Financial Covenants – Part I

Financial Covenants – Part I
Collateral Maintenance Covenant

Example

The Borrower shall procure that the sum of (i) the Appraised Value of the Collateral Vessel and (ii) the fair market value of any Additional Collateral does not fall below an amount that is equal to or less than [___]% of the aggregate outstanding principal amount of the Loans; provided that any non-compliance with this Section shall not constitute an Event of Default, so long as within thirty (30) days of the occurrence of such non-compliance, the Borrower shall either (x) post Additional Collateral or (y) prepay Loans pursuant to Section [___] in an amount sufficient to cure such non-compliance.

Who is it and what does it do?

Generally, financial covenants in a loan agreement are a tool for the lender to monitor the borrower’s financial wellbeing. They often serve as an early warning sign to the lender if the borrower’s business starts to suffer. There are many different financial measures that the lender may employ, and we will examine some of the more prevalent financial covenants in a shipping loan agreement in subsequent issues of this newsletter.

Why is it there and how is it relevant to shipping?

Perhaps the most common and arguably most important financial covenant for ship finance loans is the collateral maintenance requirement (or more colloquially, the “LTV” covenant, which refers to “loan-to-value”). Since ship finance loans are typically asset-based financings at heart, the lenders look to the value of the collateral (namely, the ship) for recovery and have to ensure that the value of the collateral is above the amount of the loans outstanding (ideally with a certain amount of excess to cover unpaid interest, costs and any priming liens). Many ship finance loans are structured in a way that the ship is housed in a special purpose vehicle with no assets other than the ship itself and certain ancillary contract rights. Therefore, the lender’s primary recourse is to the ship whose value is of paramount importance to the lender and warrants close monitoring.

How is it negotiated?

Because the collateral maintenance covenant is such an integral part of the ship finance loan agreement, the language and contours of the covenant are well-established as a legal matter. Of course, how much buffer the lender would like to maintain beyond the amount of the loans outstanding is a commercial matter that is often negotiated but beyond the scope of our newsletter.

In almost all cases, the borrower has a cure right in case of a breach within a certain period of time (for example, 30 days) pursuant to which the borrower may (1) provide additional collateral (for example, by mortgaging another ship or pledging cash) or (2) pay down the loans, so that the ratio of the collateral value to the loans outstanding is back in compliance with the requirements.

The collateral maintenance covenant is confirmed by the lender on the basis of the appraisals provided – how often (or how many) such appraisals need to be provided to the lender is also a point of negotiation, as it involves the borrower incurring costs.