Acquisition of ships is fundamental to the shipping business. Notwithstanding the mode of acquisition, i.e. whether by an outright purchase, construction of a new ship or otherwise, ship financing continues to be an integral part of ship acquisition. Financing ship acquisitions can be effected through the provision of debt or equity.
The most common means is to obtain a loan for part or all of the purchase price otherwise known as debt financing. However, due to the nature of the marine business, many financing institutions are reluctant to finance the acquisition of ships without adequate security or a good credit rating with such financial institution.
With the advent of “lease structured financing” debt and equity, as the most common ways of financing ship acquisitions appear to have found a competitor. Lease structured financing is a popular and well-tested concept among airlines and other aircraft operators.
Ship Lease Operation
The lease is perhaps best described in general terms as a conveyancing method where the possession of property passes but ownership or title in the asset does not pass to the purchaser. A somewhat more precise legal definition of a lease is that it is a contract through which the owner of property (the lessor) conveys to another person (the lessee), in consideration of payment as agreed, the right to possession and use of the property for an agreed period.
There are basically two types of lease:
1. Operating Lease; and
2. Finance Lease
Operating lease is a lease in the real sense. Outside of shipping it is widely used for rental (or hiring) of equipment and durable consumer items. The risk usually remains with the lessor who maintains the asset and the lessee normally has the discretion to terminate the lease, at the end of which the property reverts back to the lessor. However, if so provided in the contract, either party may have the right to cancel the lease. A typical example of the operating lease is the leasing of containers in the shipping industry, where container lines lease containers from container leasing companies.
As far as ships are concerned, where an operating lease is in place, it is usually in the form of a short or mid-term bareboat charter after which the lessee will return the ship to the lessor. The lessor assumes such risks as the technological obsolescence of the ship and the re-employment of the ship after the lease period. During the charter period, the lessee acts as if he owns the ship and the lease payments do not involve an amortization of the leased property; nor is there an option to purchase in favour of the lessee. Recently, there has been an increase in the use of short-term bareboat charters with an increasing number of financial institutions willing to provide ships for this market. Although it is not a financing vehicle in strict terms, it is referred to as an alternative source of finance.
It is notable that there is another quasi-operating lease where the lessor may provide the manpower and services required to operate the equipment. In aviation this is referred to as “wet lease” while in shipping it is referred to as time charter. Time chartering is not pure equipment leasing because the provider of the ship, i.e. the owner, provides the crew and is responsible for the navigational operation of the ship. The charterer is thus not in full possession of the ship. However, it is also an important and convenient way for a shipowner to expand his fleet in peak trading conditions because he can completely control the commercial operation of the ship. In this sense, time charter is very much akin to an operating lease.
It is pertinent to note that in recent times time-charter periods especially for big container ships have increased. This, together with the shortening of bareboat charter period, denotes that operating leases are playing an increasingly important role in the supply of tonnage for shipping companies.
Finance lease transfers all the risks and rewards incident to ownership of an asset. This type of lease is typically used for long –term finance of ships and covers a substantial part of the ship’s economic life. The ship is usually fully amortized (including the lessor’s returns on his investment). The lessor, whose main role is as financier gets most of his pay-out in respect of the ship because the total of the hire amount and payments are calculated to cover the cost or purchase price of the ship, the additional expenses which the lessor might incur as well as part of the lessor’s profit. The lessor also has little involvement with the asset beyond owning it, and all operating responsibilities including procurement of insurance fall on the lessee who, in the event of early termination, must fully compensate the lessor (usually the lessee anticipates a substantial down payment. This binds the lessor to the sale. If the lessee defaults, he loses his down payment as well).
Although the finance lease generally appears on the lessee’s balance sheet, its main attraction to shipping companies is that it brings tax benefit by depreciating the ship’s value against profits and by assisting companies with high profits but no suitable investment of their own to obtain tax relief by purchasing a ship. Under a finance lease scenario, the ship, built to the lessee’s specification (if a newbuilding), or chosen by the lessee (if it is a second hand), is purchased by the company providing the finance (the lessor) and leased under a long-term agreement (usually a bareboat charter) to the shipping company (lessee) which may purchase the property at a nominal price after the primary leasing period.
The advantages of ship leasing, as argued by practitioners, are similar to those claimed by the classical economists. These advantages are focused on the two major categories, tax benefit and financial position improvement.
The tax advantage argument is perhaps the strongest justification for using lease as a financing vehicle in shipping. Experts have pointed out that the tax benefits accruing out of leasing are of predominant interest. With leasing, the most significant tax benefit is the deferral of tax liability on capital allowance. The rate of hire will reflect the immediate use of the tax allowance by the lessor. Capital allowances can be used as set offs against taxable profits. The lessee would favour leasing as a financing vehicle in shipping because the lessee is usually keen on ‘disguising’ a finance lease in the form of an operating lease to derive the off-balance sheet benefit.
Financial Position Improvement
The scarcity of financing from financial institutions or other financing options for shipping lines has created a space which is now filled by leasing companies which have easier access to capital funds. In such cases, it is of great value for the carriers to have access to diverse sources of capital that will assist them with their fleet expansion and renewal plans by acquiring larger, modern and fuel-efficient vessels and achieving the necessary economies of scale to remain competitive. In a cyclical and very capital intensive industry, such as shipping, the lease can preserve the lessee’s working capital and its financial position through long-term repayment structure (often longer than the one offered from banks) and effective cash management through matching the rental profiles with income streams (cashflow). Moreover, the lease structure permits the lessor to lock in carriers to long-term charter arrangements and fixed rates that are oblivious to the volatility of the spot charter market and thus achieve a secure revenue base and higher financial leverage than other investors in the ship financing market.
Furthermore, in comparison with the traditional debt financing from financial institutions, lease financing differs in the sense that the lessor retains legal title/ownership of the ship during the lease period which provides the lessor with a built-in security that offsets the absence of a loan agreement and ship mortgage in the lease financing ‘equation’. Despite being the owner, the lessor does not have possession of the ship since such right is retained by the lessee.
Despite the current downturn in the shipping market, there are good grounds to believe that there is still overflow of available finance in the market. In the last few years, there has been significant growth and expansion in the leasing business. Similarly, there has been an upsurge inleasing transactions, particularly amongst the Chinese commercial banks, the subsidiary leasing companies of banks, hedge funds and financial institutions fueling this growth and becoming major capital providers to the shipping industry with an intention to further expand and diversify their portfolio of ships and establish their presence in Europe, America and Africa.
It can be argued that the lease structure highlights the polarisation of the shipping business. As a result, the pure asset players, such as the lessors have strengthened their financial position while the carriers have become weaker. This has changed the traditional notion of the ‘shipowner’ as we know it, in the sense that the leasing companies are now the large shipowners.
Being a sophisticated structure, whether or not the purchaser will qualify for a the ship lease will depend on the parties’ intentions, credit ratings, operational decisions and market status. Despite its restrictions, the prospects of the finance lease seems promising given the increasingly popular trend of outsourcing the asset management services of shipping companies. As a relatively new alternative in the international financial arena, ship lease is still developing and undergoing tests.
Damilola Osinuga is an Associate in the Shipping and Oil Services practice group of Bloomfield Law Practice, Nigeria
Ed’s Note – This article was originally posted here.