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Ship Mortgages in favor of “Owners” – an Update

June 2011 | By Glen T. Oxton
Ship Mortgages in favor of “Owners” – an Update

by Glen T. Oxton

In a prior note (“Ship Mortgages in Favor of an ‘Owner,’” Benedict’s Maritime Law Bulletin, Vol. 7, No. 1, p. 16, 2009), the author argued that ship mortgage liens should not be subject to rules governing maritime liens for necessaries. A recent decision in the District of Massachusetts has adopted this view, relieving practitioners of the uncertainty caused by an implication to the contrary contained in Pacific National Bank v. O.S. PACIFIC PRIDE, 549 F. Supp. 53 (W.D. Wash. 1982).

In L&L Electronics v. M.V. OSPREY, 2011 WL 570012 (D. Mass. 2011), a Connecticut limited liability company (“Watersedge”) intended to acquire and operate a fleet of luxury yachts under a time sharing arrangement. The business failed. One of the company’s yachts, the M.V. OSPREY, was sold in a ship mortgage foreclosure proceeding. The price obtained in foreclosure was $140,000, which was substantially less than the amount of the liens on the yacht, including the amount due under the mortgage of about $725,000, the claim of L&L Electronics of about $27,000 for electronics provided and the claim of Essex Boat Works for about $54,000 for work performed on the yacht. The mortgage was recorded before the liens of L&L and Essex arose.

The Court’s award of the sale proceeds to the mortgagee was challenged by both L&L and Essex on the ground that the mortgage was invalid because the mortgagee was not a “stranger to the vessel,” in other words that the mortgagee should be deemed the owner of the yacht for purposes of the rule that an owner may not have a maritime lien on his own vessel. The Court rejected this argument holding that rules governing maritime liens are not applicable to ship mortgages. The Court also rejected arguments that the mortgage should be equitably subordinated to the maritime lien claims.

Watersedge was formed by John Baxter who also served as its President and CEO. Cornelius Prior, Jr. became a member and manager of the company at about the time it was formed. Prior made equity contributions to the company amounting to $750,000, and owned 80% of Watersedge. Baxter owned the remaining 20%.

Prior also made loans to the company in order to acquire the OSPREY and another yacht and to commence upgrading them in the total amount of $1,016,004, for which he received secured promissory notes and a first preferred ship mortgage for a maximum amount of $1,250,000. The mortgage was recorded at the National Vessel Documentation Center (“NVDC”) on April 2, 2008. About a year after the loans were made, Prior assigned the notes and the mortgage to Tropical Aircraft Company, Ltd., a corporation in which he was the sole shareholder and President. The mortgage assignment was also recorded at the NVDC.

L&L performed work on the OSPREY in June and July 2008, and Essex performed work on the yacht between May and September 2008. These suppliers were engaged by officers of Watersedge other than Prior.[1] The Court found that no misrepresentations had been made to either supplier. Moreover, the suppliers had constructive notice of the existence of the prior mortgage through the mortgage recording at the NVDC prior to undertaking their work. The Court also found that Prior had no involvement in the management of Watersedge, he had no dealings with vendors and he did not use the OSPREY or other company assets for personal purposes.

The Court noted that the purpose of providing maritime liens for suppliers of necessaries was to keep the channels of maritime commerce open by ensuring that suppliers had an effective means of obtaining payment. Since owners, and those in control of owners, are on the paying side of these transactions, they are excluded from the protection provided by maritime liens under the “stranger to the vessel” doctrine (also known as the rule that an owner may not have a maritime lien on his own vessel).

The purpose of providing ship mortgages is to promote investment in vessels and provide protection to creditors in cases of default. Quoting Custom Fuel Services, Inc. v. Lombas Indus. Inc., 805 F.2d 561, 569 (5th Cir. 1986), the Court held that a shareholder may loan money to a wholly-owned corporation and become a bona fide creditor, although such transactions are subject to scrutiny for fraud, unfair dealing or other inequitable conduct. The Court further held that there was no evidence supporting the suppliers’ arguments that the mortgage lien should be equitably subordinated because Watersedge was undercapitalized, was a mere instrumentality of Prior, was unjustly enriched and engaged in tortious conduct.

The Court did not undertake a detailed analysis of the undercapitalization issue apparently because evidence was not offered on the point. No evidence was introduced as to the revenues and expenses of Watersedge, for example. The fact that Prior’s equity contributions of $750,000 to Watersedge slightly exceeded the amount outstanding under the mortgage at the time of foreclosure ($724,000) distinguishes the case from the situation in Lombas, in which there was nominal capital of $1,000 and the mortgage was for $2,600,000, which was 100% of the purchase price of the vessel. In Lombas, the mortgage was equitably subordinated to repairmen’s liens.

Practitioners will have to wait for another case to provide guidance on how to determine whether the capital is adequate when a person in a control position in the owner of a vessel is granted a ship mortgage to secure a loan to the owner.

[1] This fact is one element relating to whether Watersedge was a mere instrumentality or alter ego of Prior. Under the facts as found by the Court, however, it would seem that the result would not have been different if Prior had engaged the suppliers.