When Does Piracy Constitute A Total Loss?
By Claire Berwick, Peter Glover and Richard Milestone
Norton Rose OR LLP - Montreal Office
[Republished on June 28, 2012 with the kind consent of the authors]
The threat and actual taking of vessels as a result of piracy continues to be a prominent and regular feature in the maritime industry, and one which brings with it a number of practical and legal challenges.
We have considered a number of the legal issues in previously published articles and editions of Legalseas including the legality of ransom payments, whether a vessel chartered on NYPE terms is off hire as a result of detention by pirates and what clauses are being drafted into charterparties to address the issue of piracy.
Whilst much of the focus has been on response and charterparty issues, we have recently started to see piracy issues feature in ship finance transactions. One example is the issue of how to treat a ship taken by pirates for insurance purposes and whether confiscation by pirates will amount to a total loss for the purpose of the relevant finance documents.
As a matter of English law, an actual total loss occurs when insured property is destroyed or damaged such that it ceases to be “a thing of the kind insured”1 or where the shipowner is irretrievably deprived of the insured property. Accordingly, where a ship is captured by pirates and there is still a reasonable prospect of recovering the ship in a repairable condition, there can be no actual total loss.
On the other hand, a constructive total loss will occur where the ship is not an actual total loss, but is reasonably abandoned by the shipowner because she is likely to become so as a consequence of the improbability, impracticality or expense of recovery or repair. This would include the shipowner being deprived of the possession of its ship by a peril against which it is insured (which may include piracy) and either it being unlikely that the ship could ever be recovered within a reasonable time or the cost of recovery exceeding the value of the ship once recovered.
Where a total loss is deemed to occur under ship finance documentation, the borrower will have an automatic obligation to prepay the outstanding loan (or relevant tranche of the loan relating to that ship). Where a ship has been captured by pirates, lenders will want to trigger this prepayment obligation as soon as possible after the ship has been taken because clearly the mortgage is of limited value whilst the ship is captured. Most ship finance documentation will deem a financed ship to be a total loss after a period of 30 days has elapsed since the ship was seized with the prepayment obligation arising within an agreed timeframe thereafter - this time period is usually a period in the 90-180 day range.
The insurance market has, however, responded to concerns by insureds as to when there ceases to be a reasonable prospect of recovery by including a “Detainment Clause” in hull or war risks policies (whichever may be relevant) such that a ship will be deemed to be a constructive total loss if it has been detained for a period of 12 months and there is no realistic possibility of the ship being released. As a result, insurance proceeds for a constructive total loss resulting from piracy will, in principle, not be paid to a shipowner for at least 12 months. Of course, if it becomes clear that there is no hope of recovering the ship before such 12 month period has elapsed (notwithstanding the shipowner’s efforts, including the payment of a ransom), the insurer may agree to declare the ship a constructive total loss earlier. However, for the shipowner, it may not be realistic to expect insurance proceeds to be received for at least a one year period. It should be borne in mind that it may be possible to negotiate from underwriters different types of Detainment Clause and hence the detention period could, in particular cases, be shorter or longer than 12 months.
A shipowner will clearly prefer to avoid having to prepay a loan following a piracy event until it has received the insurance proceeds from the hull and machinery or war risks insurer. Indeed, the shipowner may not have sufficient available working capital to be able to prepay the loan without relying on insurance proceeds.
Clearly this presents a difficulty because there is likely to be a mismatch of expectations between how long a lender will be willing to wait before expecting prepayment (and if payment is not made, ultimately enforcing whatever alternative security to the ship it holds) and whether a shipowner is able to make such prepayment prior to receipt of insurance proceeds.
At the documentation stage, depending on its bargaining strength, a shipowner may be able to convince a lender to increase the time period for prepayment after the ship has been detained. As an alternative to demanding immediate prepayment (within the usual prepayment periods mentioned above), a lender who is looking for a workable solution may be willing to consider accepting additional security (for example, a mortgage over an unencumbered vessel) until such time as the insurance proceeds for the ship are paid out by the insurer or the ship is released.
With the increasing potential for ships to become victim to pirate attacks, it can be expected that shipowners and their financiers will now regularly have to confront this issue during loan negotiations and it may have interesting implications in the ship finance markets. For example, if a lender was willing to extend the loan prepayment period beyond the usual 30 + 90-180 days period it is perhaps more likely that the lender will require the shipowner to take out, and maintain throughout the loan period, a robust kidnap and ransom (or equivalent) policy to try and reduce the detention period as much as possible.
1. s.57(1) Marine Insurance Act, 1906