Cross Jurisdictional Issues in Finance Transactions (Part II): Enforcement of Security over Moveable Assets in Ship Finance

This is the second article in our three-part series on common issues faced in cross jurisdictional finance transactions.

In this and the final instalment in the series we look at the options and remedies that may be available to lenders when enforcing security over moveable assets and the cross jurisdictional considerations that lenders should take into account before deciding the most appropriate route of action. This article focuses on the enforcement of security taken over a ship in ship finance transactions; in particular, the enforcement of a ship's mortgage.

The importance of the flag state

Whether a ship finance transaction is syndicated or bilateral or is of high or low value, it will often involve some cross border element, the most common of which will relate to the flag state. The flag state of a ship will (amongst other things) govern the law of the mortgage over the ship; arguably, the most important document in a lender's security package.

Whilst there will be other security documents entered into in relation to the ship (assignment of earnings and of insurances, for example), the mortgage is the most comprehensive form of security that a lender will have in relation to the ship itself. The value of the ship is a key element in the loan/financing profile. Lenders, therefore, will have had to satisfy themselves at the term sheet stage of the acceptability of the flag state.

The laws of the flag state governing a ship's mortgage should provide the lender with recourse to the ship itself (rights in rem) as well as against the owner/borrower. This means that even if the ship were to be sold to a third party – which would most likely be in breach of the owner's covenants, the rights which the lender has as mortgagee over the ship "go with" the ship and are not absolved by a change of ownership. Whilst this is of benefit to the lender, and the mortgage and the laws of the flag under which it is registered will on the face of it govern the avenues available to the lender in reaching its ultimate recourse of recovering amounts outstanding under the financing as quickly and cost effectively as possible, the mortgage document does not operate in a vacuum. To state the obvious, a ship is a moveable asset, and whether and how the mortgagee is able to exercise its enforcement powers will depend on the location of the ship at the time the mortgagee elects to take enforcement action.

Considerations on enforcement of a ship mortgage

If an event of a default has occurred and the lender has decided to enforce its security two key matters have to be considered:

The mortgage documents (and rights under the flag state): the terms of the mortgage document need to be examined to ascertain what powers the lender has as mortgagee under that document and under the law governing it.

Where the flag of the ship's register has a prescribed statutory form of mortgage, a deed of covenant will usually have been entered into setting out the mortgagee's contractual rights under the mortgage and extending the scope of when the powers vested in it as mortgagee may be used (i.e. on the occurrence of any event of default, not solely payment defaults).

The location of the ship: this is crucial to enforcement as it is the courts of this jurisdiction that will (i) determine how the mortgage and associated security documents and the laws under which they are governed are recognised in that jurisdiction, and (ii) apply the law of that jurisdiction in relation to the procedural steps which the mortgagee is required to take in its enforcement of the mortgage, generally by judicial sale under the direction of the court.

Once it has been determined where the ship is located, and that the mortgage on the relevant "foreign" flagged ship will (a) be recognised in that jurisdiction and (b) share the same status, rights and priority as those on ships registered in that jurisdiction, the next step will be to ascertain the most favourable procedural action to enforce the lender's powers under the mortgage.

Enforcement action

There are different avenues of enforcement action available to a lender as mortgagee which will depend on the mortgage documents, the flag state and the location of the ship:

Taking possession and self-help remedies: many of the most commonly used jurisdictions under which a ship is mortgaged (including the UK, Cyprus, Singapore, Hong Kong and Malta) will grant the mortgagee the power to take possession of the ship and to sell the ship on the occurrence of an enforcement event. Indeed, the very reason that some banks may have decided at the genesis of the financing that the flag the ship is to be registered on is acceptable may have depended on the availability in, and treatment by, those jurisdictions of these self-help remedies.

At first glance, this entitlement may seem the most favourable avenue for a mortgagee to take in order to recover its debt; it circumvents the use of the courts which would be attractive to many thinking this will translate to an expedited and less costly sale process. However, in practice, this avenue is rarely taken by mortgagees as (whilst dependent on the law governing the mortgage) the mortgagee will often:

incur legal liabilities and have technical responsibilities in relation to the ship as soon as it takes possession of the ship;
be subject to certain duties in favour of the owner relating to achieving a demonstrable "true market price" or "best price" for the ship and to act in good faith (as is the case under English law) or such other similar duty in its selling of the ship; and
be liable to indemnify the purchaser against any losses that they may suffer as a result of claims which are not known to it (as it has not operated the ship) being enforced against the ship that arose prior to the sale (a sale of the ship by the mortgagee by private treaty cannot discharge certain maritime liens/preferred claims against the vessel which arise by operation of law and do not require registration, and can be extensive dependent on the jurisdiction, unless they are all identified and can be discharged from the proceeds of sale).

Arrest and judicial sale: if the mortgagee elects not to exercise its self-help remedies, it may look to apply to a court for the arrest of the ship and the establishment of the borrower's indebtedness under the mortgage documents, followed by a judicial sale. On an application for arrest, the place of arrest (i.e. where the ship is currently located) will be of paramount importance to a mortgagee. Ideally, the jurisdiction should be one that has a developed maritime law and legal system which will provide the mortgagee with some level of predictably as to how the arrest procedure, the ascertainment of the debt, the advertisement for and ranking of claims against the ship, and the exposure of the ship for sale its likely to be conducted and the costs involved. The mortgagee may therefore track the ship and choose to arrest in a jurisdiction which they deem to be "claimant friendly". In making this assessment consideration should be given to:

the obligations in relation to the ship that the local law would apply to the lender as mortgagee in possession;
the nature of the security which the court would permit a defendant owner to provide in order to secure release of the ship from arrest;
the process and length of time involved before the court would pronounce judgment for the debt and allow a claimant mortgagee to apply for sale of the ship; and
the process, length of time and conditions under which the ship is valued and then exposed for sale and whether the courts will allow sale by private treaty (court-approved private sales) or whether this is to be by way of public auction.

An additional consideration will also be whether that jurisdiction requires the mortgagee to provide counter security to the court. In many jurisdictions (although not in the England, Scotland, Ireland or Singapore to name a few examples), a court will require that the mortgagee provides payment (in the form of cash, undertaking or bank guarantee) that would cover any claims that the defendant owner may have for wrongful arrest, or the court may allow the defendant owner to apply for counter security which will be granted at the court's discretion (as is the case in South Africa and Greece).

The main advantage that a mortgagee following the arrest and judicial sale procedure will be looking for in the relevant jurisdiction will be for the purchaser to acquire the ship with clean title, free of all maritime liens and claims, and for the proceeds of sale to be applied towards any outstanding maritime liens (or other corresponding privileged or preferred claim against the ship found established by the court) before remitting the free proceeds of sale to the mortgagee in discharge of the claim secured against the ship, although not necessarily the owner/defendant's debt. This should mean that the mortgagee is able to obtain a higher price for the vessel as it will have been exposed to the market and not be being sold subject to any encumbrances or liens.

The arrest process and where to conduct it can be viewed as an interplay between a variety of competing concerns all of which must be viewed through the prevailing market conditions at the time.