The shipping industry has experienced a very turbulent and somewhat negative decade since the 2008 financial crisis. The banking industry is a lot more regulated post-recession era and risk management is paramount. Many of the traditional shipping banks have either sought to leave the shipping industry altogether or have drastically reduced their exposure in response to a significant number of defaults and non-performing loan portfolios. As a result, traditional financing is at most only available to the minority of “blue chip” shipowning companies, and this has led to a significant number of shipowners pursuing alternative methods of financing for the acquisition of vessels, including sale and leaseback transactions.
With vessel prices rising in light of regulatory demands, particularly in the area of environmental protection, shipowners are increasingly considering these types of transactions as a means of freeing up capital whilst maintaining the ability to operate a vessel and trade as owners under a long-term lease, typically a bareboat charter. In particular, lease financing provided by Chinese companies, primarily for new vessels built in China, has, in recent years become a hugely important feature of global financing for shipping.
What is a ship sale and leaseback?
The essence of a sale and leaseback transaction is that a shipowning company ,“A”, sells a vessel to another company “B”, which then leases it back to A for A’s use. A becomes the ‘lessee’ and B becomes the ‘lessor’. B is typically a leasing company, private equity fund or another type of bank or non-bank leasing company.
The vessel can be a newbuilding or a delivered vessel, the concept being broadly similar in both cases. The details of the lease agreement are tailored to the individual client on a deal by deal basis. The leases are usually arranged for a specific period, typically between five and ten years, with the contracts providing for a fixed or set charter rate and, usually, a purchase option at the end of the lease term.
A sale and leaseback can be structured in various ways. If the ship to be financed is still to be built, the shipowner will order the vessel from a shipyard pursuant to a shipbuilding contract. The shipbuilding contract will then either be assigned to the leasing company, or upon delivery, the vessel will be sold to the leasing company under a memorandum of agreement. Simultaneously with the leasing company taking delivery of the vessel, the vessel will be leased back to the shipping company under a bareboat charter. If the ship has already been built and is operating, the principal documentation will comprise a memorandum of agreement and a bareboat charter along with other key transaction documents.
The security package needs to be adapted to the particular sale and leaseback structure. The usual security includes an assignment of the vessel’s insurances and earnings, and pledges over relevant bank accounts to which the vessel’s earnings are paid. Guarantees from the shipowning company’s parent company or significant shareholders and manager’s undertakings are also commonly required.
The lessor will usually be indemnified by the lessee against all of the liabilities associated with the operation of the vessel (above all, pollution risks). In turn, the lessor will guarantee to the lessee its quiet enjoyment of the vessel as long as the lease is not in default.
What are the benefits?
Leasing has become a popular alternative to mortgage-based debt financing, which (as alluded to above) is not always readily available to shipowners. These structures have benefits for both the shipowner lessee and the financing lessor.
The principal benefit to a shipowning company entering into this type of transaction is that the absence of capital outlay gives it flexibility and allows it to free up cash, thus improving its liquidity and giving it the option to invest in other activities; the lease commitment may, depending on its terms, be capable of being treated as an “off balance sheet” transaction which may significantly assist the company’s accounting position. There may also be tax advantages in terms of capital allowances claimable by the lessor, which can be shared with the lessee in terms of a reduced lease / bareboat charter payments.
If the lease includes a purchase option, this will allow the lessor to repurchase the vessel at the end of the lease, thereby ensuring that any capital appreciation (i.e. increase in market value) occurring during the lease term will not accrue to the lessor alone.
Tax issues aside, the advantages for the leasing company lie mainly in terms of its security over the asset. Under an ordinary debt finance transaction, the shipowner retains ownership of the vessel. In the event of a non-payment default or any other default, the lender will need to commence enforcement proceedings in an attempt to recover the loan and enforce the vessel’s mortgage. This can take a considerable amount of time, money and effort. However, under a sale and leaseback transaction, the lessor is always the owner of the vessel and therefore in the event of non-payment of hire or other breach of contract, the lessor may promptly terminate the bareboat charter and readily take back possession of its vessel. Enforcing its claim to ownership is likely to be easier and quicker for the financier than enforcing a mortgage.
Overall, sale and leaseback transactions have become a widely used feature of the global financing of ships. Their continued popularity in the ship finance world looks to be assured.