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The ZouZou – MII to the rescue?1 June 2022

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Introduction

"MII policies have become an important part of the ship financier’s security package."

A ship financier’s primary security is the mortgaged ship. If the ship becomes a total loss, the mortgage will provide no valuable security, leaving the financier to rely on its rights as assignee and loss payee (and occasionally as co-assured) under the shipowner’s marine insurance policies. However, the owner’s insurers may decline a claim, for example on grounds of breach of warranty or material non-disclosure, or because the loss is not covered by the policy, such as where the owner scuttles the mortgaged ship. To fill this gap, MII policies have become an important part of the ship financier’s security package. MII Policies are usually placed on market forms based on the Institute Mortgagees’ Interest Clauses 1986 or 1987 with certain changes and enhancements.

The common perception of lenders is that, in the event of a total loss, they will be able to look either to the owner’s policies or to their own MII policy to recoup their loan debt. Indeed, the courts have confirmed that the function of MII cover is essentially to protect the lender against any losses which he may suffer as a result of the insurances taken out by the borrower proving ineffective¹. The recent decision in The ZouZou² has shown that this cannot always be taken for granted.

Background

"Where a loss is not covered by the shipowner’s policies or is excluded from cover, it may also not be covered by the MII policy."

MII policies are typically expressed to cover the mortgagee for loss that is prima facie covered by the shipowner’s policies but in respect of which there is a subsequent non-payment by the shipowner’s insurers by reason of a peril insured by the MII policy. The list of MII insured perils includes the range of defences advanced by the owner’s insurers (material non-disclosure, misrepresentation, breach of warranty and breach of the duty of good faith). The prima facie coverage requirement means that where a loss is not covered by the shipowner’s policies or is excluded from cover, it may also not be covered by the MII policy. MII policies also contain ‘stand-alone’ perils for losses not recoverable from the owners’ insurers, such as for ‘casting away’ and ‘deliberate damage’ (Institute MII clause 2.1.4) which would cover a mortgagee where, for example, the owner scuttles his ship.

In The ZouZou, the mortgaged ship was detained in Venezuela in late August 2015, after suspicions were raised that the crew had attempted to smuggle part of a cargo of high sulphur diesel oil by diverting it from the cargo tanks nominated for loading to other tanks through the cargo lines. Four members of the crew were subsequently tried and acquitted. The ship was detained for about 14 months. A mere fortnight before the ship’s release, the owner tendered notice of abandonment (“NOA”) and claimed an indemnity for a constructive total loss (“CTL”) under its war risks policy.

"Where a CTL occurs, the assured may abandon the ship to his insurers"

To explain this further, an actual total loss (“ATL”) occurs where the ship is destroyed or the assured is irretrievably deprived of the ship.³ A CTL occurs where the ship is reasonably abandoned on account of an ATL appearing to be unavoidable,⁴ or where the assured is deprived of possession and is unlikely to recover the ship, or where the ship is so damaged by an insured peril that the cost of repairing her exceeds her repaired value.⁵ Where a CTL occurs, the assured may abandon the ship to his insurers and treat the loss as if it were an ATL by giving NOA to his insurers.⁶

Most owners’ policies also expressly provide that a CTL will be ‘deemed’ where the owner is deprived of possession for a continuous period of 12 months. Where ships are detained for over 12 months, this may prompt a deemed CTL claim, even where the ship is expected shortly to be released. An owner may prefer to abandon his ship to his insurers to claim the ship’s insured value, rather than to recover possession of a ship with a significantly lower market value. 

"MII insurers declined the bank’s claim on grounds that there was no prima facie coverage under the owner’s policy."

In The ZouZou, the owner was insured for war risks by the Hellenic Club, a mutual war risks insurer. The war risks policy covered the owner for loss caused by “detainment” (rule 2A.2.2) but excluded loss arising out of action taken “under the criminal law of any state” (rule 3.5). The Club therefore rejected the owner’s deemed CTL claim as excluded under rule 3.5 and also relied on the owner’s non-disclosure of the ship’s calls into an area requiring additional premium. The mortgagee bank then claimed under its MII policy, whose terms adopted a widely used market form. MII insurers declined the bank’s claim on grounds that there was no prima facie coverage under the owner’s policy given the exclusion under rule 3.5 of the war risks policy.

Decision

The court dismissed the bank’s claim.

The court held that the loss was not prima facie covered by the shipowner’s war risks policy, because although the policy covered loss caused by detainment, that was subject to the exclusion in rule 3.5. Accordingly, the loss was not covered by clause 1(i) of the MII policy, that required prima facie coverage under owner’s policies. The bank argued that the exclusion did not apply because the owners themselves were not guilty (or alleged to be guilty) of the offence. The court held this to be of no consequence, as rule 3.5 did not draw this distinction. The court also rejected the bank’s argument that the ship’s detention was not ‘under’ but only ‘incidental’ to the criminal law of Venezuela.

"The judge placed considerable reliance on the inclusion of the word ‘alleged’ to construe the clause narrowly."

The court also held that no deemed CTL had occurred. The bank had argued that although the ship’s detention had initially been lawful, the ship ought to have been released by early October 2015, by which time the detention was no longer essential to the investigation, leaving a further 12 months to elapse thereafter before the owner gave NOA. The court acknowledged that had the detention been initially lawful but later become “illegal” or “arbitrary”, that would have broken the chain of causation. But this had not happened: the ship’s detention had been lawful throughout. At most, any errors of the Venezuelan courts or prosecutor were bona fide and so would not have broken the chain of causation, absent perversity.⁷

Even if detention had become unlawful, a continuous period of 12 months had not elapsed since the earliest moment the lawfulness of the detention could possibly be impugned. This forced the bank to justify the owner’s abandonment under s. 60(2) of the Marine Insurance Act 1906, which was hopeless because by the time NOA was tendered, it was likely the ship would be released within a reasonable time (as indeed subsequent events proved).

The court also dismissed the bank’s reliance on a separate clause (1(ii)) in its MII policy, that the bank argued to apply independently of the prima facie coverage requirement. That clause covered the bank for “loss of, or damage to, or liability arising in connection with the vessel…” “which occurs by virtue of any alleged deliberate, negligent or accidental act or omission or any knowledge or privity of any of the Relevant Parties”. “Relevant Parties” included owners, operators, charterers, managers and their servants/agents or anyone else held responsible.

The bank argued that this wording which, unlike the other coverage clauses, did not expressly cross-refer to the owners’ insurance policies, provided wide coverage for any loss or damage to the ship as a consequence of any act or omission by any of the crew or any other servant or agent of the owners or charterers or by any allegation of such an act or omission.

Although the judge agreed with the mortgagee that the MII cover was for the loss of the vessel, not the loss of the owner’s insurance cover,⁸ the judge placed considerable reliance on the inclusion of the word ‘alleged’ to construe the clause narrowly to apply only where the owner’s insurers have declined cover by alleging the loss of or damage to the ship to have been caused by the owners or their servants or agents. This interpretation limits the application of this clause to the situation where the loss of the ship is prima facie covered by the owner’s insurances and the owner’s insurers refuse to pay specifically by alleging involvement of the owners or their servants or agents in the loss. In The ZouZou, the war risks insurers had not declined cover based on any such allegation, but rather on other grounds. The fact that the Venezuelan prosecutor had alleged deliberate conduct by the crew was not sufficient to invoke Clause 1(ii).  

"Ship financiers expect MII coverage if their borrowers’ policies fail to respond to a total loss claim."

Discussion

This is perhaps a surprising finding. A number of MII claims have been settled over recent years on the basis of a market understanding that the Clause 1(ii) wording covers ship mortgagees for alleged deliberate, negligent and/or accidental acts or omissions of Relevant Parties irrespective of whether they caused the owner’s claim under its policy to be rejected.  It is perhaps unfortunate that this wording was first subjected to judicial scrutiny in the context of a CTL claim where the owner had not only recovered the ship but had done so a mere fortnight after tendering NOA. Nevertheless, until further judicial consideration, this ruling will no doubt dissuade MII insurers from accepting or settling MII claims for a CTL on this wording unless satisfied that the loss was prima facie covered under the owner’s policy.

Where does this leave ship financiers who risk losing their security in the event of a CTL following a protracted detention for which their borrower is not covered? The potential gap in MII coverage found in The ZouZou is one that may certainly occur in other scenarios. Loss arising from detentions is often subject to exclusions in war risks cover, for example the exclusion for loss arising from: “detainment…by reason of infringement of any customs or trading regulations”.⁹ Earlier decisions in the Kleovoulos of Rhodes¹⁰ and the B Atlantic¹¹ have shown that where drugs are found onboard, ships are liable to be detained for prolonged periods and, whether or not the owners were involved, the resulting loss is likely to be excluded under their war risks policy, thereby precluding an MII claim.

Another exclusion is loss, damage, cost or expense arising out of: “ordinary judicial process”.¹² This would likely preclude war risks and MII claims arising out of any detention for alleged breach of governmental trade sanctions (even if such a loss were not also excluded under separate sanctions specific wording).

Conclusion

Whilst MII insurers may be pleased with a reported authority that restricts the scope of MII coverage, this is not necessarily a positive development for them in terms of the coverage the market will demand in response. Ship financiers expect MII coverage if their borrowers’ policies fail to respond to a total loss claim. Whilst in The ZouZou, the judge held that “the MII policy is intended to operate as a secondary source of indemnity to the Owner’s Policies”¹³, the fact is that the MII policy also contained ‘stand-alone’ cover for ‘casting away’ and ‘deliberate damage’ (Clause 1(ii)). If an owner scuttles his ship, he will clearly not be covered, but his mortgagee’s MII policy will at least respond. In The ZouZou, the judge was not persuaded that clause 1(ii), that clearly contained an element of stand-alone cover, also provided stand-alone cover for a CTL.  That reading of this wording will now be followed, unless successfully appealed or overturned. But there is no reason in principle why ‘stand-alone’ MII cover should not be extended to a CTL if one side of the market requires it and the other side accepts it. The earliest reported case on an MII policy was The Captain Panagos DP in 1985,¹⁴ in which this firm acted for the mortgagee bank. The policy in that case included cover for “Loss of or damage to or liability of the Vessel involving a peril not insured against by the Owners Policies or Club Entries”. In that case, MII insurers admitted liability and the case was concerned with the amount payable, but it shows that umbrella or ‘difference in conditions’ cover has been available in the past. When the implications of decisions like The ZouZou are appreciated by the market, there is likely to be demand for wider coverage.

[1] Per Hobhouse J in The Good Luck [1988] 1 Lloyd’s Rep. 514 at 521.
[2] Piraeus Bank AE v Antares Underwriting Limited & Ors (“The ZouZou”) [2022] EWHC 1169 (Comm.).
[3] s. 57 Marine Insurance Act 1906
[4] s. 60(1) Marine Insurance Act 1906
[5] s. 60(3) Marine Insurance Act 1906
[6]Ss. 61 and 62 Marine Insurance Act 1906
[7] The Anita [1971] 1 Lloyds Rep 487 at 493-494 and The Silva [2011] 2 Lloyds Rep IR 470 at [41]; The B Atlantic [2015] 1 Lloyds Rep 117 at p. 162 (per Flaux J).
[8] At para 231.
[9] Clause 4.1.5 of the Institute War and Strikes Clauses Hulls-Time (1/10/83)
[10] [2003] 1 Lloyd’s Rep. 138.
[11] Navigators Insurance Company Limited & Ors v Atlasnavios-Navegacao LDA [2018] UKSC 26.
[12] Clause 4.1.6 of the Institute War and Strikes Clauses Hulls-Time (1/10/83)
[13] At para 231.
[14] [1985] 1 Lloyd’s Rep., 625

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