Over the course of the last few days, with the dramatic plunge in oil prices and increased concern around the impact of COVID-19 (coronavirus), the need for shipping financiers and owners to consider its implications under their financing agreements has become even more pressing. Before the virus took hold we had already seen challenges facing the industry with IMO 2020, upcoming maturities on facilities and auditors looking hard around the going concern statement. To add further to these challenges with COVID-19 and the oil price deterioration means we are expecting to see real challenges for the shipping sector in the next few months.
There are obvious segments, such as cruise and containers, where we are already seeing issues. Cruise lines are having their credit ratings cut and there is much commentary in the press around the refinancing risk for containership owners. However, the impact will not be limited to cruise and containerships and we are seeing problems elsewhere, including for example, in the offshore sector and the dry cargo segment.
In terms of specific points to flag, the list below is not exhaustive of the issues but highlight the need to consider and take advice on loan agreements given the current crisis.
One of the most pressing concerns we foresee is centred on liquidity. What we have found over the last few years is that liquidity can dry-up very quickly and even where there is a willingness for lenders to provide further financial support, it can be difficult to make this available at short notice. The nature of ship financing and the security package lenders take as part of this makes it difficult for new lenders to make available facilities on a secured basis and the restrictions on incurring financial indebtedness do not typically have baskets permitting new financing. We have seen an increase in sale and leaseback arrangements over the last few years in the shipping sector and although this might be a means to address liquidity needs, such arrangements would typically be restricted by existing facility agreements.
An owner cannot simply “turn off the tap” on incurring opex on vessels, maintaining insurances and even paying for lay-up costs. Forward planning is obviously therefore important should owners think there will be a need for working capital facilities. We have seen companies in the past fall into insolvency precisely because they left it too late to address all the hurdles they face in injecting new money. Owners also need to be aware that negotiations with creditors with a view to rescheduling any of their indebtedness can be an event of default under existing loan agreements, although this typically will exclude such discussions with any existing lender in its capacity as such and just having exploratory discussions is unlikely to trigger such events of default.
Material adverse change
The outbreak of COVID-19 has brought with it much talk of triggering material adverse change or material adverse effect provisions in contracts. It is unlikely that the fact that a party is located in, or is trading to, an area which is affected by the outbreak would of itself constitute a material adverse change in its financial condition (although, depending on the surrounding facts, it might have a material adverse change in its prospects). However if a borrower subsequently experiences financial difficulties as a consequence of the outbreak, then that deterioration in financial condition could constitute a material adverse change in its financial condition.
It has been held that for an event to be material it must (a) not be temporary and (b) significantly affect the party’s ability to perform its obligations under the contract. It is not known how temporary the outbreak will be and, in any event, a temporary event may have permanent consequences. To establish a material adverse change is inevitably going to be a highly subjective process involving careful consideration of the drafting and surrounding circumstances. Nonetheless, where a borrower is suffering financial problems as a result of the outbreak, it is likely that other contractual provisions, such as a breach of a financial covenant, a payment default or the failure to perform an obligation, will also be triggered. It would be much easier to rely upon and enforce those more specific contractual provisions than to argue that a material adverse change has occurred. However, as we discuss further below, parties to financing arrangements will need to be mindful of the material adverse change provisions in their documents and ensure that they are comfortable that obligations around these are being met properly during the outbreak.
Issues under existing financing arrangements
Most loan agreements will contain some form of information undertaking and borrowers will need to ensure that they comply with this. The scope of the undertaking will vary across different facilities and will also be dependent on the nature of the financings; for example, a newbuilding financing will contain wider information undertakings around underlying contracts such as building contracts than a post-delivery facility would. Borrowers will need to look at the nature of these undertakings to see if the effect of the outbreak, or any discussions or processes implemented around this trigger any information requirements. In addition, some information undertakings will give the lenders the right to ask for information and so borrowers will need to ensure that they respond to any such requests within appropriate time limits.
If the loan is not fully drawn, the parties will be examining whether the circumstances will result in a draw-stop, particularly if force majeure has been called in relation to key underlying contracts for the loan agreement – for example, under a building contract in a newbuilding finance. Borrowers will need to look carefully at statements being made in connection with any utilization under a loan agreement. Often conditions’ precedent will require that the borrower confirm that there has not been any material adverse change in the financial situation of the borrower, or the wider group at the time of utilization. Whilst this should not be difficult to confirm for loan facilities that have been signed recently, borrowers will need to give consideration to whether they can make these statements for facilities which were signed before the COVID-19 outbreak.
Events of default
Aside from material adverse change or material adverse effect events of default, which are discussed above, there are a number of other potential events of default which could be triggered as a result of the COVID-19 outbreak, including:
- Non-payment: Depending on the length of interest periods, it may not take long before businesses incur payment defaults. It could be argued that the likelihood of being unable to meet a payment known in advance is an indicator of insolvency or what may be defined as a “default”, being an event of circumstance which may in due course constitute an event of default. However loan agreements typically give debtors the benefit of the doubt until the payment default actually occurs – there is always the chance of an improvement in liquidity or other possible solutions such as third-party funding which could be available before the time comes for payment.
Non-payment may also be an act of repudiation if it evidences an intention not to repay the loan facility although any lender should be careful before placing too much reliance upon such clauses, particularly where it is a temporary state of affairs or where, as is often the case, a borrower is not making an unequivocal statement that would be required to evidence a repudiation event of default .
- Financial covenants and the MVC: If set correctly, financial tests will indicate early signs that a business is not performing as planned and are always a more comfortable default for lenders to rely on without risk of challenge or need to prove materiality. Loss of income and deterioration in asset values are likely to negatively affect financial covenant compliance. Lenders may be kept waiting though by test dates and timely provision of financial information, and financial covenants are commonly backward looking. Furthermore, borrower-friendly markets in recent years have resulted in many “cov-lite” facilities being agreed and as a consequence, breaches of the financial covenants may never be triggered expect in extreme circumstance and long after the borrower has requested new money.
In terms of shipping specific covenants, a tangible net worth covenant, which is typically an all-times test, may present issues as will a minimum liquidity covenant. Although test dates may be some time in the future, the nature of these being all-times tests means these may trigger a default prior to an event of default. In terms of a minimum value covenant, a lender may have a right to call for valuations to be undertaken at any time or the period may be fixed by the loan agreement. Either way, we expect the current volatility in the market will be impacting significantly on broker valuations and if there is a security shortfall on the basis of these, borrowers may face real challenges providing additional security, particularly if they reasonably conclude that such “free” assets may be required to support immediate working capital needs.
- Cross-default: No lender wants to be left out in the cold whilst other creditors are exercising their rights to refinance, require early repayment and/or take enforcement action, and neither do they want to be under a continuing obligation to lend where other creditors are seeking to make recoveries, so most finance transactions will include cross-default provisions by reference to widely defined concepts of borrowings and transactions having a similar commercial effect such as derivatives transactions, finance leases, and counter-indemnity obligations for guarantees and letters of credit issued in support of their payment obligations to counterparties.
- Insolvency: Once formal insolvency procedures are underway, restructuring options have usually been exhausted unless they are part of a restructuring plan (for example, an arrangement with creditors or pre-packaged administration) but earlier cash-flow or balance sheet insolvency default events may result quite quickly from a drop off in business where a company’s working capital is finely balanced, or where there is a sharp drop in the value of key assets (for example, vessel values). However, determining whether a company is balance sheet or cash flow insolvent is not always straightforward and there can be different rules from an accounting perspective than there are from a legal perspective.
- Cessation of business: A mere threatened suspension of a material part of a business will trigger an LMA-style cessation of business event of default (being where a borrower or guarantor suspends or ceases, or threatens to suspend or cease to carry on, all or a material part of its business. Quarantined vessels remaining in port, developments halted by lack of crew etc., all have the potential to force a temporary suspension of business.
- Expropriation: Often overlooked as an event unlikely to occur, but expropriation provisions are usually widely drafted to include business curtailment resulting from any restriction or other action by a governmental, regulatory or other authority, which may be relevant if, for example, some governments start to impose restrictions on vessel trading.
- Breach of laws: If government advice on business conduct during an epidemic and which becomes a law or regulation and which is not adhered to, a representation as to compliance with applicable laws and regulations may be breached on deemed repeat dates, but this is not usually an evergreen provision so lenders could be left waiting for interest payment dates before it triggers an event of default.
- Charter termination: The loss of a key charter as a result of its cancellation, rescission of frustration on the basis of COVID-19 is a particular concern where this triggers an event of default. There may be a period of grace to find a replacement charter but such a cure right will typically be limited in time and subject to criteria around the replacement charter.
Transfers and debt trading
One of the most notable changes within shipping over the last few years has been the growth in the secondary trading of shipping loans. In this regard, we expect to see existing lenders seeking to exit and new entrants actively seeking to buy up loans, whether as portfolio sales or as single trades. This can be a particular cause for concern for shipowners and restrictions on transfer and borrower consent rights will typically fall away when an event of default is continuing.
Often with larger shipping groups there is a sharing of certain costs such as salaries, general and administrative costs. Owners need to be aware that if they face financial difficulties, the ability to move money around groups may be curtailed, either through covenants and undertakings in existing loan agreements but also in view of directors’ duties considerations which means the directors typically need to consider these issues on a company-by-company basis rather than a group-wide basis.
In conclusion, there are various pitfalls and traps for the unwary, whether looking at things from the perspective of the lender or the borrower. Parties, especially borrowers, will need to look carefully at their obligations under their financing arrangements and ensure that these are being met in the context of the challenges presented by COVID-19 and business planning around the outbreak. We recognize how fast-moving and volatile the current situation is but wherever possible, lenders and borrowers need to consider now issues such as those addressed above.
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