Introduction to key contracts in asset finance – Quiet enjoyment letters

While the core basics of asset financings are not much different from that of other financings, such as the loan agreement, there are some particular agreements and tricky issues that are unique to asset financings. These can often be a pitfall to a transaction if attention is not paid to them at an early stage of the transaction.

In this series, we will focus on asset financings and look at some of the key contracts that parties to an asset financing need to pay attention to. Often these contracts involve third parties, such as charterers, managers, ship yards and insurers. In this article we will look at a quiet enjoyment letter in a ship financing transaction.

Right to Quiet Enjoyment

It is important for lenders to check whether the ship they are financing is subject to a long term charterparty such as a bareboat charter or a long term time charter, because this is where the cash flow for debt servicing comes from. However, this also turns a bilateral financing relationship between the ship owner and lender into a tripartite act with the charterer.

一个关键领域承租人关注权利to quiet enjoyment use of the ship. In summary, a charterer's quiet enjoyment right means its right to undisrupted use of the ship according to the underlying charterparty unless there is a charterer's event of default (or termination event) under the charterparty. This is usually a bilateral contractual undertaking given by the ship owner (as lessor) to the charterer in the charterparties. However, if the ship is being financed so that a lender also comes into the picture, the simple bilateral relationship will become more complicated, as the lender will very likely take a mortgage over the ship and the lender's exercise of rights under the ship mortgage, such as right of repossession and sale in the loan event of default, may disrupt the charterer's quiet enjoyment of the ship.

Quiet Enjoyment Letter

这是关键文档,将双边会谈eral relationship between the ship owner and charterer into a tripartite relationship with the lender. A quiet enjoyment letter provides a direct contractual undertaking by the lender to the charterer that the charterer's right to the use and enjoyment of the ship will not be disturbed as long as there is no charterer's event of default under the charterparty, whether or not the ship owner as borrower is in default under the loan agreement.

Issues to consider

It sounds straightforward, but balancing the interests between the parties in such a document is often tricky. On one hand, a lender often sees the need to recognise a charterer's quiet enjoyment right as a hindrance to it when a lender may want speedy enforcement of a mortgage from the ship owner. The charterer may request a quiet enjoyment letter to have further protective measures, such as a standstill period where the lender cannot immediately enforce the mortgage, or in case of the lender exercising the right to sell the ship, a requirement that the new owner needs to be approved by the charterer. Such protective measures limit the enforcement options and speediness of recovering the debt which may otherwise be available to a lender.

On the other hand, charterers may see it as a "backdoor" way of a lender imposing additional requests on the charterer which were not in the charterparty. For example, in order to ensure the charterer continues to pay hire to keep the cash flow for debt servicing, a lender would require the charterer to ensure that the charterer will notify the lender of the ship owner's default under the charterparty and give the lender a standstill period and the right to remedy the ship owner's default to keep the charterparty "alive". This limits the charterer's right to terminate the charterparty immediately, which is even a bigger concern if the ship owner's default is in relation to its insolvency or illegality.

Another additional request often made by a lender is for the contractual step-in right for a lender or its nominee to step into the shoes of the ship owner under the charterparty and continue the charterparty, though in those circumstances a charterer would often counter argue for the right to approve the nominee before such step-in rights can be exercised, as a charterer may not want to deal with a party other than the original ship owner. There may also be tax consequence for the charterer where there is a tax gross-up provision in the charterparty, and if the new owner's different place of residence is different from the original owner, the charterer will need to gross up the hire payment if there is any withholding tax requirement due to this change of residence of the new owner.

The dynamics between the parties can be even more complicated when there is a purchase option or purchase obligation of the ship granted to the charterer under the charterparty. In this circumstance, while the charterer will expect that the ship it purchases back will be released from the ship mortgage, if there is a cross-collateralisation under the loan between ships owned by the same ship owner or where the loan amount securing a ship is higher than the purchase option (or purchase obligation) price under the charterparty, lenders may impose additional conditions under the loan agreement before a vessel being purchased back by the charterer will be released from the security package (such as satisfaction of the loan-to-value test of the remaining vessel to the outstanding loan, or more commonly condition such as no existing event of default in connection with the loan related to the other vessel). These issues will need to be addressed in the quiet enjoyment letter but may also mean changing the fundamental structure of the financing.

And what are the implications for the ship owner? A quiet enjoyment letter ultimately matters most when there is a loan default by the ship owner when the lender and charterer want to protect their respective interests so ship owners often see this as something that does not really concern them. However, the charterparty often will include a ship owner's undertaking that the ship owner must (or even if watered down, use its "best endeavors") to procure the future financiers to provide the charterer with a quiet enjoyment letter before the ship owner can enter into the ship mortgage. Failure of the ship owner to comply with this undertaking constitutes a breach of its part under the charterparty, exposing it not only to risk of a contractual claim by the charterer but also risk of reputational damage. It may also trigger a loan event of default day one when the loan agreement is signed if there is any event of default that relates to the owner's breach under the charterparty or cross default.

Takeaways

The most important takeaway is not to leave this quiet enjoyment letter as a second priority during the documentation stage, and to start engaging the charterer early on – bearing in mind the charterer may not have incentive to cooperate with the financing so its responses may not be as speedy as lenders or ship owners would hope for. One mitigating step ship owners can take is to pre-agree a form of quiet enjoyment letter with the charterer when the charterparty is signed. However, it is often the case that a lender, even after due diligence of the charterparty including the pre-agreed form of quiet enjoyment letter, would still want to build in additional provisions into the document, as different lenders would have different expectations or internal requirements, which could not be predicted when the "pre-agreed" form was agreed. In some cases, the charterer may also want to use this document to increase its bargaining power if it is also contemplating some other negotiations or arrangements with the ship owner, in particular when the rental market is fluctuating.

BIMCO quiet enjoyment letter

Currently there is no standard quiet enjoyment letter in the international market but the Baltic and International Maritime Counsel (BIMCO) is developing a standard form which is expected to be published in October 2023. To have a standard form that brings expectations of parties closer to each other during negotiations is an important step, but since one size does not fit all, and negotiations also depend on the current market and the bargaining powers of the parties, the quiet enjoyment letter remains a major piece of the financing process that parties need to pay closer attention to.