Don't Let Your Preferred Mortgage Get Equitably Subordinated

• Published date: 29 June 2022
• Subject Matter: Finance and Banking, Transport, Charges, Mortgages, Indemnities, Financial Services, Marine/ Shipping
• Law Firm: McGlinchey Stafford
• Author: Mr Benjamin O. Schupp

Equitable subordination originated as a doctrine in the bankruptcy courts that allows for subordination of claims when the claimant has engaged in some type of "inequitable conduct" which has conferred an unfair advantage on the claimant or resulted in injury to creditors.¹ The good news is that getting your preferred ship mortgage equitably subordinated is rare and preventable. The bad news is that getting subordinated can be quite expensive. Adopted relatively infrequently by admiralty courts, equitable subordination is a favored play of outranked maritime lien creditors with few options - sort of a Hail Mary pass. However, as heartbroken football fans are well aware, sometimes those passes hit pay dirt.

How can such subordination be prevented? Let us count the ways:

Exercise Due Diligence to Discover Potential Fraudulent Activities of Your Borrower

We will assume that Marine Money's diligent readers are not

Adopted relatively infrequently by admiralty courts, equitable subordination is a favored play of outranked maritime lien creditors with few options - sort of a Hail Mary pass.

inclined to commit fraud themselves. However, what if a lender's substandard lending practices unintentionally allow a borrower to defraud others - including the bank itself? A Southern District of Florida decision indicates that the bank's mortgage can be subordinated.² The borrower created two different hull identification numbers ("HIN"s) to enable him to use the same vessel both as collateral for a bank loan and to sell the vessel to an innocent third party for cash.³ The bank had knowledge from a survey that the original HIN was not permanently affixed to the vessel at construction as required by Coast Guard regulations.⁴ Further, despite the borrower's financial free-fall, the bank extended its loan to borrower without appraising the collateral, requiring proof of insurance or investigating whether the vessel remained under the borrower's control.⁵ The Court found that the bank's "... gross deviation from acceptable banking practices in 2008 and its failure to insist that [borrower] permanently affix the HIN on the vessel before initial documentation in 2003 - justify the subordination of the Bank's mortgage in this case."⁶

Don't Use the Debtor as Creditor's Alter Ego or Instrumentality

While making a loan to a subsidiary is not uncommon in the maritime world and is not, by itself fraudulent, it does come with some added risks. The Fifth Circuit's seminal decision in Custom Fuel v. Lombas⁷, illustrates how such a loan should not be done. The bank foreclosed on a...