the difference between risk of default and risk of loss

8/6/2019 The Difference Between Risk of Default and Risk of Loss

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NIKOLAOS NOULEZAS

Diploma in Ship Finance

The difference between risk of default and risk of loss


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What is risk management?

The phrase risk management is used in different contexts. To a professional lender, itbroadly means a systematic approach to taking safety precautions at all levels of business,including the management of financial and commercial risks, and the obtaining of insurance

cover.

Legal risk management is somewhat indetermine term, which generally means themanagement of risks arising from the drafting and/or performance of contracts. In broaderterms, it encompasses any risks which may potentially result in legal consequences includinglitigation, or dispute resolution risks.

What is risk exposure?

Risk exposure to a professional lender will result from failing to identify potential risks,evaluate their frequency, probability or recurrence and their potential consequences. Theconsequences may include environmental or civil liabilities resulting in financial losses, loss ofreputation and possibly criminal prosecution or risks inherent in particular forms of corporate

structures.

Banks do not lose money solely because the initial decision to lend was wrong. In shipping,where the perceived risks and cyclicality are greater, losses normally occur if warning signsare ignored. When market fundamentals do get shaky, companies with too much leverage orflawed strategy begin to suffer financial difficulties very quickly. The earlier a problem isspotted, the better the chances are of avoiding a loss, as it usually allows for moreopportunities to resolve the situation.

Risk of default and risk of loss

Default risk, or otherwise known as counterparty risk, is the likelihood that a borrower woulddefault on its contractual debt obligations to the lender.

Risk of default is addressed in a loan transaction by carefully setting the parameters of whatwill constitute a default and, implicitly, what will not be a default. Protective covenants arewritten into loan agreements that allow the lender to manage the risk of default by imposingcertain obligations in respect of a range of prohibited behaviour and a range of requiredbehaviour which, if complied with, should reduce the likelihood of a borrower defaulting on itsobligation to pay the lender.

Covenants on the borrower will generally restrict changes of ownership, ship registration,vessel management and enforce minimum operating standards. Main financial covenantsincluding maximum leverage, maximum net worth, minimum liquidity/cash, minimum cashflow.

As a consequence, risk of loss for the lender is arising from borrowers default.

Taking security over the borrowers assets the primary legal focus is on reducing the risk ofloss giving the lending bank the power to access a borrowers assets, following default.

Since exposure to credit risk continues to be the leading source of problems in banks world-wide, a bank should be able to draw useful lessons from past experiences and past shippingcycles. Lax credit standards for borrowers and counterparties, or a lack of attention tochanges in shipping markets or other economic circumstances can lead to deterioration in thecredit standing of a bank's counterparties.


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Importance of the assignment to the lender

The principal source of earnings for the owner of a commercial vessel will be sums payable tothe owner for the use of the vessel by charterers. It is these earnings to which the lender willnormally primarily look as the source of repayment of his loan and interest.

An invariable part of a financing banks security package is an assignment of the earnings,and off course the benefit of the insurances of a mortgaged vessel.

The reason for this is obvious. It is highly probable that the bank will be lending to a one-shipcompany with no source of income other than from the operation of the financed vessel. Thelender should therefore, be able to exercise some control over the earnings flow. Moreimportantly, it will want to be sure that, on default, the charterers, and any others from whomearnings may be due, can be called on to pay those earnings to the lender free of any claimfrom the borrower or its liquidator, reducing in this way the lenders risk of loss following adefault from the borrower.

In this point, we must underline that a lender should, however, be wary of placing too muchimportance on the assignment. While it is vital, it will be of no use to a lender if the ship stops

trading, for example if a charterer defaults, or if an insurance claim is not met. While theremay be other sources of repayment available to a lender in such circumstances (for example,loss of earnings insurance or mortgagees interest insurance), he may nevertheless need tolook to his other security for full repayment of the outstanding indebtedness.

Earnings assignments are likely to be defined in wide-ranging terms in the facility documents,usually either in the assignment itself or in the underlying facility agreement.

A sample definition is as follows: all hires, freights, pool income and other sums payable to orfor the account of the borrower and/or the bareboat charterer in respect of the vessel,including (without limitation) all remuneration for salvage and towage services, demurrageand detention moneys, contribution in general average, compensation in respect of anyrequisition for hire and damages and other payments (whether awarded by any court or

arbitral tribunal or by agreement or otherwise) for breach, termination or variation of anycontract for the operation, employment or use of the vessel.

Notice of assignment

In English law, the benefit of a contract, such as a charterparty or a policy ofinsurance, falls within the category of personal property known as choses in action.Section 136 of the Law of Property Act 1925 sets out detailed rules for theassignment of choses in action. As a result, to effective under Section 136 as a legalassignment (as opposed to an a equitable assignment only) an assignment must be:A) in writing B) signed by the assignor C) absolute, and not purporting to be by wayof charge only.

Additionally, written notice of the assignment must be given to the debtor (the charterer). Anassignment that satisfies all the above tests transfers to the assignee, from the date of thenotice to the debtor:

The legal right to the debt or other chose in action.

All legal and other remedies for the recovery of the debt or the enforcement of thechose in action.

The power to give a good discharge without involving the assignor.

This is not to say that an assignment that fails any of the above tests is invalid: rather, it islikely to operate as an equitable assignment. For the lending bank, however, an assignmentwhich is only equitable, rather than legal, has two potential disadvantages. First, the lendercannot give a good discharge for the debt (for example a receipt for a settled insurance claim)without the agreement of the borrower. Secondly, he cannot sue the debtor (the charterer)without joining the borrower into the action, either as a joint-claimant or (if the borrower willnot cooperate) as a defendant, both of which are potentially cumbersome.


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As a result, for the lenders risk management policy neither of these two disadvantages isinsurmountable, and any assignment will in any event always be equitable as regards anyfuture rights assigned, but a full, legal assignment is preferable where possible.

Formalities

The notice to the debtor must be in writing, no other formality is required, nor need it besigned by either party. It can be given by assignor or assignee, and can be either in aseparate document or contained in the body of an agreement to which the debtor is a party.

Also, there is no time limit in which notice must be given, so long as it is given after theassignment and before any reassignment. The effective date of notice, and thus of theassignment itself, is the date on which notice is received by the debtor. Ensuring receipt istherefore extremely important for the assignee, who will be well advised to adopt a policy ofpersonal delivery of notices of assignment, unless the notice is been given to a debtor ofundoubted repute.

In case a debtor ignores a notice of assignment and pays the assignor, he can be compelled

to make a second payment to the assignee. In this regard, notices of assignment will oftencall for acknowledgment by the debtor that he has received the notice and will makepayments to the assignee.

As more than one assignment of a particular chose in action can exist at any given time, anda priority between assignments, whether legal or equitable, will normally be governed by theorder in which written notice is given to the debtor (unless the second assignee, at the time oftaking his assignment, knew of the first assignment), prompt giving of notice of assignment isalso important to prevent a subsequent assignee obtaining priority.

Effects of not serving notice of assignment

In case the lender does not give notice of assignment to the debtor (charterer), the debtor will

be free to pay the earnings to the owner and to deal directly with the owner in relation to themby, for example, agreeing discounts and other freight/hire negotiation/reduction.

The debtor will also be free to exercise wide rights of set off, unless these are excluded by thecontract under which the earnings arise. In this point it should be noted that, even withoutservice of notice the assignment should be effective to give the lender (assignee) a betterclaim to the earnings than the owner (assignor) and a better claim than persons claimingthrough the owner.

In other words, even if the owner receives the earnings, the lender has a right, exercisableagainst the owner, to have them paid over to it irrespective of whether or not a notice wasserved on the debtor, from whom the earnings were due. That is to say, the service of noticeto the debtor, or the lack of it, does clearly not affect the nature of the relationship between

the borrower and the lender.

Nikolaos Noulezas04.08.2009

the difference between risk of default and risk of loss

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