To bid or not to bid: Credit bidding in vessel sales pendente lite
In the maritime sector, this process often takes place in the context of forced judicial sales of vessels pendente lite (i.e., during the course of litigation) and frequently before judgment is obtained against the borrower shipowner.
However, why would or should the secured lenders be bidding on a distressed asset in the first place? How does the process work, where can it be done, and who might object?
This article seeks to explore some of these questions in the context of judicial sales of ocean-going vessels and looks at some of the differing jurisdictional approaches to credit bidding.
A typical credit bid scenario in the maritime industry may occur where a borrower defaults on a loan secured by a mortgage over a vessel. That vessel is then arrested and ultimately sold under the supervision of the courts in the arrest jurisdiction.
Often, the borrower’s default is a payment default; however, it might equally be a breach of covenants in the facility, such as the obligation to maintain a minimum value of collateral to the loan amount.
In these circumstances, the lender usually serves a notice of the default. Sometimes, the borrower will cure the breach, and sometimes the parties might otherwise renegotiate or restructure the facility. Sometimes, however, the parties are unable to find a mutually acceptable path forward. This latter scenario becomes more likely where the lender has lost confidence in the borrower’s long-term ability to service the loan or where the lender has concerns relating to the integrity of the vessel (which, of course, serves as the main collateral for the facility).
Where a default scenario cannot be resolved to the mutual satisfaction of the parties, a lender may arrest the subject vessel to put further pressure on a borrower to cure the default (i.e., to make the missing payments or to prepay the loan to re-balance the loan-to-value obligations) or to re-negotiate commercial terms.
Where consensual agreement cannot be reached, a lender may apply for judicial sale of the vessel in the jurisdiction in which it was arrested. In terms of timing, each jurisdiction differs; however, it would not be unusual for a lender to obtain a sale order within two to three months of arrest.
Why would a lender bid at all?
Why, you may ask, would a secured lender be inclined to bid in a judicial auction for a vessel that secured its loan? There are a number of reasons why this would seem unlikely. The lender may be unlikely to count ship owning or operating amongst its core activities or commercial ambitions. Further, vessel ownership or operation comes with commercial and technical challenges that the lender is unlikely to be able to service in-house. Finally, it may be difficult to square the risk profile of vessel ownership (including significant exposure to third-party risks, such as pollution), with the usual risks with which the lender is associated, the most obvious being credit risk. Of course, where a lender is determined, none of these reasons are insurmountable, particularly with the assistance of third-party commercial or technical managers, insurers, and good legal advice.
The usual reason why a mortgagee lender might bid on the vessel is the same as why the lender might foreclose the loan position in the first place – to protect its financial investment. The borrower and registered owner of the vessel is likely to be a single-ship-owning special purpose vehicle (being the traditional manner in which ships are owned and operated). It is, of course, possible that the lending party may have the benefit of a facility with multiple borrowers whose obligations are joint and several (i.e., another party to go against for the balance of the debt). It is also likely that the lending party will have the benefit of some sort of corporate or personal guarantee. Nevertheless, the judicial sale of the subject vessel is likely to represent the most direct and effective means by which the lender can recover at least some of its investment from the borrower.
The lender’s position will therefore be severely prejudiced if the sale of that vessel does not yield the anticipated return, and the lender will either be forced to crystallise and absorb that loss or look elsewhere to make up the shortfall. In other words, it is in the lender’s interests to maximise the recovery from the vessel being sold and to pro-actively prevent it from being sold at too low a price. The risk of a vessel selling at too low a price and thus preventing a lender from maximising its recovery position is usually compounded both by market conditions and the borrower’s distressed financial position. Simply put, if depressed market conditions have contributed to forced judicial sale, then those same distressed market conditions mean that the vessel is unlikely to achieve the best price at auction (although notwithstanding the volatility of the shipping markets).
Equally, the standard rule of thumb is that vessels being sold at judicial auction usually achieve 20 percent to 25 percent less than equivalent trading sales. This is, in part, because prospective purchasers build in a margin for the fact that a vessel operated by a distressed owner may not have been maintained as highly as it might have been and, depending on the location of the arrest (particularly in warmer waters), the vessel might have deteriorated during its time under arrest. The purchaser in the auction will acquire the vessel “as is, where is” and so the depressed bid valuations will likely reflect the element of risk for any purchaser here.
It is our experience that lenders credit bidding in judicial sale environments do so in order to protect their investment, rather than to become shipowners (although, who wouldn’t want to own a ship!). Accordingly, a lender will not usually want to remain the owner of the vessel for any longer than it takes to restore the vessel to a seaworthy condition fit for a trading sale. In depressed conditions, it may involve the lender weathering the market conditions until there is an upturn in the sector or wider market.
Advantages of credit bidding for the mortgagee lender
The advantages of a lender being able to credit bid in these circumstances are obvious, being that the lender can use existing funds, which have already gone out the door (as loan principal) to try and purchase the vessel at the judicial auction. Where the credit bid is successful, the amount of the credit bid will be deducted from the outstanding balance of the loan.
In jurisdictions where credit bidding is not permitted, a lender wishing to protect its investment and potential recovery is forced to fund the purchase of the vessel with new money. Assuming a typical scenario where the mortgagee is a high ranking creditor to which the majority of the proceeds of the sale will ultimately be paid, the new cash is effectively round-tripped; it is paid into the local courts, held by the local courts (usually for a few months) pending determination of priorities and, finally, distributed to the mortgagee lender. Arguably, it is not the most efficient use of capital for either the lender or the wider industry, the latter of which might benefit from increased liquidity at a macro level.
Arguments against credit bidding
The arguments against credit bidding usually revolve around an unfair advantage being obtained by the relevant lender and/or the fact that credit bidding prejudices prospective higher-ranking claimants. The first argument, of course, overlooks the fact that the lender has already “paid” for the vessel once. The second concern can adequately be dealt with by the relevant court insisting on the lender providing some sort of security (whether by cash left in court or guarantee) that it will meet any claims that out-rank its own. Another argument to consider is that the presence of a mortgagee may discourage other prospective purchasers, since those bidders know that it is likely that the lender will bid at least up to the value of the debt. However, in practice, this tends not to be the case, and in a recent auction in South Africa, in which Reed Smith was instructed, the identities of the bidders were not even known to one another.
In another recent case in which Reed Smith was involved, the borrower challenged the lender’s application to credit bid, disputing the merits of the lender’s right to enforce the loan at a substantive level. The borrower argued that should the lender be permitted to credit bid, in circumstances where the borrower prevailed on the underlying dispute, the borrower would be prejudiced by the decision not to compel payment of funds into court. In that case, the United States District Court for the Western District of Louisiana refused the mortgagee’s application to credit bid.
We set out below a snapshot detailing the status of credit bidding in the context of sales pendente lite in some of the more well-known maritime jurisdictions in which Reed Smith has had recent experience*:
*The information on the jurisdictions is based on our recent experience, however, we should be pleased to receive comment on the article where other experience differs.
Where dealing with a defaulting borrower, and where such scenario demands that a lender take enforcement action against a mortgaged vessel by way of arrest, the lender should carefully consider its strategy following arrest, including judicial sale, where that process might best take place to the lender’s advantage (including the ability to credit bid).
The Asset Finance and Litigation teams in Reed Smith’s Transportation Industry Group have extensive experience of advising and acting for all types of lending clients in prospective and actual lending default scenarios. Reed Smith can advise on both the corporate restructuring and litigation/enforcement aspects in such scenarios, including execution of self-help remedies and arrests on behalf of mortgagees, favourable jurisdictions for judicial sale of vessels, priorities on payment out of the proceeds of sale, and all aspects of structuring ownership of the vessel should the mortgagee lender decide to bid!