This article is the second of two articles focused on taking security in ship finance transactions. This article focuses on the interaction with, and consideration of the role of, third parties when taking security in asset finance transactions. As in our first article, our focus here is on asset finance transactions in the maritime sphere, however the principles and issues highlighted can be largely transposed to other forms of asset finance, particularly in circumstances where the borrower is a special purpose vehicle.
The nature of the security taken in relation to an asset and the asset itself dictates that the lender may need to have interaction with parties who are not a party to the financing but whose cooperation is required for the lender's security to be effective or at least desirable to provide the lender with the necessary degree of comfort in relation to its security rights.
Third Party Considerations
In our first article "Security in asset finance transactions - Documentation and jurisdictional considerations " we looked at the form of the security that would be taken in relation to a vessel's earnings, insurances and requisition compensation (namely, a general assignment). Here, we look at the interaction with third parties/counterparties to the underlying assets being assigned under that general assignment.
Assignment - Earnings: A vessel will generate revenue through a contract of employment, i.e. a time charter between the borrower/owner and the charterer, which will be utilised (in part) to pay down the loan. The mortgagee/lender will want to take an assignment of the earnings as unless it were actually to take possession of the vessel (which for a whole host of reasons the lenders are not always keen to do), it otherwise has no automatic right to its income.
In practice, the borrower/owner and the lender will typically agree that a notice of the assignment will only be sent (and thereby fulfilling the last criteria which would create a legal assignment) to a charterer of long term contracts of employment/charters. For spot charters it is often the case that to ease the burden on the borrower/owner, notice is only required to be sent to the relevant charterers on an event of default. As with all legal assignments, there is no need for the lender to obtain an acknowledgment from the charterer to the notice to ensure the assignment's legal validity. However, a lender will often request that an acknowledgement is provided as there are likely to be certain confirmations that the lenders will be keen for the charterer to provide to them, for example confirmations from the charterer that:
- upon receipt of notice (typically served on an event of default) from the lender to the effect that all earnings are to be paid to an account of the lender, the relevant counterparty will pay all earnings to that account;
- it has not received notice of any other assignment (this goes to the issue of priority of security interests referred to above);
- it acknowledges the mortgage over the vessel and the rights of the lender as mortgagee in relation to it.
The above are examples of confirmations that should (typically at least) not be controversial for a charterer to provide. However, if the charter is a long term time charter or a bareboat charter, the lender may be wise to seek undertakings from the charterer in relation to its rights under the charter vis-a-vis the lender's rights as mortgagee. For example, the lender may seek undertakings that the charterer will subordinate all claims that it may have against the borrower/owner and the vessel to those of the lender as mortgagee and/or consent to repossession by the mortgagee on enforcement.
Undertakings of this nature will likely require extensive negotiation between all three parties and are not straight forward (especially where the charterer is not privy to/or concerned with the borrower/owner's financing arrangements) and more extensive documentation in the form of a letter of quiet enjoyment between the lender and the charterer (and in some cases, the borrower) may therefore be required.
However, where the lender is only seeking certain acknowledgments and/or confirmations to the borrower/owner's notice of assignment, the communication in relation to the service of the relevant notice of assignment and any corresponding acknowledgment is likely to be undertaken between the borrower/owner and the charterer only, without the direct involvement of the lender. This is generally due to the fact that there is typically a nuanced relationship as between the borrower/owner and charterer independent from any of the relevant financing arrangements where (especially in "plain vanilla" financings where the charterer is a non-connected third party to the borrower/owner) direct communication as between the lender and the charterer may not be deemed to be appropriate.
The above issues/practicalities can be said to be typically an issue or at least a consideration for lenders in "plain vanilla" financings. However, it is worth highlighting that where the financing structure is one which includes a finance lease, the involvement and interaction with the charterer or the "lessee" in the security package provided to the lender will be key and therefore will differ to that set out above. The reasons for structuring a transaction in this manner are varied and beyond the scope of this article and would (amongst other things) require any lender to take advice on the tax consequences of such a structure. However, the principal reason for structuring a vessel's purchase by way of a finance lease arrangement would be to move risk away from that of the vessel and the SPV borrower (and its group company) to that of the charterer/lessee. In such a structure, the lessee is intrinsic to the transaction and as such some of the practical and technical hurdles to taking security from it as a "third party" referred to above would not be relevant.
Assignment – Insurances: A borrower's/owner's insurance will typically be spilt into three policies covering the hull and machinery, the P&I (protection and indemnity) and war risks. As stated earlier, the main recourse that a lender will have to the repayment of the loan on default will be the vessel itself. If therefore the vessel were to become total loss or a constructive total loss, that recourse will no longer be available. Hence, lenders require recourse to the proceeds of the insurances.
It is also important to note that in certain instances where a vessel has caused damage to third party property it can result in maritime liens attaching to the vessel. In such cases, the lender will want access to the proceeds of the insurances so they can ensure that these claims are dealt with swiftly so as to remove any maritime liens as quickly as possible.
Unlike the assignment of earnings or of any charter, the interaction with the relevant counterparty in relation to the rights being assigned in, and in connection with, the insurances will typically be carried out directly by the lender (or as is more likely) lender's counsel. Lender's counsel will contact the insurance brokers directly ahead of the date on which the assignment is to be taken to request a number of confirmations in relation to the assignment, namely that the insurance brokers will arrange with the insurers to give effect to the notice of assignment (assigning the borrower's/owner's rights in and to the insurances to the lender) and to the loss payable clause. The direct nature of this communication is a matter of standard practice in the market as the commercial relationship between the borrower/owner and the insurance broker is less nuanced and can be said to be on more standard commercial terms than that found between parties to a charter
Assignment - Requisition Compensation: Requisition compensation basically refers to all compensation which may be payable to a borrower as a result of a vessel owned by it being requisitioned for title or in any other way compulsorily acquired.
This does not include requisition for hire (which amounts of hire would be included under the assignment of "earnings" and so provision in relation to the right to receive such hire should be included within the assignment of earnings clause).
The phrase "requisitioned for title" generally refers to the (rare) occurrence where the flag state which registered the title of the ship requisitions a vessel in times of war; the ownership of the ship in such cases is effectively taken over by the flag state and equated for all practical purposes for the borrower and the lender that the ship is a total loss. Any compensation therefore paid by the government of the flag state to the borrower is required to be assigned to the lender.
A lender's or borrower's interaction in relation to the rights to requisition hire or title would be with the relevant government/ state and notice would be served upon them at the point of their requisition of the vessel and/or its earnings. The general assignment therefore will typically contain undertakings from the borrower/owner that it will serve such notice at that point and also contain a power of attorney granted by the borrower/owner in favour of the lender which would allow the lender to execute and serve the notice of assignment if the borrower/owner does not do so. Any interaction with a government or state in this regard is likely to be extremely rare.
In summary, taking security in ship finance transactions will often dictate that the parties need to consider factors that may not be obvious at first glance and go beyond the commercial intricacies of the deal. The relationship which a borrower/owner may have with the charterer of its vessel may have its own particularities of which a lender may need to be mindful when negotiating the form of its security package.
Our Banking & Finance and Shipping & Marine teams regularly advise on taking security in finance transactions.