As a result of the spread of COVID-19, the shipping industry is one of many contending with a global crisis. We have received numerous queries from concerned lenders and borrowers as to the potential effect of the crisis on their English law loan facilities and the following is intended to address at least some of these concerns.
However, each facility agreement is different and, as with any contract, the devil is in the detail, so a review of the relevant agreements is vital before any action should be taken. So far there has not been any UK government intervention which directly affects the issues touched upon in this briefing, but government policy is constantly evolving in response to the crisis so this might yet come.
WHAT PROVISIONS COMMONLY SEEN IN A SHIP FINANCING FACILITY AGREEMENT MIGHT BE TRIGGERED BY THE CURRENT GLOBAL PROBLEMS?
Any breach of a provision of a facility agreement is likely to constitute an event of default either immediately or after a contractual grace period which will entitle the lenders:
• to accelerate outstanding amounts; and
• to refuse to comply with a utilisation request.
Each facility agreement is different, but the following are standard ship finance facility provisions that are particularly relevant:
These are always deal-specific but the following are the most common:
• EBITDA and similar covenants: A significant fall in group-wide income might also trigger a breach of financial covenants set in relation to the guarantor or topco borrower. However, as these are usually tested by reference to annual audited accounts or semi-annual accounts, it is likely to be some time before a breach will be shown to have occurred.
• Loan to value: A global downturn in the shipping industry is very likely to have an adverse effect on vessel values. Ship values are volatile at the best of times and this is one area where the effect of COVID-19 is likely to have a more immediate and measurable impact where (as is usually the case) the loan facility includes loan to value provisions although often valuations are restricted to set times in each year which might give the relevant borrowers some breathing space.
• Covenant status: One sometimes sees provisions requiring a guarantor to have a minimum share price or rating (such as with Moody’s or S&P). Both are likely to be affected by the global downturn.
• Fall in income stream: It is rare to see income stream covenants looking at charter income (unlike in real estate finance where lease income is often carefully monitored). However, in more structured deals where the loan repayments rely on specific charter income, breach by the relevant charterer of its obligations under the charter might trigger a default as might reliance by the charterer on a force majeure clause, depending on how the events of default have been drafted.
Surveys and certification are likely to be delayed owing to COVID-19 which might result in breach of class requirements. However, this is something that flag states seem to be considering and it is likely that waivers and extensions will be available in most jurisdictions.
While governments and some lenders are already talking about offering these, many facility agreements will include, as an event of default, where the borrower/an obligor “by reason of actual or anticipated financial difficulties commences negotiations with one or more of its creditors, excluding any finance party in its capacity as such, with a view to rescheduling its indebtedness”. This is therefore unhelpful for groups talking to their lenders, particularly where there are cross guarantees in place or where a company has multiple facilities. Owners will need to navigate around this carefully.
Laying up ships/cessation of business
Where a ship is not being utilised, its owner may consider laying it up in order to reduce costs until such time as the world returns to normality and this is something that many cruise operators must be considering. However, most ship facilities include a covenant prohibiting the de-activation or laying up of the relevant ship. Even where no such covenant exists, such an action may well trigger what is an LMA standard event of default, namely that the borrower/an obligor suspends or ceases to carry on all or a material part of its business. This latter provision might be qualified that such cessation is likely to have a “Material Adverse Effect” but generally not in relation to the borrower. Shipowners will have to consider carefully how to temporarily suspend or curtail vessel or more general operations without triggering either of these provisions.
Material Adverse Effect
Unfortunately, again, this point is, to a certain extent, dependent on the drafting in the agreement and there is no ‘market standard’ definition or agreed wording for the event of default with the LMA offering various different definitions, all of which are in square brackets as this is often a point that is heavily negotiated. However, in some form or another, the events of default will invariably include the occurrence of an event that constitutes (or in many cases is only reasonably likely to constitute) a Material Adverse Effect.
Lenders are, however, very wary of relying on such provisions, unless they are very certain that the provision has been triggered since a failure to fund or an acceleration in breach of their contractual obligations would most likely result in them being obliged to pay substantial damages as well as the accompanying reputational damage.
In the current situation, a number of factors suggest that it unlikely that lenders will seek to rely on COVID-19 as having a Material Adverse Effect:
• The change cannot simply be temporary – a permanent adverse effect needs to be shown and it is accepted that global pandemics do subside;
• The lender needs to provide evidence that there is an adverse effect on the relevant obligor and as we saw in relation to the financial covenants, such evidence might well not be immediately available and, if it exists, will more likely be used in relation to a potential breach of any financial covenants. A lender cannot simply point to general economic or market changes and say that these must have an adverse effect;
• A change in financial condition is only going to be materially adverse if it significantly affects the company’s ability to perform its obligations under the relevant finance documents or simply its payment obligations (depending on the drafting). If it is currently performing them then that is very hard to prove and, if it is not, no doubt other events of default will have already been triggered;
• A lender cannot rely on a Material Adverse Effect based on circumstances of which it was aware when it entered into the agreement so it could not be used for facilities entered into following the emergence of COVID-19;
• There is also case law that might be relevant if the adverse effect is ‘in the reasonable opinion of’ the majority lenders or that the effect is ‘reasonably likely’, both of which are fruitful areas for potential litigation were the lenders to seek to rely on the provision; and
• Lenders we have been speaking to have indicated that they are not looking to rely on this provision in relation to COVID-19.
OTHER THAN OWING TO THE OCCURRENCE OF A DEFAULT/EVENT OF DEFAULT, ARE THERE ANY OTHER COMMON PROVISIONS THAT MIGHT ENTITLE LENDERS TO AVOID MAKING FUNDS AVAILABLE?
LMA style facility agreements generally include provisions including the concept of a “Disruption Event” which includes a banking system failure which could be a consequence of the global pandemic. However, although such a failure might prevent the lenders from funding, there is nothing specific in the LMA agreements that excuses the lenders from meeting their funding obligations as a result of a disruption event.
Difficulty in sourcing relevant currency
If LIBOR should temporarily cease to be available owing to problems arising from COVID-19, standard LMA provisions simply include a number of fallbacks to establish a rate, ending with cost of funds. However, some facilities do include a provision that entitles lenders to refuse to advance new loans if they are unable to obtain the currency of the loan which, in theory might be triggered if the markets became badly affected. It is not an LMA provision however and is rare as borrowers understandably dislike it and it is hard for lenders to justify, particularly in respect of ‘major’ currencies such as US dollars. There is some evidence that certain lenders are currently seeking to bolster protections for difficulty in funding but, given that this was not introduced following 2007 (when bank liquidity was a major issue) it seems hard to justify now, particularly where bank liquidity should have been bolstered by Basel III measures.
OTHER FACTORS TO CONSIDER
Even if the loan to value covenant is not being breached, lenders might be concerned that the borrower’s ship is being under utilised resulting in a cash flow shortfall. They should bear in mind that most ship finance facilities include wide ranging information covenants enabling the lenders to obtain information about the relevant ship’s employment which can be used to trigger a discussion with the relevant borrower and any guarantor as to how any shortfall will be met rather than waiting until a payment default occurs.
This is not a concept seen in loan documentation but a force majeure clause is invariably included in commercial contracts such as charters and shipbuilding contracts. A force majeure clause may excuse one or sometimes both parties from performing all or certain of its obligations under a contract following the occurrence of specified events which are outside the relevant party’s control. If validly triggered, the party relying on the clause is not liable for the consequences of its non-performance or delay in performance. We are already seeing such clauses being invoked in the context of shipbuilding contracts where the clauses typically operate in favour of the shipyard only and entitle the shipyard to an extension of the contractual delivery date for a period equivalent to the delay in delivery caused by the delaying event (rather than the duration of the delaying event itself). Buyers under shipbuilding contracts may not be able to invoke these clauses to delay payments of instalments that have fallen due. However, where the due dates in question are linked to the achievement of particular physical construction milestones by the shipyard, one of the consequences of the force majeure event may, of course, be to delay the achievement of the relevant milestone and therefore, in turn, the payment due date. In the same way that we have seen these clauses invoked by shipyards, we expect the same will happen in relation to charters, resulting in other potential problems for owners.
Other than force majeure, COVID-19 gives rise to a number of other areas of potential dispute and difficulty under charterparties, engaging specific provisions such as: off-hire; safe port, laytime and demurrage and quarantine. While serious, with the notable exception of prolonged off-hire, these issues are unlikely in themselves to have a direct impact on an owner’s financing arrangements. In recent weeks ‘COVID-19 clauses’ favourable to owners have been developed, in particular by BIMCO and Intertanko. It is possible that, ultimately, the doctrine of contract frustration could be invoked but we do not think we are yet in a situation where that is likely to be invoked successfully. Stepping back from the legal issues to the wider context, the operational and logistical challenges which COVID-19 presents to the shipping industry cannot be over-estimated but are outside the scope of this note.
Avoid the occurrence of an event of default
It is generally better for borrowers to discuss potential defaults sooner rather than later and seek and obtain waivers or amendments. Failure to do so might have a knock-on effect and result in cross defaults in relation to otherwise performing loans, particularly in relation to a guarantor. Rather than agonising over the wording of the relevant agreement, in the current extraordinary situation, it might be preferable to talk to the relevant lenders. The COVID-19 crisis will be transient and should not affect long-term demand in the industry. Where lenders think a borrower’s problems are only a result of the current crisis, they should appreciate that value can often be preserved by working with the relevant borrower rather than rushing into enforcement. From talking to our banking clients, the general impression is that they are sympathetic, acknowledging that this is an unprecedented event, and are keen not to be seen to be taking advantage of it.
Business Interruption Insurance
Notwithstanding the government’s announcement that insureds should be entitled to rely on business interruption insurance as a result of not being able to operate owing to COVID-19, it remains to be seen how insurance companies deal with claims.
Source: Watson Farley & Williams LLP