The ever-growing importance of ship leasing as an alternative to debt financing means that one specific – and potentially difficult and uncertain – issue, is the risk of a lease being re-characterised in US legal proceedings. This has been prompted in part by a recent case in the aviation context which appears helpful [¹], write John Kissane, Dan Rodgers, Celinda Metro, David Osborne and Dominic Pearson of law firm Watson Farley & Williams LLP.
Unlike English law, US law adopts a ‘substance over form’ approach to whether a transaction is, as it is described, a lease or whether it is really financing. This is embodied in the Uniform Commercial Code (‘UCC’) section 1-203, which has been adopted in similar form by all States, including New York, which is the source of law under which finance leases are re-characterised as loans.
This statute requires a US court to apply the so-called ‘bright line’ or ‘residual value’ test to determine whether a lease is disguised financing. The first limb of analysis requires determining whether the consideration the lessee is required to pay the lessor for the right to use or possess the asset is an obligation for the term of the lease and is not subject to termination by the lessee, in the sense that the lessee essentially has a right to walk away. Any lessee purchase option is significant, as set out below. If that limb is satisfied, the court goes on to consider whether any one of the following factors are also present: (i) the lease term equals or exceeds the asset’s remaining economic life; (ii) the lessee is bound to become the owner of the asset or renew the lease for the remaining economic life of the asset; (iii) the lessee has an option to extend the lease for no or below market value consideration; or (iv) the lessee has an option to purchase the asset for no or below market value consideration.
If application of the bright line test does not compel a conclusion that the lease at issue is financing, a US court considers the economic substance, or economic realities, of the financing. In so doing, a US court could consider, inter alia, whether (i) the lessor maintained a meaningful reversionary interest in the asset at the end of the lease term; (ii) the lessor has the right to accelerate the hire, sell the asset and hold the lessee liable for any shortfall; (iii) the lessor is in the business of leasing; and (iv) the lessee is obliged to insure the asset and is strictly liable for any damage.
When might this be relevant in a ship leasing context?
The issue could arise in any ship arrest or re-possession proceedings that occur in US waters. More significantly, however, the issue could also arise if the lessee is made subject to US bankruptcy proceedings, most notably pursuant to Chapter 11 of the US Bankruptcy Code. Given the ease with which it is possible for a debtor to establish the jurisdictional requirements for bankruptcy proceedings – to which a significant number of Chapter 11 bankruptcies of shipping companies bear witness – the issue is therefore of potential relevance even where a transaction’s nexus to the US is not obvious or substantial.
What is the effect of reclassification?
The lessor would not be treated as the owner of the asset but rather as a creditor. In Chapter 11 proceedings, a true lessor can force the debtor lessee to assume or reject the lease and can also seek administrative expense status for the lessee’s use of the equipment in bankruptcy. In contrast, a secured creditor cannot collect post-petition lease payments and must seek relief from the worldwide automatic stay which prevents suits against the debtor and its property, including the asset. A secured creditor can also seek ‘adequate protection’ for the use by the debtor of its collateral. However, if the lessor did not perfect its security interest in the asset, as may very well be the case when it believes it is the owner of the vessel, it will be left as an unsecured creditor with diminished rights and ranking alongside all other unsecured creditors. True lessors and creditors may also have different rights of recovery under the debtor’s plan of reorganisation.
“In Chapter 11 proceedings, a true lessor can force the debtor lessee to assume or reject the lease and can also seek administrative expense status for the lessee’s use of the equipment in bankruptcy.”
The terms of the lease are important
The threshold issue is whether the transaction satisfies the bright line test for reclassification as a disguised financing rather than a true lease (see above). Ship leasing is done on different terms from deal-to-deal and not all transactions are at risk. However, many will be determined to be finance leases subject to reclassification as they require the lessee to purchase the vessel at some point.
Is the chosen law of the lease relevant?
As noted above and in previous briefings, English law takes a very different approach to reclassification than US law. If a lease is governed by English law, would the US courts respect the choice of law, including the issue of reclassification? While one might hope that this would be the case, and US courts generally respect the choice of law in contracts, there are indications that a US court may disregard the parties’ choice of law, particularly where third-party creditors of the lessee are involved.
A recent case [²] (which involved aircraft and Chapter 7 (insolvency) rather than Chapter 11 (reorganisation) proceedings) might give some comfort to lessors. The bankruptcy court in the Southern District of California held that the choice of English law to govern the aircraft leases meant that the bankruptcy trustee’s attempt to have the leases reclassified did not succeed. The court referred to the well-known differences between US and English law. The case is not binding on other courts, including those in New York or Texas, the places where US bankruptcy proceedings of international shipping companies are most likely to take place – but it could have persuasive authority. It should also be noted that the case followed the approach on federal common law choice of law rules taken by the Restatement (Second) of Conflict of Laws. That all said, the case is at least potentially good news for lessors of ships where leases are governed by English law.
The ship leasing context
There is precedent for reclassification in bankruptcy in the ship leasing context. See for example In re Lykes Brothers Steamship Co., Inc. [³] While reclassification of vessel leases is not common, reclassification disputes form a significant part of bankruptcy litigation. Some of the issues around reclassifications which potentially arise in, and are specific to, the ship leasing context are briefly examined below.
As a general point, the interface between US maritime law, US general secured transactions law and US bankruptcy law, and applicable State law, respectively, creates some uncertainty around some of the issues until resolved by the courts.
The position of a mortgagee under a mortgage granted by the lessor
“The issue could arise in any ship arrest or re-possession proceedings which occur in US waters. More significantly, however, the issue could also arise if the lessee is made subject to US bankruptcy proceedings, most notably pursuant to Chapter 11 of the US Bankruptcy Code.”
In ship leasing transactions the lessor frequently grants a mortgage to its financiers, either at the inception of the deal or later by way of ‘back-financing’. On first impression, the existence of such a mortgage ought to mean that in bankruptcy of the lessee where the lease is re-characterised the secured position of the mortgagee is respected, leaving the lessee’s ‘equity’ (if any) in the vessel subject to the effects of re-characterisation. This might not be the case, however. The effect of reclassification is that the lessee rather than the lessor is treated as the owner with the lessor being considered the lender, so that it logically follows that the mortgage is a sub-mortgage only of the lessor’s interest. This would mean that not only is the mortgage subject to the automatic stay in respect of the lessee’s property (as re-characterised) but that the mortgagee has no greater rights and priority vis-à-vis the lessee’s bankruptcy estate than the lessor.
Perfection of the lessor’s re-characterised security interest
If the lessor’s interest is reclassified as a loan rather than an ownership interest the issue arises whether it has a security interest that may be perfected by a UCC filing to at least allow the lessor to obtain the status of a secured lender. If the lessor is perfected, which is generally accomplished by a UCC filing, it will be a secured creditor with significantly greater rights than unsecured creditors in the lessee’s bankruptcy. Precautionary UCC filings in respect of leases are common practice with other types of assets, notably aircraft and equipment. To provide a basis on which to file, the lease must contain a ‘savings clause’ to the effect that, despite and without prejudice to the intention of the parties that the lease is a true lease, the lessee grants a security interest to the lessor. A precautionary UCC filing will be made in a state (if any) where the lessee is known or thought to have a place of business and/or (in any event) in Washington DC. There is some doubt about whether such a filing in respect of the lease of a ship (as opposed to another type of asset) is effective due to the interplay of the US federal act governing ship mortgages and the UCC. Prudence might point towards filing notwithstanding such doubts and uncertainties.
Registration of leases on the ship register?
The Marshall Islands register, followed by Liberia, some years ago introduced an amendment to its ship registry law to allow the registration of ‘financing charters’ on the ship’s registry. This is stated to operate as a ‘deemed preferred mortgage’ granted by the charterer in favour of the registered owner. This development was no doubt in response to the reclassification risk, possibly influenced by the legal uncertainties, noted above, relating to ships and UCC filings. In this context, it is of interest to note in passing that the 2001 Cape Town Convention on International Interest in Mobile Equipment, and its related asset-specific Protocols, includes leases as registrable International Interests alongside security interests. Article VIII of Cape Town expressly gives effect to the contracted choice of law clauses, including in relation to leases. The Cape Town Convention does not apply to ships and it is thought unlikely that it will be extended to ships any time soon. The ‘fix’ adopted by the Marshall Islands and Liberia registers is an ingenious attempt to address issues relating to leasing within the context of the rules of a conventional ship register, i.e. a system where the lessor is the registered owner and the traditional preferred mortgage is granted by the registered owner rather than in its favour. It is as yet untested in the courts.
Other possible risk mitigants
There are two possible risk mitigants but they will not be capable of being applied to all transactions. First, the lessee could be a ‘ring-fenced’ or made a bankruptcy-remote entity, incorporated in an appropriate jurisdiction and with relevant steps taken in respect of its constitution and governance. Of more general application, where the lessee is an SPC, another possibility is to take shares security so that, if it is enforced quickly enough before a Chapter 11 filing, the lessee is removed from the bankruptcy estate of the lessee’s group. This is merely an application in the leasing context of a well-known creditor weapon to escape the effect of Chapter 11.
The authors of the report are Watson Farley & Williams LLP NYC partners John Kissane and Dan Rodgers, NYC counsel Celinda Metro and London partners David Osborne and Dominic Pearson.
 King v CAVIC Aviation Leasing (Ireland) 22 Co. Designated Activity Company (in re Zeta Jet USA, Inc.) CH. 7 Case No. 17-bk-21386-SK, Adv. No. 19-ap-01147-SK, slip op. (Bankr. C.D. Cal. October 15, 2020).
 See above.
 196 B.R. 574 (Bankr. M.D.Fla. 1996).