Class reform

Brian D Starer, senior partner at Holland & Knight LLP, calls for an International Convention on Classification Societies to help ensure surveyor independence

SEAMEN have long been treated as wards of the US admiralty courts in need of special protection. Surprisingly, courts of admiralty have similarly guarded against any encroachment of classification societies’ rights for different reasons. Classification societies have successfully argued over the decades that shipowners and charterers have a non-delegable duty to ensure their vessels are seaworthy. Further, the relatively small fees generated from a survey pale in comparison to the damages that could potentially be sought as a result of incidents caused by their errors. Finally, if classification societies were held liable for casualties caused by their actions, it would not be cost-effective for them to perform surveys on ageing or partially-damaged vessels that are most in need of their services.

Since the 1970’s, US courts of admiralty, especially in the Southern District of New York, have endorsed these arguments in an effort to protect these ‘public watchdogs’ that are essential to maintaining the safety of international maritime commerce. Classification societies were initially formed at the behest of hull underwriters as not-for-profit organisations whose objective was to provide independent evaluations of a vessel’s seaworthiness. Governments subsequently employed them for similar purposes. Today, classification societies continue to perform the vital role of setting standards for the design, construction, and maintenance of vessels.

Nevertheless, with a number of major vessel casualties over the last decade, classification societies have come under stricter scrutiny from the US Congress, European Union, International Maritime Organization (IMO), and even the courts, albeit slowly. The most recent case in the US, however, that significantly analysed the classification society industry did not involve a major casualty but the purchase of a high-speed passenger vessel. In Otto Candies LLC v Nippon Kaiji Kyokai Corporation, the US Court of Appeals for the Fifth Circuit affirmed a lower court’s decision to hold the Japanese classification society Nippon Kaiji Kyokai (NKK) liable to Otto Candies LLC (purchaser) for negligent misrepresentation based on statements made in a vessel classification survey prior to Otto Candies’ purchase of the vessel Speeder.

NKK argued that the purchaser was neither entitled to bring, nor prevail on, a negligent misrepresentation claim. After reviewing the law concerning claims against classification societies, the court held that “the general maritime law cautiously recognizes the tort of negligent misrepresentation as applied to classification societies.” In so holding, the appellate court initially addressed whether the purchaser was eligible to bring a negligent misrepresentation claim against NKK. In order to demonstrate such eligibility, the court required the purchaser to prove that NKK provided the class certificate to the previous owner with knowledge that the certificate would be provided to the purchaser for its guidance in determining whether to purchase the Speeder.

Given the facts, the court agreed with the district court that NKK actually knew at the time it re-classified the vessel that the results of the classification survey would be conveyed to the purchaser for the purpose of influencing its decision to purchase the vessel. Accordingly, the court affirmed that Otto Candies was entitled to bring its negligent misrepresentation claim. The Otto Candies matter is quite significant because it was the highest court in the US to ever affirm the imposition against a classification society of liability to a third party.

Since Otto Candies, parties have continued to bring suits against classification societies and the scope of the decision is currently being tested. Outside the courts, it is the obligation of the maritime community to similarly scrutinise the actions of classification societies to determine if their role as unofficial international policemen continues to be performed with the public's interest in mind.

So, is the time-honoured perception of classification societies as not-for-profit entities whose main concentration is to protect the maritime community still accurate? Unfortunately, the answer is no. Classification societies have gradually become more concerned with their company’s bottom line than overall safety. Through synergy, classification societies have used their client contacts in the surveying world to offer a variety of for-profit consulting services. Unlike vessel surveying fees, which are relatively small when considered individually, consulting fees can be lucrative and add a new profit centre for classification societies. Granted, this business model is not unique to the classification society world. Accounting companies were working under the same auditing/consulting model for years until one of the worst corporate frauds in recent history - the Enron scandal - came to pass.

Before its collapse, the energy company Enron had grown to become America’s seventh-largest company and employed thousands of persons throughout the world. Thanks to a ‘whistleblower’ employee at Enron, the world became aware of the numerous frauds committed by the company’s top executives. Enron’s executives grossly inflated the company’s profits while hiding through questionable accounting practice the huge amount of debt it had amassed. It is a widely held belief that Enron would not have succeeded with this widespread deception without the nonfeasance of its accounting company, Arthur Andersen.

Andersen failed to alert regulators about Enron’s false accounting in a timely manner. In the wake of the Enron collapse, when the relationship between the companies was analysed by prosecutors, the press, and investors, a theory for Andersen’s inactivity became apparent. Investigators discovered that Andersen earned more money from providing consulting services to their clients than from their auditing services. In all, the consulting work was so lucrative that Andersen received $27 million from Enron in consulting fees as opposed to $25 million for auditing services. This raised serious conflict of interest issues for Andersen and other accounting companies that similarly provided auditing and consulting services to the same client because the temptation not to lose such a significant revenue source is great.

As a result, the US Congress acted swiftly and decisively by enacting the Sarbanes-Oxley Act of 2002 which prevents future conflicts of interest by prohibiting auditors from participating in certain non-auditing services such as consulting. Consequently, the major auditing firms sold-off their consulting services to other companies. The term commonly used for this type of separation is auditor independence. Auditor independence has begun to restore the public’s confidence in the auditing profession, which was shaken due to a number of high-profile company failures like Enron. This independence allows auditors to provide opinions without being affected by outside influences that may weaken their professional judgment and objectivity. Public reaction has been so positive to this independence movement that the US Congress has begun evaluating other auditing-type companies like credit-rating firms which offer consulting services to companies whose bonds they rate. With the recent demand for professional independence from known conflicts of interest, such as offering consulting services to the same client one was hired to examine, could the maritime community, and specifically classification societies, be far behind? Hopefully not.

Conflicts of interest have directly resulted in a collapse of the maritime safety net. Shipowners, shipbuilders, port states, flag states, charterers, P&I Clubs, and notably, classification societies have traditionally worked closely to enhance safety on the high seas. Progressively, however, classification societies have become the primary safety group connecting all the maritime entities. Flag states retain classification societies instead of creating their own regulatory agency. Port states rely on classification societies to confirm a vessel is in class before allowing the vessel to pass into their waters. Charterers, shipowners, and P&I Clubs also rely on classification societies to confirm a vessel is compliant with international conventions such as SOLAS and Load Lines. As a whole, when classification societies are relied on by all the major entities in the maritime community and they are nonetheless receiving additional and substantial consulting fees from their various clients, conflicts of interest are bound to arise. With the environmental and safety issues at stake, allowing classification societies to offer their clients consulting services in addition to surveying services can no longer be countenanced.

To that end, the adoption of piecemeal prohibitions by various governmental agencies throughout the world will not effectively and expediently solve the inherent conflicts of interest issues permeating the classification society community. The best way to ensure surveyor independence is with an International Convention on Classification Societies. Through the combined efforts of the maritime industry, stricter regulations can be set on classification societies to ensure that their surveyors are not influenced by non-surveyor services such as consulting. Following the example of the auditing firms, classification societies must completely divest themselves of their consulting services so that the appearance of impropriety disappears.

In addition, individual surveyors should be given the protections necessary to ensure they can, in good faith, report classification society impropriety without retaliation from their employer. In the US, whistleblower statutes are an effective means in meeting this goal. The purpose behind these statutes is to encourage insiders to assist the government in enforcing various laws and protecting the public. This is exactly the kind of gesture needed to restore confidence in classification societies.

Classification societies will likely argue that these dramatic changes will cause them severe financial hardship. Indeed, classification societies have often taken this tact. For example, in Sundance Cruises v American Bureau of Shipping, ABS argued that the disparity between the fee the classification society charged and the potential resultant exposure was too great. This comparison, however, is an oversimplification of the realities of the industry. A survey fee typically costs several thousand dollars, and, over the life of a ship, fees paid to the classification society may run into the hundreds of thousands of dollars. In addition, the disparity between price and liability has never presented much of an impediment in a products liability case where, for example, the cost of a product such as a lawnmower may be quite low but the damage award for severing a foot due to a design defect can be quite high. In Otto Candies, it was also argued (albeit unsuccessfully) that the imposition of liability upon classification societies for ‘risk management’ costs would lead to higher fees charged to clients, which would hurt the maritime industry.

An analysis of another related industry, however, belies this argument. In the auditing industry, the results of tougher ethical standards and governance regulations have not hampered the growth of auditing companies. Indeed, global revenue for the major accounting firms rose three to seven percent around the world, notwithstanding the mandate for auditor independence and the concomitant loss of consulting services fees. While surveying fees will undoubtedly rise, the highly qualified classification societies will be in greater demand because compliance with ever-changing regulations in the maritime community will command the use of only the best companies – ones that are not tainted with accusations of conflicts of interest.

The need for stricter scrutiny of classification societies, surveyor independence, and surveyor protections such as whistleblower statutes is greater than ever in light of the major casualties suffered by vessels in the last decade. Classification societies have played a role in these incidents and the only way to avoid the next Enron-type situation from happening in the maritime industry is to have the international maritime community participate in an international convention under the UN and IMO auspices. With these necessary changes, innocent third party victims of these conflicts of interest, such as coastal states, fisherman, and honest shipowners, will be saved the horror of an avoidable casualty even greater than the Prestige incident.