Ship mortgage: Right of sale upon non-financial covenant default

The rights of both the bank and borrower when it comes to non-financial covenant default will not remain a question anymore.

Over the last year, we have had a significant number of inquiries from shipowners concerned about the actions which may be taken by a bank to enforce its mortgage over a vessel and, in particular, upon a non-financial covenant default. This article will consider the rights of both the bank and borrower in this situation.

A potential concern is that a bank may be able to enforce its rights when there has only been what the shipowner regards as a “minor” or “technical” breach of a provision of the relevant loan facility agreement. Most borrowers will know that a loan agreement is a densely packed slab of pages with a multitude of obscure clauses. This could potentially affect shipowners, who might well be keeping up with their repayment obligations, but be caught out by a technical default. If a determined lender chose to enforce its rights under the loan agreement, this could result in a shipowner’s ships being arrested and loans being recalled.

Such a set of facts did indeed arise in the Privy Council case of Banque Worms v Owners of The Ship or Vessel “Maule” (Cyprus Flag) & Another (“The Maule”) [1997] 1 W.L.R. 528, which originated in Hong Kong. Although 13 years old, it is still current law and shipowners should take note of the rights of their lenders, and not allow themselves to become complacent.

In The Maule, the bank lent money to the Defendants, who in return mortgaged their vessel, the Maule, as security for the performance of their obligations under a loan agreement. This agreement was entered into by the Defendants together with two other shipowning companies within the same group, on condition that one of the other companies secured employment for their vessel, the FDII, by a certain date. If this was not accomplished, the lender could give notice requiring the sale of the FDII within 60 days. Following the failure to secure employment, the lender duly gave notice for the sale of the FDII.

However, it was not sold within the time limit. This lack of sale constituted a ‘default’ under the terms of the loan agreement by all three companies (the Defendants having undertaken to procure the compliance of the other shipowning companies who were party to the loan agreement) and, as a result, the bank issued a writ to arrest the Maule in Hong Kong and enforce its power of sale. The point to note was that the loan was paid up to date and no monies were outstanding.

Initially, the Hong Kong Court of First Instance and Court of Appeal held the writ to be unlawful as the bank could only sell a mortgaged vessel when money was due. However, this ruling was reversed by the Privy Council decision, in which Lord Lloyd held that the parties were free to determine the rights and duties which appear in their agreement. Since the parties had agreed, in the event of any default, that the lender may sell the vessel, the Defendants had become duty bound to accept the sale of the vessel notwithstanding that no monies were due and outstanding under the loan agreement. The courts would not come to the Defendants’ aid to strike out this unfavourable term.

This case is very pertinent to shipowners and has shown that:

1. A mortgagee is entitled to enforce its power of sale even if no money has become due, as long as it is empowered to do so by its loan agreement;

2. If a provision allows such a sale, it would confer rights and obligations on the parties binding them to any lawful extent and the courts would not imply a condition that money should first become due pursuant to the loan agreement.

The law allows parties a wide latitude in the construction of loan agreements. Indeed, Lord Lloyd said in his judgment in the Maule that in the case of ship mortgages, the rights and duties of the parties are “overwhelmingly dominated by contract” and it was accepted in that case that “if the contract is clear enough, an express power of sale may be exercised even though there is nothing due under the loan”. Thus, a term empowering a lender with a draconian remedy such as to sell a vessel upon the occurrence of a default other than in respect of a payment obligation could, depending on the particular terms of the loan agreement, be enforceable at law.

The main point to take home from this case is that shipowners need to be aware that if they agreed to a term when concluding the agreement, no matter how unreasonable it may now appear, they must be prepared to honour the agreement, rather than relying on the courts to set such a term aside. Great care therefore needs to be taken at the negotiation stage of such agreements rather than see the matter go to litigation – prevention is better than cure after all.