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Ship Mortgages in Favor of Owners

June 2010
Ship mortgages in favor of “owners”

Some transactions, including French tax lease deals, call for a ship mortgage in favor of a shareholder of a corporate shipowner. The typical structure involves a shipowner that is a wholly owned subsidiary of a bank, and a ship mortgage is granted to the bank. This structure raises the issue of whether a ship mortgage may be granted in favor of an “owner.” Under normal principles of corporate law, the bank would not be considered the owner of the vessel without applying the extraordinary remedy of piercing the corporate veil, but this detail has been ignored by some courts. Some courts and practitioners also incorrectly assume that a ship mortgage gives rise to a “maritime lien.” The mistaken application of traditional maritime lien rules to ship mortgages creates uncertainty as to the validity and priority of a ship mortgage granted to a shareholder of the shipowner.

Under the Maritime Lien Act (recodified in 46 U.S.C. §§ 31341-42), providers of necessaries to a vessel are granted a maritime lien to secure payment. The shipowner, of course, is obliged to pay for the necessaries provided to his vessel. Thus, the rule that a shipowner cannot have a maritime lien on his own vessel is a sensible one. The shipowner should not obtain a priority over creditors simply because he has paid his bills. When there is a corporate shipowner and a shareholder pays for the vessel’s necessaries, the issue is less clear. The separate identity of the corporation should be respected, but it does not seem equitable to permit a shareholder as an indirect owner to have a priority over other creditors when he benefited indirectly from the provision of necessaries to the ship, and payment for them should have been made from the assets of his corporation. In The NATCHEZ, 236 F. 588, 591 (D. La. 1916), for example, the corporation was dormant, there were no other assets, the vessel was laid up and a shareholder sought a lien for advances made for repairs to the vessel. The court held that the shareholder was a virtual owner of the vessel and said “...in these circumstances it would be inequitable in the last degree to grant a secret lien to the virtual owners of the vessel to the prejudice of the materialmen because of the legal fiction of her ownership by a corporation.”

While it may be reasonable to deny a maritime lien to a shareholder who paid for necessaries, the situation is very different if a shareholder makes a bona fide loan to the shipowning corporation that is secured by a ship mortgage. There are economic and legal differences between a shareholder who pays the provider of necessaries and hopes to obtain a maritime lien on the vessel and a shareholder who makes a bona fide secured loan to the corporation. First, there could be no bona fide loan by a shareholder if the shipowner is undercapitalized. A “loan” made to an undercapitalized corporation should be deemed to be capital. Second, by recording a ship mortgage, the shareholder would be relying on the recodified Ship Mortgage Act and not on the Maritime Lien Act, for its security. The two statutes have different but compatible purposes. The Ship Mortgage Act was adopted in order to encourage financing of ships, while traditional maritime liens are intended to protect local merchants. By recording the mortgage, subsequent providers of necessaries are put on notice that there is a senior mortgage lien.

Because ship mortgages give rise to a lien that is enforceable in rem in admiralty, the statutory preferred mortgage lien is often confused with a maritime lien. In Security Pacific National Bank v. Pacific Pride, 549 F. Supp 53, 54-55 ( W.D. Wa. 1982), the court, in dicta, purported to apply the maritime lien rule to a ship mortgage without acknowledging or discussing that it might not be applicable:
The sole issue here is whether a ship mortgage granted by a partnership in favor of individual partners, securing a loan of funds to the partnership by those partners, may constitute a valid preferred ship mortgage. *** The opponents of this motion correctly point out that the law is clear that owners, part owners, joint venturers and stockholders cannot have a valid maritime lien on any vessel in which they own an interest. (Emphasis added)

The court refused to permit the partner mortgagees to foreclose the mortgage without a full trial as to the validity and priority of the mortgage. A practical problem was a major factor in the court’s decision. The partner mortgagees sought to credit bid at the foreclosure sale, and the court could not defer resolution of the issue of validity or priority until after the sale was conducted.
In fact, the ship mortgage lien is a statutory lien that bears little resemblance to a traditional maritime lien. This distinction has been recognized by the courts. U.S.v. GOLDEN DAWN, 222 F. Supp. 186 (E.D.N.Y. 1963); Custom Fuel Services, Inc. v. Lombas Industries, Inc., 805 F.2d 561 (5th Cir. 1986) (“Custom Fuel”). Maritime liens are secret liens, whereas ship mortgages must be recorded in a public registry. Maritime liens rank in inverse order to the time they are incurred while the priority of ship mortgages is based on the first to be filed. Unlike maritime liens, ship mortgages are not subject to laches.

The Ship Mortgage Act, recodified in 46 U.S.C. §§ 31301-30, consistently refers to the mortgage lien as a “preferred mortgage lien,” or a “mortgage lien.” Section 31325 states that “A preferred mortgage is a lien on the mortgaged vessel…” Nowhere in the Act is the mortgage lien characterized as a “maritime lien.” Indeed, § 31326, recognizes that a mortgage lien is not a maritime lien: “When a vessel is sold … to enforce a preferred mortgage lien or a maritime lien…the vessel is sold free of all those claims.”

Rules governing maritime liens, including the rule quoted above from the Pacific Pride case, are not applicable to ship mortgages. The criteria for reviewing the validity and the priority of ship mortgages to “owners” were established in Custom Fuel. While stating that mortgages to “owners” must be closely scrutinized for inequitable conduct, the court appeared to accept that in the absence of bad faith or fraud, compliance with the statutory requirements and the existence of a valid debt would establish the validity of a ship mortgage. If there is inequitable conduct related to an “owner’s” mortgage, it will become an issue of the priority accorded to the mortgage lien, not its validity.
In Custom Fuel, the shipowner was a wholly owned subsidiary of a bank. The bank loaned the shipowner 100% of the subsidiary’s purchase price of the vessel and took back a ship mortgage. The vessel was then bareboat chartered to a vessel operator. After incurring repair liens on the vessel, the charterer became insolvent, and the bank commenced a foreclosure action against the vessel. The court found that it would be inequitable to permit the mortgagee bank to obtain in foreclosure the full value of the vessel to the exclusion of the repair yard. The court analyzed the 100% mortgage amount and the nominal $1,000 capital of the shipowner and concluded that the shipowner was inadequately capitalized. As a result, the court applied the doctrine of equitable subordination to give the repair yard’s maritime lien priority over the mortgage. The issue of the reasonableness of capital is normally analyzed at the time a transaction is initiated, and presumably, had the mortgage been recorded for only 75% of the purchase price, the court would not have found the shipowner to be inadequately capitalized even if the outstanding loan amount at the time of foreclosure exceeded the value of the vessel.

Loss of priority for a foreign flag vessel would normally be of little consequence in the United States because ship mortgages on foreign flag vessels are subordinate to maritime liens in favor of those providing necessaries in the U.S. There are, however, provisions in the Maritime Laws of each of the Marshall Islands and Liberia which create uncertainty not only as to priority but also as to the validity of a mortgage to an “owner.”

The Liberian Maritime Law was adopted in 1949, and was modeled on the U.S. maritime statutes. It incorporates by reference the general maritime law of the United States to the extent not inconsistent with the Liberian statutes. In 1990, the Marshall Islands adopted a Maritime Law that followed very closely the Liberian statute. Both statutes state that “A preferred mortgage shall constitute a maritime lien on the mortgaged vessel…” Liberian Maritime Law § 107; Marshall Islands Maritime Act § 311. The origin of the insertion of “maritime” in the adoption of the U.S. statutory provisions is unclear. The original Ship Mortgage Act stated that “A preferred mortgage shall constitute a lien on the mortgaged vessel...” Ship Mortgage Act, 1920, Subsection K. This section was re codified in 46 U.S.C. § 31325, quoted above, in which “is” was substituted for “shall constitute.” The references to the mortgage lien in the other sections of the Liberian and Marshall Islands laws are similar to those in the U.S. statute, and in most places it is referred to as a “preferred mortgage lien.”

Except for the characterization of the ship mortgage lien as a “maritime lien,” ship mortgages under the laws of both Liberia and the Marshall Islands have the same characteristics as the U.S. ship mortgage when compared to maritime liens. Thus, it is probable that the characterization is an error by the draftsmen of the Liberian and Marshall Islands statutes. Until the error is corrected, however, there remains uncertainty as to the treatment of ship mortgages in favor of a shareholder of the shipowner in Liberia and the Marshall Islands. In light of these provisions, it is not clear whether the rule of Pacific Pride or Custom Fuel is to be incorporated by reference into Liberian and Marshall Islands law. These statutory provisions leave open the possibility that such mortgages would be held to be invalid under the maritime lien rule that an “owner” may not have a lien on his own ship. Whereas, under the U.S. statute and the Custom Fuel decision, the consequence is that the transaction will be subject to special scrutiny for inequitable conduct, and in the worst case there would be a loss of priority.