Defaults and Enforcement
(a) [payment default]
(b) [inaccuracy of representations]
(c) [breach of covenants]
(e) [insolvency event]
(f) [judgment default]
(g) [change of control]
(h) [invalidity of guarantee or security interest]
(i) [vessel / deal specific events or circumstances]
What is it and what does it do?
Events of default are specified events or circumstances that act as warning signs for the lender. The occurrence of one or more events of default may signify that the prospect of the lender’s full recovery on the loan has been diminished. While they can include deal- and industry-specific items, events of default in a U.S.-style loan agreement follow a fairly standard list of events or circumstances as mentioned in the Example section above.
Why is it there?
For a lender, an event of default has three main purposes and/or consequences: (1) to stop lending (to the extent there is any remaining lending commitment), (2) to accelerate amounts that have already been lent, and (3) to exercise its remedies, such as foreclosure on collateral.
In most cases, there is optionality given to the lender with respect to these consequences. Very rarely, they are instituted automatically (which may not be beneficial to the lender because then the lender is deprived of any bargaining leverage to negotiate for concessions). One notable example is an insolvency event of default, which is triggered either by the action of the borrower (voluntary insolvency), or the actions of third parties (involuntary insolvency). In either case, the lender’s commitment to lend would automatically terminate and its existing loans would accelerate without further action by the lender. The automatic acceleration obviates the requirement to provide notice of acceleration, which in the bankruptcy context could violate the “automatic stay” under the United States Bankruptcy Code. The “automatic stay” is a central tenet of the US Bankruptcy Code and prohibits any creditor action against the debtor or its property upon commencement of a bankruptcy filing. The automatic acceleration also allows the lender to make a claim for the full amount of the loan against a guarantee given by a non-bankrupt guarantor, even if the automatic acceleration may have otherwise been invalid or prohibited (provided the guarantee has language that a full claim may in any event be made against the guarantor).
Short of the “nuclear options” described above, an event of default can also lead to other consequences. For example, many loan agreements have a default interest concept pursuant to which the principal of a loan accrues interest at a higher rate (typically 2-3% above the normal rate of interest) upon an event of default, or there may be a “late fees” concept where the borrower is assessed a penalty for being late on its payments.
The borrower may also lose certain privileges it has under the terms of the loan agreement upon an event of default. For example, the borrower’s right to consent to an assignment of the loan by the lender may be suspended during an event of default. Certain “baskets” to incurrence-based covenants may have a default blocker where they are no longer available if there is an event of default.
How is it relevant to shipping?
In a ship finance loan, the list of events of default often include: (1) the cancellation of a charter, (2) an arrest of a vessel lasting more than a negotiated period of time, (3) the termination of a shipbuilding contract (in a construction financing scenario), and (4) increasingly, a sanctions violation.
In addition to the consequences mentioned above, an event of default in the shipping context often allows the lender to commission additional valuations of the vessel at the borrower’s cost (which can be a significant sum if the loan is collateralized by a large number of vessels).
An event of default in shipping can also kick off the process of a vessel arrest, which is one of the important remedies available to a ship finance lender.
How is it negotiated?
While the list of events of default is fairly standardized, the contours of each event of default can sometimes be heavily negotiated and has important consequences for both the lender and the borrower. As examples:
- some events of default are given a grace period, meaning that the borrower is granted time to cure the default before it gives rise to the various consequences;
- the inaccuracy of representations is often qualified by materiality. If no materiality is included, any technical, inadvertent misrepresentation (however inconsequential) can potentially result in the lender being able to exercise its rights;
- a cross default provision is sometimes drafted in a way that any grace period afforded to the borrower to cure a default in another credit facility becomes a useless tool because a cross-default is triggered in the first credit facility as soon as a default occurs in the second credit facility; and
- the remedies section in security documents reference the soccurrence of an event of default. Sometimes, the lender’s ability to exercise remedies is limited to the occurrence of an event of default that is continuing, signifying that the lender loses such ability once the default has been waived or cured.
Please contact any member of S&K’s Maritime Practice Team.