending on the number of secured creditors who have lent to a borrower/borrower group, the types of security that they have taken and their respective exposures.

As a result of Watchfinder, the key questions for lenders and other financiers are:

  • whether they will retain the ultimate veto where finance related rights and restrictions are subject to their consent;
  • if not, how can they protect their veto rights insofar as possible?

To look at these questions, it's worth pausing to look at where these consents might currently be found within finance arrangements.

In what kinds of areas are consent provisions seen in finance documents?

Unfortunately, there is no hard and fast rule on this, as it will always depend on the form of agreement that is used as a starting point and what provisions are added when they are negotiated. However, some typical areas where consent provisions are sometimes seen include:

  • Business restrictions in loan/finance agreements (for example around disposals, acquisitions, other indebtedness), so that the restriction is only lifted where consent is given;
  • Restrictions in intercreditor arrangements (these can be wide ranging and affect areas such as acceptance of payments, enforcement of security and amendments to levels of debt. The lifting of restrictions can require consents from single or multiple classes of creditors such as senior and mezzanine lenders and hedge counterparties);
  • Conditions to side letters (for example as a condition to a waiver of a breach and to allow ongoing monitoring, a lender may impose a restriction around an area of its borrower's business which wasn't of concern prior to the breach, which can then only be lifted with that lender's consent).

Also, consent provisions may not be immediately obvious to the naked eye, because they can be hidden within definitions too (for example a clause may say that a borrower can't make an acquisition other than a 'permitted acquisition' and that definition of 'permitted acquisition' could include a standalone line of 'acquisitions made with the lender's consent').

Will lenders and financiers retain the ultimate veto where the exercise of rights and lifting of restrictions are subject to their consent?

The ruling in Watchfinder means that this won't always be clear, but taking a decision not to consent without exercising sufficient thought around your reasons for that and/or reaching an irrational decision to withhold consent, may raise a few eyebrows with judges and result in the courts substituting their own assessment in place of yours.

Can veto rights be protected in finance arrangements?

Watchfinder has cast some doubt on this, but there are some areas that should be considered that could bolster your protections here:

  • Consider whether you actually need to make a right or restriction subject to consent in the first place

    By making the exercise of a right or the lifting of a restriction subject to consent, you potentially open it up to the treatment in Watchfinder. Whether requiring consents or amendments under agreements, in both cases you are going to need some form of approval process (ideally documented in writing). So, if you can keep a restriction absolute rather than making it subject to consent, that will provide far better protection and avoid the issues in Watchfinder.
  • Make the lifting of a restriction or exercise of a right subject to specified conditions, rather than consent

    Another option is to make it clear that the ability to do something without restriction will only arise if certain conditions are met. However, those conditions should be clear and absolute. Otherwise, if the conditions confer a further discretion on the financier/creditor to decide whether or not that condition has been met, a court might still say that any discretion had to be exercised in a rational, non-arbitrary and non-capricious way.
  • Make sure that records of meetings which look at consents are minuted and reasons for withholding consent recorded

    One of the main failings in Watchfinder was that there was little evidence to suggest that the decision to withhold consent to exercise of the share option had been properly considered in the board meeting. Taking contemporaneous minutes of board and credit committee meetings which give reasoned decisions for withholding consent will provide better protection than refusing to consent, just because the finance agreement says that consent needs to be given.
  • What if I can't avoid having a consent provision?

    It won't always be possible to avoid making rights and restrictions subject to consents, particularly in multi-lender and multi-creditor scenarios. In those situations, should a court decide that a consent provision provided creditors with discretionary powers rather than an absolute veto, ensuring that consents have been considered carefully and in a well-reasoned way will be particularly important. Any parties acting in an agent capacity should also consider ensuring that they have adequate confirmations from other parties where dealing with and/or fronting any consent process. Agents should also ensure that their role is purely administrative, rather than a decision making one.

What's the likelihood of Watchfinder being applied by the courts in a financing scenario?

As our insight 'Risk of challenge to fees charged in finance agreements' shows, Watchfinder isn't the only case where the exercise of discretions has come under recent scrutiny by the courts, so in our view it isn't unlikely that Watchfinder could be applied to lending and finance scenarios.

However, it's important to point out that Watchfinder related to the exercise of a 'right' (namely, the option) that was subject to the consent of another party (the board of directors), rather than a restrictive undertaking that needed to be lifted. So, in the future, a court may only decide to apply Watchfinder to consents that relate only to the exercise of rights. It's also worth noting that this case didn't relate to debt finance, so a court may not necessarily follow the decision in the future where the context is debt finance rather than equity.

However, there is no guarantee of that and courts do sometimes follow and apply principles of law to different scenarios, rather than applying them on a factually rigid basis. In that respect, it's worth saying that where the exercise of a right is subject to obtaining consent, the commercial effect of that is to restrict a party from taking an action unless it gets that consent. And, having a restrictive undertaking (rather than a right) that can't be lifted without consent has the same practical net effect. As such, courts may view consents that affect the exercise of rights or the lifting of a restrictive undertaking in exactly the same way. In due course, it may even extend to the giving of waivers for breaches or defaults.

Where does this leave provisions in finance agreements that say 'consent not to be unreasonably withheld and/or delayed'?

Watchfinder didn't really touch on this. Whilst there is a body of case law that has looked at these types of provisions against sets of different facts, using this kind of language in finance agreements without saying exactly what constitutes 'unreasonably withheld and/or delayed' can be fraught with danger. If the provision that you are trying to protect is really important to you or your exit strategy, it is better to avoid using this type of language in finance agreements, as it can create ambiguity and may prove to be difficult to enforce.

Final observations

Whether or not consent is or isn't granted may also impact in other areas of an agreement. For example, an intercreditor agreement may contain a provision that says that a security agent may if instructed by the majority senior lenders, and if the parent of the borrower group consents, amend security documents.

It is unclear whether a court would say in those circumstances that the parent's ability to veto an otherwise agreed amendment to the security documents was a discretionary, or an absolute one.

For borrowers or creditors requiring consents under finance arrangements, Watchfinder doesn't provide carte blanche to do something if you don't get the consent that you are looking for. Given the complexities of this area of law, if you wish to carry out a restricted action under an agreement where consent hasn't been forthcoming, it is better to seek appropriate advice first, rather than thinking that Watchfinder will come to your rescue if you proceed without consent and an aggrieved counterparty then brings a breach of contract claim.

This is certainly an area that merits further clarity from the courts, but until further certainty is provided, consents in finance documents could remain within the reach of the fuse lit by Watchfinder.

If you have any questions or concerns arising from this article, please contact one of our Banking and Finance experts, who would be pleased to help.

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