Law of Ship Finance Abhinayan Basu Lund University November 2012

1. Law of Ship Finance AbhinayanBasu Lund University November 2012

2. Shipbuilding Markets • Markets are of cyclical nature: Where are we now and where to next? • Heavily dependant on globalisation trends • World economic crisis: many shipping sectors turned more rapidly and steeper from boom to bust than other industries • Less consumption in industrial countries: particularly container transport – traditionally enjoying highest growth rates – is effected • Dry bulk shipping: heavily dependent from growth in China & India • Oil consumption: somewhat restrained, but may start to rise soon • In the long run, fundamentals for strong demand of ocean transport capacities will retain their validity

3. Ship Building Prices

4. Investment Volume • Annual investments rose steeply until 2007 and dropped to nearly zero in 2009 • Order backlog mid 2009: investment volume of about USD 490 billion, spread over 3 - 4 years of delivery • Until recently, customary financing: 30% equity / 70% debt • then about USD 340 billion debt to be provided • by banks • capital markets • Due to the financial crisis, commercial banks are for the time being not capable or willing (?) to provide sufficient lending • Will government-owned banks in Asia step in for a larger share? • Ship owners will be forced to look for additional alternative financing structures and sources

5. Capital Sources • Family-owned companies still a substantial part of shipping • particularly in Greece, also in Italy and Turkey • In the present decade: emerging trend of family-owned companies going public, at least partly • Trend has currently come to a halt, but relevant again in the future • Generating equity / cash reserves • through vessel sales • out of the operating surplus of the fleet

6. Capital Sources • Time-charter rates for several years substantially above financial break-even • Nowadays, completely changed picture • Container ships: often below operating costs • Financial break-even based on • newbuilding prices (here: contracted 2006) / fleets often acquired at much lower, some ships at higher prices • lending 70% of the market value • redemption 1/15 p.a. • interest, currently calculated at 4 % • Private owners and public limited companies were capable of accumulating cash for investments • In current markets, particularly single voyages, quite limited possibilities of internal finance

7. One-year Time Charter Rates

8. Stock Markets • Quite a number of publicly-listed large shipping companies • liner companies • diversified groups • leading tanker and dry bulk companies • few cruise operators • Newly established shipping groups in the last years through IPOs (Initial public offerings) and follow-on issues • especially on stock exchanges in New York, also Oslo, Athens and the Far East • Active stock markets until end 2007, when subprime crisis first hit capital raising • Equity markets have been dried up, particularly for shipping issues, with a few exceptions of follow-on shares

9. Financing • Range of methods by which money is made available commercially for the ownership and/or operation of ships. • “equity” - contribution of money in return for an ownership interest in the ship so as to share proportionately in gains or losses, both capital and income, arising from the ownership and operation of the ship - “principal” or “sponsor” provides equity • “debt” - the lending of money on condition that it be returned together with interest over an agreed period of time - banks provides debt financing up to about 60-70% of the value of the ship • The net income from the ship (after paying operating expenses and other costs), or the proceeds of selling the ship, are then used • First to pay interest on the debt and • Then to repay the principal of the debt. • Any remaining income or proceeds of sale can then be paid to the equity investor. This is the investor’s “return on equity”.

10. Financing Financing Alternatives Variations of “debt” and “equity” are used in ship finance Debt finance with an equity “kicker” Lease finance Subordinated debt finance Mezzanine finance 10

11. Financing Debt Financing interest payments on loan security over the borrower’s assets; an interest in, or right over, the borrower’s assets which will permit it: to force a sale of the assets if the borrower does not repay the debt, and to receive the proceeds of sale (up to the amount of the debt) without having to share them with other creditors (i.e. it has “priority”). The principal assets over which security is typically taken are: the ship (secured by a mortgage); the insurances (secured by an assignment or “charge”); and the earnings of the ship (secured by an assignment or “charge”) 11

12. Overview of Ship Finance Citibank NA v Hobbs Savill [1978], Lord Justice Roskill “The bank advances to one or more owning companies a large sum of money. It of course requires security. It will take a mortgage on the ship for that security. It may take other mortgages on other ships for the same security. If the ship…is about to be time chartered, then the bank will take an assignment of the time charter in order that the bank as assignee can benefit from the time charter in order to reduce the mortgage debt. In addition, it will almost invariably…take an assignment of insurance policies and P&I Club cover in order that in the event of a total or partial loss of the ship the bank, as lender, may be suitably secured. As a result, over the last quarter of a century when many ships similarly built and financed have been totally lost, banks have found themselves completely protected in the events which have happened. The effect of all this is to ensure that the lending bank is completely secured against the insolvency of the borrower who intends that the bank shall obtain complete priority over the other claims of the creditors against the borrower.” 12

13. Ownership Structures Incorporation: Limited Liability The liability of a shareholder for the debts of the company is limited to the amount paid up on the shares he holds and the unpaid calls on those shares. Beyond that, in principle, no matter how much the company owes its creditors, the shareholder is not required to contribute to its debts. The shareholder’s liability for the activities of the company is, in principle, limited to the amount of its investment in the company. 13

14. Ownership Structures Alternatives to Incorporation Common practice to use partnership structures instead of companies to own ships. Limited partnerships Unlimited partnerships where unlimited partnerships are used to own ships it is common practice for the individual partners themselves to be limited liability companies 14

15. Ownership Structures Limitations of Incorporation Piercing of corporate veil Sister ship arrest In South Africa, vessels owned by different companies within the same group of companies may be arrested for each other’s liabilities if the claim is recognized as creating a “maritime lien”. 15

16. Ownership Structures Limited Liability and Piercing the Corporate Veil Salomon v Salomon [1897]) Adams v Cape Industries [1990] Despite this, creditors of many companies have sought to assert that shareholders, affiliated companies and people holding controlling interests in the companies of which they are a creditor should be made liable for some or all of the debts or obligations of that company. the company is the agent of its shareholder; Atlas Maritime v Avalon Maritime (No 1) [1991] the corporate structure is merely a “sham” or a “façade” and should, therefore, be ignored; the structure (or the business relationship between the company and its affiliate or shareholder) was operated to attain fraudulent ends or, possibly, to evade pending claims and should, therefore, be ignored; debts due to a shareholder should be treated less favourably than debts due to third party creditors if a Mareva injunction is granted against a company; and by exercising control over the company’s actions the controlling shareholder incurs liability to creditors in tort either as a result of unlawfully conspiring with the company to injure the creditor or by breaching a fiduciary obligation (itself incurred as a shadow director). 16

17. Ownership Structures Incorporation and its Effectiveness Shareholders who act as shadow directors of a company may incur liability to a liquidator if they act in a manner which is in breach of their fiduciary obligations A court will regard a corporate entity as a mere “façade” if, in practice, it does not act as a separate legal entity. Recent case law suggests that the courts are becoming less and less inclined to recognize “sham” as exceptions to the rule that corporate entities have separate legal personalities. Rather, the courts will properly interpret an individual transaction as either a sham or genuine. It is likely that in the future, in order to be successful, claimant creditors will need to frame their actions within the statutory schemes created to prevent the dissipation of assets (at an undervalue) of a company or the preference of one creditor over another rather than relying on common law “principles” to pierce the corporate veil. 17

18. Basic Principles of Lending Introduction Banks charge borrowers on a cost plus basis External costs to bank for the loan plus a mark up or profit Mark up consists of fees and a margin 18

19. Basic Principles of Lending Interest Exception: Islamic lending Interest is a charge for the use of the loan over time. Commitment fee until the borrower actually borrows – usually a proportion of the margin – a charge for availability Costs of Funds LIBOR PIBOR EURIBOR Floating Interest Rate 19

20. Basic Principles of Lending Other Costs of Lending Legal Costs Withholding Tax Gross up Tax Credit Cross Border Legal Issues Taxes Increased Costs Regulatory Costs Capital Adequacy Costs 20

21. Lending: Owner’s Commercial Relationships Introduction Borrower believes that it will be able to repay the principal as it falls due and pay the interest accruing while the loan is outstanding. Lender has to be satisfied that the borrower should be able to perform his obligations it is unlikely to agree to lend to the borrower. This will depend on an analysis of the income the borrower will generate from the operation of the ship and an analysis of the outgoings it will incur in order to generate that income. That, in turn, depends upon what the borrower will do with the ship and the level of risk it will take and a range of factors (such as freight rate fluctuations and interest rates) outside the control of either party. 21

22. Lending: Owner’s Commercial Relationships Owner’s Commercial Risks On the income side: the borrower’s exposure to fluctuations in freight rates and charter rates; and the risk of the income generated by the ship being interrupted as a consequence of loss of the ship, breakdown or third party interference such as ship arrest. On the outgoings side: the borrower’s exposure through the loan to fluctuations in interest rates and increased costs of lending passed on by the lender through the loan agreement; the borrower’s exposure to increases in operating costs for the ship, such as seamens’ wages, insurance premiums, provisioning and maintenance costs; the borrower’s exposure to fluctuations in the costs of individual voyages; and the borrower’s exposure to the costs of unanticipated repairs and third party claims. 22

23. Lending: Owner’s Commercial Relationships Owner’s Commercial Contracts Voyage charter Contracts of affreightment Time charter Bareboat charter “hell and high water basis” – removes all risks save for interruption in the use of the vessel arising from the borrower’s own actions, leaving the borrower’s exposure limited to fluctuations in interest rates Interest rate fluctuations can be managed by entering into a “swap” 23

24. Lending: Owner’s Commercial Relationships Commercial Contracts: Influence on Finance Documents Track record of the borrower Historical analysis of freight rates Creditworthiness of the charterer Condition precedent that a charter is in place Practical problem Charter commences when the vessel leaves port (dropping outward pilot) Transfer of title by which borrower acquires ship takes place when the ship is in port (alongside or at anchor) Representation and warranty to provide lender with charter details The “ship covenants” will include covenants by the borrower to perform the charter, to keep the charter in place and not to amend the charter. Assignment of the charter in the Deed of Covenants 24

25. Lending: Owner’s Commercial Relationships Vessel Operation: Influence on Finance Documents Vessel “in class” Conflict Between Commercial Relationships and Lender’s Interest Lender’s Interest ship operating uninterrupted generate sufficient revenue for debt service and expenses if the borrower gets into financial difficulties the lender can collect the unpaid freights may want the option of taking over the benefit of any charter it can procure a sale of the ship and use the proceeds to repay the debt if there is a problem ship will be in a good state of repair wants to ensure that any insurance claim to cover damage to the ship is indeed applied to repair the ship in the event of the ship being lost, it wants to receive the insurances itself 25

26. Lending: Owner’s Commercial Relationships Conflict Between Commercial Relationships and Lender’s Interest Third Party Interests Compete and even conflict with those of the lender. two groups those who have rights to use the vessel those who have claims against the owner The group of persons who have claims against the owner further divide into: ordinary creditors; those who have maritime claims (arrest the ship without necessarily giving rise to a maritime lien); and those whose claim gives them a “lien” on the vessel (i.e. a claim against the ship itself which may continue to exist even if ownership of the ship changes and which may have priority over claims of ordinary creditors). Priority of Creditors’ Claims Cargo Claims Suppliers’ Claims “necessary” can vary from supply of fuel and lubricating oil, through ships stores to insurance premiums and P&I Club calls. All these aspects are addressed in a typical loan agreement and security documents. 26

27. Lending: Owner’s Commercial Relationships Conflict Between Commercial Relationships and Lender’s Interest Third Party Interests Insurer’s Interests US case (Liverpool and London P&I v Queen of Leman MV (2002)) concluded that unpaid P&I calls could be recognized as giving rise to a lien on the ship. English law, the placing broker will be liable to pay the unpaid premiums In either event, unpaid insurance premiums can reduce the amount received following an insured incident, potentially resulting in the vessel itself having a diminished value due to the full value of the insurance claim not being available to repair the ship or to settle the relevant third party claims. 27

28. Insurances A vessel can be insured against a broad range of risks hull and machinery insurances war risks insurances protection and indemnity insurances covering a range of third party liabilities 28

29. Insurances Owner’s Insurance and the Finance Documents Insurance Obligation Any lender will make them a compulsory requirement of the loan The Loan Agreement will also require that the insurances are for a satisfactory amount and that the lender is satisfied both that the insurer is acceptable and that the insurance terms are satisfactory Insured Value The level of insurance required is usually linked to the value of the loan. It is customary to require the vessel to be insured for around 120% of the loan as a minimum This is so that if the vessel is lost and the insurers take a while to pay the money, when received, should be sufficient to cover the loan and any unpaid interest Where the loan amount would be less than the market value of the ship, there will be an obligation to ensure that the ship is insured for not less than its full market value. This is to prevent the principles of “averaging” 29

30. Insurances Owner’s Insurance and the Finance Documents Ongoing Insurance Requirements Lender will impose obligations to maintain the insurances Pay the premium Mortgagee’s Insurances If borrower fails to observe the duty of utmost good faith then the lender is at risk. A mortgagee’s interest insurance policy is taken out by the lender directly and the cost of it is paid to the lender under an indemnity from the borrower. Mortgagee’s additional peril insurance Relates to oil pollution OPA 90 30

31. Ship Mortgages The normal order of priorities in a sale by the Admiralty Marshal: First, Admiralty Marshal’s costs and the legal costs Second, maritime lien claims, e.g. claims for wages of the crew and master Third, possessory lien claims, e.g. claims of a ship repairer for as long as the ship remains in the repairer’s possession Fourth, mortgages and charges on the ship. Fifth, statutory lien claimants Sixth, after the payment of these claims, the balance of the fund will be paid to the owner or, if the owner is insolvent, the liquidator or trustee in bankruptcy, or any judgment creditor of the owner who has obtained a charging order. 31

32. Ship Mortgages Ship mortgages are an important form of security because: they give the mortgagee rights directly against the ship (rights in rem); the mortgagee has priority over unsecured creditors of the mortgagor; and the mortgagee may take possession and/or sell the ship to recover its loan upon default by the mortgagor. 32

33. Ship Mortgages Effectiveness of Mortgage Security Against Others Mortgagees faced with different rules in each jurisdiction Portuguese and German law does not recognize a contractual right of the mortgagee to take possession of a mortgaged ship In Spain, taking possession against the owner’s wishes is a criminal offence. In South Africa, an owner is entitled to the release and return of its ship if a mortgagee takes possession in another jurisdiction in order to move it to South Africa as an otherwise more favourable jurisdiction. Italian law does not recognize a contractual right of the mortgagee to take possession of a mortgaged ship, nor a right of private sale; the only remedy exercisable without the owner’s co-operation, regardless of prior agreement between the owner and mortgagee, is arrest and court sale. In Belgium, a power of private sale will only be recognized if it is granted in a post-mortgage agreement, thereby protecting the owner’s weaker position in initial negotiations. 33

34. Ship Mortgages Effectiveness of Mortgage Security Against Others Mortgagees faced with different rules in each jurisdiction In Denmark and Italy there are mandatory notice periods which must be given before a sale. In Mexico the courts will not recognize or enforce foreign ship mortgages or mortgages given in respect of non-domestic debt. In France, the courts will not have jurisdiction to try a mortgagee’s claim under a non-French law loan agreement even if the mortgaged ship is under arrest at a French port. 34

35. Security Over Rights: Assignment Purpose of Security prevent the owner dissipating assets; prevent other creditors obtaining a claim against those assets which would have priority over the lender’s claim; and provide the lender with a claim against those assets which has priority over the claims of other creditors of the borrower in the event of its insolvency. “Rights” as Assets In addition to the ship, shipowner’s assets consists of choses in action 35

36. Security Over Rights: Assignment Assignment An assignment involves the transfer of ownership of the right in question from the person granting the security (the “assignor”) to the person receiving the security (the “assignee”), generally the bank. “legal assignment” transfer of the legal ownership of the right to the assignee “equitable assignment”, transfer of the equitable ownership of the right, in which event the assignor will remain the legal owner and will hold the rights on trust for the assignee. This makes little difference in practice. Where such an arrangement is used with the intention of providing security, the law recognizes an inherent right for the assignor to have the rights returned to it on satisfaction of the debt whether or not the agreement includes such a provision. 36

37. Security Over Rights: Assignment Charge A charge does not involve the transfer of an ownership interest in the assets but involves the so-called “appropriation” of the relevant assets by the chargor exclusively to the payment of the debt or liability to the chargee. Charges may be “fixed” or “floating”. If fixed, the charge will remain attached to the property even if the chargor disposes of the property. A floating charge leaves the chargor free to deal with the relevant assets (or their proceeds) in such a manner that the chargor can take them outside the ambit of the charge provided this is done before the floating charge “crystallizes”. In ship finance transactions, assignments are more commonly used than charges. In practice, the two terms assignment and charge are used almost interchangeably and an assignment may be reclassified by the courts as a floating charge. 37

38. Security Over Rights: Assignment Assignability Marine insurances will generally include express restrictions on assignment. The rules of each of the P&I Clubs comprised in the International Group of P&I Clubs prohibit assignment of a member’s rights unless (and to the extent that) it has been consented to by the club. The Institute Time Clauses Hulls provide that an assignment will be ineffective as against the underwriters unless and until a notice of assignment signed by the insured has been endorsed on the policy. For this reason it is customary to require an assignor to sign notices of assignment although as a matter of general law there is no requirement that a notice must be signed by the assignor in order for it to be effective notice as against the debtor. 38

39. Dealing with Borrower’s Deteriorating Financial Condition with the Co-operation of the Borrower Alternatives to Court Sale assisting the borrower to reduce its third party debts through restructuring permitting a sale of the vessel by the owner or even selling the vessel privately as mortgagee a mortgagee may elect to assist a borrower to fight its creditors by providing additional credit in the form of bonds, to prevent the arrest of the ship whilst claims are tried formal restructuring 39

40. Dealing with Borrower’s Deteriorating Financial Condition with the Co-operation of the Borrower Paper Restructuring “Paper transfer” of the vessel to a new registered owning company This will not avoid maritime liens, as they will still be effective against the ship notwithstanding the change of ownership. Courts might set aside the transfer The position is different where the transaction in question takes place for full value The value received can then be used to repay secured indebtedness The lender’s role in facilitating this is to advance a loan to the new owner in return for being repaid by the original owner. 40

41. Dealing with Borrower’s Deteriorating Financial Condition with the Co-operation of the Borrower Sale Voluntary transfer by the owner to an unconnected third party for full value and application of the proceeds to the mortgage debt. Appropriate if the open market value is more than the debt The seller may obtain a better price. 41

42. Dealing with Borrower’s Deteriorating Financial Condition with the Co-operation of the Borrower Mortgagee Sale A mortgagee’s sale may be effected either under the mortgagee’s general legal rights or under the express terms of the mortgage contract. Any purchaser from the mortgagee will require from the mortgagee some form of indemnity or other guarantee against creditors of the former owner Two categories of claim will survive a private sale. maritime liens; statutory liens. 42

43. Dealing with Borrower’s Deteriorating Financial Condition with the Co-operation of the Borrower Bond and Fight If vessel’s operation is being interrupted by inflated or unfounded claims, it may be appropriate to issue guarantees against arrest and to fight the claims through the local court either to conclusion or to achieve some acceptable level of settlement. In the majority of jurisdictions (other than, perhaps, Israel) a guarantee issued by a mortgagee in these circumstances gives rise to a direct contractual relationship between the mortgagee and claimant under which the mortgagee (guarantor) will be liable to pay out under the guarantee regardless of any question of priority. If the claim is good, it has to be paid regardless of whether it would or would not rank ahead of the mortgage following a court auction. This approach can be justified and will operate successfully only where certain criteria are satisfied. They are: first, that the arresting creditor will accept a guarantee or other security conditional on the vessel departing safely from the port at which she has been arrested without further arrest from other parties; second, that the arrest of the vessel by the creditor in question is not simply the tip of the iceberg. Formal Restructuring 43

44. Enforcement Of Security (Including Arrest And Auction Sale) Enforcement Considerations Priority of claims Taking control and location Ship arrested by trade creditor in jurisdiction unsympathetic to the interest of the bank After taking control of the vessel the bank incurs potential liability same as those of the shipowner Collision damage Pay for salvage services Pollution damage Liabilities to third parties 44

45. Enforcement Of Security (Including Arrest And Auction Sale) Jurisdiction for Ship Arrest and Mortgage Enforcement The Principal Criteria The local law with regard to priorities of claims against the eventual proceeds of the sale of the vessel. How quickly can the vessel be sold? What are the other costs of auctioning the vessel and can the bank easily recover the balance of the proceeds? 45

46. Enforcement Of Security (Including Arrest And Auction Sale) Choice of Jurisdiction Often a question of balancing these different considerations. One jurisdiction may provide for a swift and efficient sale procedure, that same jurisdiction may penalize the mortgagee bank in terms of domestic rules on priorities. South Africa - Established procedures for arrest and judicial auction of vessels allow for the entire process to be completed within approximately five to six weeks from arrest. The South African law on the priority of claims, however, as set out in the Admiralty Jurisdiction Regulation Act of 1983 (as subsequently amended) gives priority to a wide variety of trade creditors whose claims have arisen during the course of the previous 12 months. The list of such creditors includes creditors in respect of insurance premiums. Since insurance premiums are often amongst the first items to go unpaid when an owner’s financial position begins to deteriorate, so very significant debts in respect of premiums can quickly accumulate to a level which represents a significant proportion of the value of the vessel in question. In such a situation, the advantages of a swift and efficient sale procedure are quickly lost when the proceeds of sale are finally distributed. 46

47. Enforcement Of Security (Including Arrest And Auction Sale) Enforcement: Common Law and Civil Law Jurisdictions Common law jurisdictions Common law courts recognise the benefit for all creditors of sale of the subject vessel pendente lite. Common law courts will usually allow the writ to be served on the vessel herself as the subject matter of in rem proceedings. The proceedings are, accordingly, able to be got underway quickly and efficiently. Civil law jurisdictions. In civil law countries, the vessel will remain laid up for as long as is necessary for the arresting creditor to obtain a final (unappealable) judgment Many civil law courts, on the other hand, require the writ or complaint or similar document to be served on the vessel’s owners at their registered office in, say, Monrovia or Panama City. The process of service itself can be extremely slow 47

48. Enforcement Of Security (Including Arrest And Auction Sale) Local Considerations The procedure for distribution of the proceeds of the sale of a vessel in South Africa is subject both to scrutiny by a referee and by the courts which can lead to significant delay in obtaining reimbursement of the mortgage debt in cases where other creditors put up a fight. Certain trade creditors also take priority over the mortgagee in South Africa and very high levels of interest on priority claims is often awarded. In the US, many domestic creditors will take priority over a non-US mortgage. In the Bahamas, stamp duty is imposed at 0.8% on the total amount of any claim submitted to the Bahamas courts (in addition to the Marshal’s broker’s commission of 1% on the sale proceeds). Duties charged by reference to the amount of a claim rather than by reference to the amount recovered can be punitive, particularly where the mortgaged vessel is only one of a fleet mortgaged for a large debt. Gibraltar has very limited (and expensive) cargo removal/storage facilities in cases where the vessel in question is laden. 48

49. Enforcement Of Security (Including Arrest And Auction Sale) Local Considerations The Indian courts operate extremely slowly (partly because of the political/bureaucratic roles which are imposed on the judiciary in addition to their judicial function). Some common law jurisdictions (Gibraltar, the UK, Canada and, more recently, The Bahamas and Singapore) recognise a procedure known as sale by “private treaty” which can be achieved with great speed if certain criteria can be satisfied (principally, a third party is prepared to buy the vessel for an amount which can be demonstrated to the satisfaction of the court to be at least as much as would be realised by public auction). It is always necessary to look at specific prevailing circumstances which may affect the timing of the enforcement process; e.g. civil wars, strikes, etc. The order of priority of claims against the proceeds of sale under Canadian law depends on the law governing the claim itself. This can lead to significant uncertainty and protracted litigation over the distribution of the sale proceeds (a situation more often encountered in civil law jurisdictions such as The Netherlands, Belgium, Greece and many others where the court may decide priorities by reference to the law of the flag of the vessel or the law governing the claim). 49