Security in ship finance transactions - Letters of quiet enjoyment

This article is the third in a series of articles on taking security in ship finance transactions. In our first article we considered documentation and jurisdiction issues which arise in ship finance transactions, and our second article looked at considerations around third parties in these deals. In this article we bring these two topics together and look at letters of quiet enjoyment (LQEs).

LQEs create a contractual nexus between the borrower, the lender and third parties in relation to security rights in ship finance transactions.

As in both our first and second articles, 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.

Competing interests in relation to vessels

In ship finance transactions the nature of the security taken and the asset itself mean that the lender may need to have interaction with parties who are not a party to the financing. The cooperation of those third parties is required, or at least desirable, to provide the lender with the necessary degree of comfort in relation to its security rights.

In our first article we looked at a lender's rights as mortgagee of a vessel. However, under long term charters, the charterer of the vessel also has certain rights vis-a-vis the vessel and these may potentially compete/conflict with the enforcement rights of the mortgagee under its mortgage, and thus potentially undermine the rights of the charterer under the charter. Due to these competing rights and interests, the charterer or the mortgagee (or both) will often seek to enter into a letter of quiet enjoyment (LQE) with the other (and, more often than not, also with the borrower). The primary aim of an LQE is to streamline or clarify the competing interests and rights that each of the charterer and mortgagee has in relation to the vessel and, as noted above, to create a contractual nexus (which would otherwise be absent) in relation to those rights and interests.

What is quiet enjoyment?

Quiet enjoyment is the right under English common law of a charterer of a vessel to the use and enjoyment of a vessel free from interference. The right of quiet enjoyment can be legal (i.e.it is a concept under English common law) or contractual (i.e. set out in an LQE).

Right of quiet enjoyment without an LQE

What enables the charterer to continue to have the right of use and enjoyment of a vessel free from interference, including "interference" from the mortgagee, in the absence of an LQE? A lack of a clear set of criteria makes answering this with any certainty quite difficult. Precedent in the form of case law is limited as often there will be an LQE in place which governs the competing interests, or the owner/borrower will have become insolvent which means the charter can't be performed by it in any event.

In general, though, the charterer will have the right of quiet enjoyment of a vessel provided that:

• the charterer is in compliance with its obligations under the charter
• the security constituted under the mortgage is not jeopardised by the use of the vessel under the particular charter, and
• the owner/borrower is able to continue to perform its obligations under the charter.

One other guiding principle will be whether the mortgagee has actual notice of the charter. If so, and particularly when coupled with the criteria above, the mortgagee will be severely limited from doing any act which interferes with the rights of the charterer (including enforcing its rights under the mortgage and taking possession or arrestment of the vessel).

As we noted in our second article, a charter is often signed well before the granting of the mortgage, meaning that the lenders will often have notice of the charter (usually through a thorough due diligence process) before taking security. So, at least under English law, a charterer of a vessel could benefit from rights akin to quiet enjoyment without signing an LQE.

However, vessel financings invariably involve multiple jurisdictions, such as the flag state of the vessel, the location of the vessel, the jurisdiction of the parties and the governing law of the charter. In these circumstances, determining the applicable law could be a complex matter, and there is no guarantee that English law will apply.

For the reasons we have outlined above, an LQE often will (and in our view generally should) be sought.

Benefits of an LQE

LQEs bring benefits not only for the charterer but also to the lender mortgagee. A mortgagee would be wise to utilise any request or indeed be the instigator of a request to enter into an LQE to obtain step-in rights.

If the earnings under a charter are a key part to the financing for the lender, and are seen as a credit enhancer, then the mortgagee may wish to agree with the charterer that it is able to substitute itself (or in all likelihood, a nominee) in the place of the defaulting borrower. This enables the mortgagee (or its nominee) effectively to "step into the shoes" of the owner/borrower under the charter agreement so that the charter may continue and the earnings under the charter are able to continue to accrue and service the loan.

While LQEs may seem to be primarily for the protection of the charterer, they can provide lenders with greater certainty as to their rights when a default by the borrower has occurred. Where the negotiation strengths of the parties permit, LQEs can also provide a wider degree of options for a mortgagee should a default under the financing occur.

Our marine finance team are experienced in drafting and negotiating LQEs. If you would like to discuss any aspect of LQEs or other shipping finance matter please contact the authors of this article.