The United States – and specifically New York – is a global financial centre and leading jurisdiction for vessel-financing transactions. Home to many large financial institutions and public exchanges, shipping companies have long sought financing in the United States. Furthermore, many international shipping companies, as well as major legal, financial and other service providers to such companies, are located in the United States. In addition, admiralty law is subject to US federal jurisdiction establishing consistent court precedent providing security for business practice.
Historically, the shipping industry's principal source of capital has been the domestic and international debt finance bank market. The shipping industry was affected by the worldwide economic downturn and financing has proven much more difficult to secure. The US vessel finance market has adapted to this changing landscape and has expanded sources of capital to include public capital market debt and equity offerings as well as the infusion of private equity (PE) investments. In the latter case, PE investors have learned the intricacies of the shipping markets and invested in a multitude of different projects.
Also, the surge in US crude production created strong demand for US trades. Future oil prices continue to dictate the direction of this trend.
ii LEGISLATIVE FRAMEWORK
Domestic and international law and regulation
The financing of US-flagged vessels is regulated by national, state and local laws as applied through various administrative agencies. National legislation includes the Ship Mortgage Act, the Merchant Marine Act, the Maritime Security Act, the Oil Pollution Act (OPA), the Comprehensive Environmental Response, Compensation and Liability Act and the Coast Guard Authorization Acts. Administrative agencies include the United States Coast Guard (USCG), its sub-agency, the National Vessel Documentation Center (NVDC) and the Maritime Administration (MARAD).
Vessel documentation requirements
Section 27 of the Merchant Marine Act, also known as the Jones Act, provides for the registration and documentation of vessels under the US flag. The NVDC is authorised to document any vessel of at least 5 net tons not documented under the laws of a foreign country and wholly owned by an 'eligible owner'. An eligible owner, also known as a 'documentation citizen', must satisfy certain management-level criteria. For example, in the case of a corporation, the chief financial officer (by whatever title) and chairman of the board of directors must be US citizens. All directors, except a minority of the quorum, must be US citizens.
A US-flagged vessel is eligible to receive one of three 'endorsements' – registry, fisheries and coastwise – each of which permits the vessel to engage in certain types of commercial activity. As part of its due diligence prior to financing the purchase of a US-flagged vessel, a financier should examine the relevant vessel's trade endorsement and confirm that the vessel is authorised to conduct the contemplated commercial activity. A registry endorsement entitles a vessel to engage in trade between a US port and a foreign port, and between two foreign ports. A coastwise (cabotage) endorsement entitles a vessel to engage in trade between two points in the United States to which the coastwise laws apply, either directly or via a foreign port. To be eligible for a coastwise endorsement, a vessel must be built in the United States and owned, operated and manned by US citizens. A corporation is only deemed a US citizen for coastwise trade purposes if at least 75 per cent of its equity interests are held by US citizens.
Since the 1996 amendments to the Ship Mortgage Act (eliminating the requirement of the 'Westhampton Trust'), there are no restrictions on the citizenship of mortgagees holding a mortgage on a US-flagged vessel. If a mortgage covers the entirety of a documented vessel, it will be characterised as a preferred ship mortgage, valid against the grantor, mortgagor or assignor, the heir or devisee of any such party, or any other party having actual notice of the mortgage. To be valid against third parties, it must be perfected by filing with the NVDC. This requires that the mortgage identify the vessel, state the name and address of each party, state the amount of the direct or contingent obligations, the interest of the grantor, the interest mortgaged and be signed and notarised. A foreign mortgage is deemed preferred in the United States if it was executed under the laws of a foreign country and has been registered at a foreign central office.
An entity that meets the documentation citizen requirements in relation to a registry endorsement is permitted to own a vessel with a coastwise endorsement if: (1) the entity is primarily engaged in leasing or other financing transactions; (2) the vessel is under demise charter for at least three years in duration to an entity qualified to engage in coastwise trade; and (3) the owner is independent from and not affiliated with any charterer or any person that has the right to direct vessel movement or its use. This 'foreign lessor exemption' was designed to permit passive foreign leasing companies to finance, under a lease structure, US vessels with a coastwise trade endorsement. In the event of a default, while lessors cannot operate a coastwise vessel directly, they may sell the vessel to a US citizen or a non-US citizen with MARAD approval or appoint a new lessee to charter the vessel (under a new lease or a lease assumption). A foreign lessor should be exempt from the strict environmental liability provisions of OPA 90 and CERLCA if they hold an 'indicia of ownership' primarily to protect a security interest, and do not exercise decision-making control over the vessel.
In the Lykes Bros Steamship case,1 a bankruptcy court held that a vessel lease-financing transaction was a mere 'financing transaction' and not a 'true lease'. The court recharacterised the transaction and held that the demise charterer was the true owner, rendering the lessor an unsecured creditor. To protect against this risk of recharacterisation, lessors can require the demise charterer to execute and file a preferred ship mortgage (usually for the full value of the vessel) in favour of an affiliate of the lessor. Typically, the foreign lessor then purchases the vessel back from the demise charterer for a nominal sum before chartering back the vessel. This legal framework attempts to ensure that if the transaction is recharacterised as a loan, the preferred ship mortgage in favour of the bank's affiliate, which predates the transaction, operates to provide the bank with some degree of security over intervening creditors.
iii FINANCIAL REGULATION
i Regulatory capital and liquidity
Banking organisations in the United States are subject to complex risk-based regulatory capital rules. Some banking organisations may use internal risk management models approved by the relevant regulator; others must use standardised rules set out in the regulations. Generally speaking, the more risk associated with a particular loan, the more capital that must be reserved against it on a bank's books. The risk associated with shipping has put capital constraints on ship lenders.
The United States has adopted the Basel III risk-based capital requirement regime. Each federal bank regulatory agency has promulgated the requisite risk-based capital requirements.2 For example, under the standardised regulatory capital regulations, ordinarily, corporate loans are assigned a 100 per cent risk weight, which can be adjusted upwards by the applicable supervisory authority. In accordance with the applicable regulations, collateralisation of a loan may then mitigate the risk weight of a particular asset. Notwithstanding, the delivery of standard ship security (mortgage, assignments of earning and insurances, etc.), loans to finance ships are considered high-risk and impose significant capital reserve requirements on banks lending to this sector.
In addition to the risk-based capital requirements, banking organisations also need to comply with a leverage requirement, which is a ratio of its Tier 1 capital (e.g., common equity) to an aggregate of certain assets (e.g., on-balance sheet assets such as loans). Banking organisations also will be subject to certain short and long-term liquidity requirements. Requirements may vary depending upon the amount and nature of the banking organisation's assets and activities.
ii Supervisory regime
In the United States, there are several bank regulators. Bank holding companies are regulated by the Board of Governors of the Federal Reserve System (Federal Reserve Board). Banks can be chartered by either a US state regulator, such as the New York Department of Financial Services (a state-chartered banking organisation), or the United States Department of the Treasury (a national bank or federal savings association). Federal deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC). State-chartered banking organisations also have a federal overlay of banking regulation and supervision, by either the Federal Reserve Board or the FDIC, depending upon whether the state-chartered banking organisation is a member bank of the Federal Reserve System. The applicable federal and state banking laws, including the capital regulations, are the primary banking legislation and regulation affecting the banks' ability to lend into the transport sector, but their applicability may be limited by more specific US transport-financing laws and regulations discussed elsewhere in this chapter.
iv SECURITY AND ENFORCEMENT
i Security documents
Lenders typically require a package of security documents, enforceable against the shipowner, or the ship itself, in the jurisdictions into which the ship calls. These include preferred ship mortgages, assignments of a vessel's earnings, insurances, charters and requisition compensation, share pledges by owner holding companies, undertakings by vessel managers, guarantees and assignments of deposit accounts.
Under US law, the most common form of US vessel security is the 'preferred ship mortgage' under the Commercial Instruments and Maritime Liens Act (CIMLA). To gain preferred status, a mortgage must meet several requirements, including being made in favour of a mortgagee that is either a United States state, the United States government, a federally insured depository institution, a citizen of the United States, a person qualifying as a citizen of the United States under Section 50501 of Title 46 of the United States Code, or a person otherwise approved by the Secretary of Transportation. A preferred ship mortgage is perfected by filing the mortgage with the central registry at the NVDC.
ii Enforcement, arrest and judicial sale
The primary mechanism for enforcement of a preferred ship mortgage on either a US or foreign-flagged ship in the United States is an in rem action under a federal court's admiralty jurisdiction. Such an action may be brought in any US district where the vessel is physically present. The court may appoint a receiver to operate the mortgaged vessel in global trade so the vessel may continue to earn revenue while maintaining in rem jurisdiction over the vessel, or, if the court finds that the lender's mortgage is valid and in default, the court may order that the vessel be arrested by the US Marshals Service and sold in a judicial sale. The US marshal for that judicial district will then serve the warrant and related documents to the vessel and effectuate the arrest. If the owner is unable to post a bond or other security for the mortgage claim, the vessel will remain in the custody of the court pending an interlocutory sale thereof. When a vessel is sold by order of a US district court in an in rem action, all claims against the vessel are terminated and subsequently attach to the proceeds of the sale.
Ranking of liens
Judicial sale does not guarantee the lender full repayment. The proceeds from a judicial sale are used to satisfy maritime liens in order of relative priority; for example, competing maritime liens are ranked according to class and top-ranked claims are paid out first, while among maritime liens of equal class, later liens have priority according to the 'inverse order' rule.
Preferred ship mortgages rank highly as maritime liens, taking priority over all claims (except the costs of administering the sale) that are not 'preferred maritime liens', consisting of seaman's liens, salvage and general average liens, tort liens, and any other maritime liens arising before a preferred mortgage was filed. As between two mortgages, each is prioritised according to the 'first-in-time' filing rule, subject to the application of the 'voyage rule', which provides that two claims of the same class arising during the same voyage are paid pro rata. The date a mortgage is filed is the relevant date for the ranking analysis, not the date the funds are actually advanced, provided the mortgage covers the subsequently advanced debt. If a mortgage is amended to provide for an advancement of new funds not covered by the original agreement, then the new funds are likely to be treated as being covered by a separate, newly created mortgage.
A lender is not bound by the remedies afforded it by operation of US federal law. A lender can exercise private and extrajudicial remedies – such as taking possession of the vessel – if such remedies are permitted under the contract (mortgage or loan agreement) and under the laws of the state where the vessel is located. CIMLA expressly allows lenders to 'enforce [a] preferred mortgage lien or a claim for the outstanding indebtedness secured by the mortgaged vessel [. . .] by exercising any other remedy (including an extrajudicial remedy) against a documented vessel [or] a foreign vessel [. . .] for the amount of the outstanding indebtedness or any deficiency in full payment of that indebtedness', but only if the remedy is allowed under the law of the state where the vessel is docked. For example, in the Dietrich v. Key Bank case,3 the court held that a bank could repossess a vessel that was docked at a Florida harbour because the bank specifically contracted for such a self-help remedy and the right of repossession existed under Florida state law.
Repossession by a non-citizen
Complications can arise when a vessel with a coastwise endorsement is repossessed or purchased at a judicial sale by a non-citizen mortgagee. Such a right of purchase by a mortgagee is specifically provided for in 46 USC, Section 31,329, notwithstanding the strict regulation of the citizenship of entities that own and operate coastwise-qualified vessels under the Jones Act. If a coastwise-qualified vessel is repossessed or purchased by a non-US citizen mortgagee, the vessel may only be held temporarily for resale subject to emergency sale restrictions. It may not be 'operated, or caused to be operated, in commerce'.4 As long as it complies, the vessel should also not permanently lose its coastwise trading privilege, which it would if it were sold to a non-citizen.
v CURRENT DEVELOPMENTS
i Recent cases
The definition of which structures constitute 'vessels', thus capable of being the subject of preferred ship mortgages, was recently revised by the Supreme Court in the decision Lozman v. City of Riviera Beach, Florida.5 In that case, the Court considered whether a houseboat, permanently moored and without a propulsion mechanism, constituted a vessel subject to federal maritime law. The Court referenced the Rules Construction Act, which defines a vessel for purposes of the US maritime statutes as including 'every description of watercraft or other artificial contrivance used, or capable of being used, as a means of transportation on water'. The Court further articulated that a floating structure is not a vessel 'unless a reasonable observer, looking to the [structure]'s characteristics and activities, would consider it designed to a practical degree for carrying people or things over water'. This has come to be known as the 'reasonable observer' test for determining vessel status. Under this test, 'not every floating structure is a 'vessel'', and the mere ability to relocate a structure over water does not automatically render it a vessel. Moreover, the subjective intent of the structure's owner is irrelevant – only the 'physical attributes and behaviour of the structure', which are 'objective manifestations' of the structure's 'purpose', affect vessel status. The decision has cast doubt over established principles of the United States Circuit Courts of Appeals, and created confusion regarding which vessels can be subject to preferred ship mortgages. The decision also creates the potential situation that, despite a structure's USCG status as a documented vessel, it may not constitute a vessel under the general maritime law as applied by federal courts.
The challenge of a public company satisfying coastwise citizenship requirements was highlighted in the USCG's recent investigation into the citizenship of Trico Marine Services Inc. In that case,6 a non-citizen shareholder of Trico alleged that, through its two vessel-owning subsidiaries, Trico had breached the 75 per cent US citizenship requirement of its vessels' coastwise endorsements. Trico contended that it was impossible to verify whether public shareholders were of US citizenship as certain shareholders are entitled to prohibit the disclosure of their identity under SEC regulations including the Exchange Act. In the alternative, Trico relied upon shareholder declarations obtained through the Depository Trust Company programme, which showed that no more than 25 per cent of shareholders were non-citizens. In making its decision, the Coast Guard dismissed both of Trico's defences as inadequate to establish compliance with the 75 per cent threshold. It held that if a publicly traded corporation sought the 'privilege of engaging in the coastwise trade', it must 'structure itself and its equity securities in such a way [. . .] by which it can satisfy its obligations under the Jones Act'. The Coast Guard fined Trico approximately US$6 million and recommended that the NVDC invalidate each vessel's certificate of documentation. The decision arguably left publicly traded corporations with little guidance as to how to structure their operations to ensure compliance with coastwise requirements.
ii Developments in policy and legislation
The shipping industry is frequently subject to changing legislation that affects the profitability of vessels and the value of vessel security. For example, new environmental regulations and vessel security measures require shipowners to make additional capital expenditures to ensure compliance. It is important to note that these regulations are imposed by local, state, national and international authorities, and can be inconsistent.
While legislation is often proposed in the US Congress to repeal the restrictions on coastwise endorsements and to open the Jones Act trade market to foreign-flagged vessels, they have been defeated because of strong opposition from US shipyards, maritime unions and national defence interests. Notwithstanding, the US Department of Homeland Security has issued waivers permitting non-coastwise qualified ships to carry cargo in these areas to aid relief efforts following unprecedented hurricanes in the US Gulf and Puerto Rico.
There have also been recent concerns about a global trade war that could affect the US shipbuilding industry through legislation. In late 2015, Congress was considering legislation that would require all US-produced LNG to be exported on US-built-and-flagged vessels. However, the proposal failed in order to protect the competitive advantage of US energy exports.
iii Trends and outlook for the future
New York will continue to be a key jurisdiction in vessel-financing transactions. While traditional sources of financing have constricted in the United States and elsewhere, the US market has adapted and responded to meet the financing demands of shipping companies. With the increase investment in shipping by US private equity investors, US-based lending through US lenders and US branches of foreign lenders has also increased. These newly created US-based companies backed by US private equity interest will continue to require US law transactions.
1 In Re Lykes Bros Steamship Co Inc, 216 BR 856 (MD Fla 1996).
2 See 12 CFR Parts 3, 217 and 324.
3 Dietrich v. Key Bank NA, 72 F.3d 1509 (11th Cir 1996).
4 46 CFR § 221.19.
5 Lozman v. City of Riviera Beach, Florida, 133 S Ct 735 (2013).