Ship Finance

At first glance, the ship finance market may seem unrelated to the daily operations of a Shipbroker or Shipowner. However, it plays a crucial role in decisions related to the chartering and particularly the sale and purchase of ships.

Developments in the Ship Finance Market impact all ships to varying extents, regardless of whether their funding comes from the owner’s equity, third-party equity, or different forms of debt.

The various debt and equity stakeholders in a particular ship or company each have unique risk and return requirements, and these competing priorities shape the purchasing and operational strategies for ships.

Similarities exist between the Shipping Markets and the Ship Finance Market. Both are driven by Supply and Demand fundamentals and are influenced by regulatory factors that affect financing availability. The conditions under which finance is granted for a specific ship or project depend on the financier’s evaluation. Once a deal is struck between a Borrower and a Lender, it requires Formal Documentation. However, even well-evaluated, meticulously structured transactions can encounter issues, especially given the volatility of today’s shipping and financial markets.

Shipbroker and other shipping market participants will discover how the Ship Finance Market is structured and operates, and how decisions within it can significantly influence the broader shipping markets.

Objectives of Lenders and Borrowers in Ship Finance

Established Lenders in the shipping business primarily aim to:

Support the development and growth of their shipping company clients;
Generate sufficient profits from loans and related activities to meet shareholder return expectations;
Minimize the risk of losses from non-repayment of funds;
Comply with increasing regulatory, capital adequacy, and legal standards.

The main goals of Borrowers in the shipping industry depend on the ownership and strategy of the company but generally include:

Securing high leverage to maximize equity returns, which might be moderated by a need to maintain a conservative financial structure;
Obtaining favorable terms (e.g., low pricing, lenient covenants, extended repayment periods, minimal security) to enhance returns and reduce default risks.
Maintaining strong relationships with Key Lenders may be crucial for future operations.

In cases where there is a strong, longstanding relationship between a Borrower and Lender, often reinforced by personal connections between key individuals, it is more likely to reach agreements that satisfy most of both parties’ goals as described above.

Flexibility is often necessary, as a transaction cannot meet all parties’ needs entirely.

Pricing Conflicts often arise when a strong relationship can only continue if the existing Lender matches the lowest rate available to the Borrower. Sometimes, Lenders must accept returns below their required levels to preserve a relationship with a specific Borrower.

Another potential conflict area is Leverage. While some companies prefer to maintain a conservative financial profile, others aim to maximize leverage to minimize equity contributions and maximize investment returns. High leverage, particularly when provided near the peak of the shipping cycle, can significantly increase the risk of default if market conditions decline, thereby jeopardizing the lender’s objective to minimize loss risks. For example, a high advance ratio (e.g., 80%) loaned at or near a market peak, like during the 2004-2008 boom, significantly raises the risk of a default. Consider a scenario where $120 million was loaned against a capesize bulk carrier worth $150 million in June 2008, requiring a break-even rate of about $55,000 per day in a market where spot earnings were around $190,000. The market downturn led to the ship’s value dropping below $50 million, with Time Charter Earnings falling to $9,000 per day, a level insufficient to service the loan. While not all instances are this extreme, they highlight the increased credit risk associated with high leverage during market highs.

Shipping Cycles

Shipping markets are predominantly cyclical, and while sensible lending and borrowing can be conducted at any market cycle stage, misjudgments in timing can lead to severe consequences for both parties. Furthermore, financial markets have also shown high volatility, as evidenced during the recent financial crisis.

In economic recessions, many counties coupled with the banking, financial, and sovereign debt crises, especially within Europe, and a sharp decline in most shipping markets, have created a perfect storm.

Current Status of the Ship Finance Market

Current Situation

The present state sees banks, especially in Europe, nearing the completion of a phase where they had to manage significant credit impairment issues due to the economic downturn. Corporate bankruptcies have reached unprecedented levels across various countries, with additional concerns about the sustainability of households burdened by substantial debt.

While some banks have returned to profitability, many have incurred substantial losses since 2008, severely depleting their capital reserves. In many instances, banks in the UK, Ireland, Germany, Greece, and other countries have required government equity injections to sustain necessary capital levels. Several of these bailed-out banks remain under significant state control.

Regulatory Pressures

Capital pressures have been intensified by regulatory demands to bolster bank capital reserves, following the introduction of Basel III regulations.

Banks have also encountered liquidity pressures. The cost of borrowing in the interbank market has deviated notably from LIBOR, reflecting increased perceived risks among banks when lending to one another. This shift increases the likelihood of banks incurring losses on various loans.

Effects on Ship Finance Lenders’ Appetites

These capital and liquidity constraints have dramatically impacted banks’ lending capabilities, with these limitations being even more pronounced within the shipping sector due to its underperformance.

This is why numerous commercial banks, mainly in Europe, have opted to scale down or completely exit their ship finance operations.

Shipping Markets

The financial crisis alone would have been detrimental, but similar demand issues have also severely impacted the shipping industry. This situation has been exacerbated by an oversupply of ships across most shipping sectors.

Shipping Cycles

Shipping cycles have been a historical constant, driven by the fundamental market dynamics of supply and demand for tonnage and the transport of cargoes (in tonne miles). Each sector (dry bulk, tankers, container ships, etc.) has distinct supply and demand characteristics and may react differently and not always in sync.

The lifecycle of a shipping cycle is simple to understand.

In a weak market characterized by an oversupply of ships, freight rates drop (as charterers have numerous ships to choose from) and ship values decline (due to limited earnings potential and few interested buyers). Typically, the order book for new ships shrinks significantly because ordering a new ship for delivery into a weak market is economically unviable.

After enduring a weak market for a duration, conditions eventually tilt in favor of the shipowner. The supply of ships diminishes as the existing order book completes without renewal, and the fleet reduces in size due to increased demolitions—a response to the poor market conditions. Demand may rise due to an improving economic climate, or it may remain stable, but either way, a smaller fleet means that the demand for cargo transport will lead to higher freight rates. This rejuvenates the appeal of operating these ships, enhancing their value and attracting more buyers.

Shipyards, having experienced a lull in orders, may offer attractive prices in a now-thriving market, particularly as second-hand prices climb. This leads to a resurgence in orders, with the order book expanding rapidly once more. However, since it can take up to five years for new ships to be delivered, the influx of new tonnage doesn’t impact the market immediately but rather when it’s often too late.

The market surge will inevitably taper off as the delivered fleet meets the cargo transportation needs. Then, as continued deliveries lead to an oversupply, freight rates, ship values, and newbuilding prices will start to decline again, swinging the market from boom to bust.

In the shipping industry, these cycles are further influenced by the availability of shipping finance. During a boom, when the economics of a transaction (high earnings, strong values) are favorable, financing is usually readily available and often on beneficial terms due to competition. The opposite holds true in a downturn, where poor earnings and low values make economic justification tough, and few lenders are willing to finance ship acquisitions. This availability, or lack thereof, of funds to the market intensifies the peaks and deepens the troughs of the cycles.

Relationship between Shipping and Financial Markets

The connection between financial markets and shipping markets has become increasingly tight, with the boom experienced in various market sectors during the mid-2000s being as much a result of the readily available finance as it was of any actual increase in demand for the shipping of cargoes.

Many orders at shipyards were financially viable primarily due to the abundance of debt and equity funds.

Oversupply of Ships

Despite a portion of the order book likely never being delivered, it remains substantial and will require time to integrate into the fleet, necessitating scrapping across most sectors to achieve balance.

Although it was hoped that the scarcity of ship finance from banks would curb excessive new orders, the presence of private equity continued to support a high level of orders until recently. This influx of capital is now declining as several investments failed to achieve anticipated returns, and together with increased ship demolitions, is expected to eventually reduce fleet sizes to more manageable levels. This adjustment is anticipated to positively impact earnings and values as demand rises.

Unattractive Financing Proposition

Currently, the shipping market presents a challenging outlook for Lenders, with ships in certain sectors struggling to cover even their operating expenses, let alone service debt. Even without the financial markets facing their own turmoil, Ship Finance would still be seen as an unappealing business area.

There’s an argument that adopting a counter-cyclical approach to any market, including shipping, can yield long-term benefits. While this holds true, and the few new players in the ship finance market in recent years are poised to succeed, it’s unlikely that many decision-makers in financial institutions will embrace this strategy.

Lender’s Perspective in the Ship Financing Decision

How Typical Loans Are Assessed, Structured, and Documented

Process

In most banks, the sequence from the initial interaction to drawing funds under an agreed facility typically follows these steps:

Initial discussions occur between the Borrower and Lender.
The Lender conducts a Credit Assessment and structures a transaction that meets the bank’s credit policy while providing the owner with a suitable facility. Several indicative term sheets may be exchanged between the lender and Borrower until consensus is reached.
Once terms are preliminarily agreed upon, the Lender prepares an Internal Credit Document (in the Bank’s Standard Format) to obtain approval from the appropriate Credit Authority within the bank for the transaction agreed with the Borrower. Credit documents vary by institution but aim to highlight specific risks and mitigants of a transaction, demonstrate the credit assessment performed, and explain the rationale behind the agreed structure.
Discussions often occur between the Lender and their credit team or committee, after which Credit Approval is secured. Credit Authority might require modifications to the transaction, which the lender will then negotiate and agree upon with the Borrower.
A committed offer letter is issued to the Borrower, outlining the main terms of the facility the bank is prepared to provide. The difference between this letter and the earlier Indicative Term Sheet is that the bank is now committed to providing the facility, contingent on acceptable documentation and other prerequisites, effectively placing the bank ‘on risk.’
The Borrower usually has a specified period to accept the committed offer by signing and returning a copy.
Following the acceptance of the committed offer letter, the bank appoints maritime lawyers to draft the facility and security documentation based on the terms agreed in the committed offer letter. Depending on the complexity of the transaction and the institution, maritime lawyers may be involved as early as the committed offer letter stage.
Once documentation is finalized and signed, the facility becomes available for drawing, subject to meeting various conditions precedent.

Transaction Structuring

In discussions with a prospective Borrower, a lender should structure a transaction within their Bank’s Credit Policy that aligns well with the Borrower’s profile, the ship, employment conditions, etc., always aiming to minimize the bank’s risk. Key elements adjusted to reach a suitable structure include:

Advance Ratio/Loan Amount
- The bank generally adheres to a maximum Loan to Value (LTV) percentage as stipulated in its credit policy. Within these limits, a higher Loan to Value (LTV) might be considered if there’s a strong corporate guarantee supporting the transaction or if the financed ship is under long-term contract to a reputable counterparty.
Borrower/Guarantor
- In the shipping industry, it is common for each ship within a shipping company to be owned by a Single Purpose Company (SPC) to mitigate risks like sister ship arrest and other liabilities. Historically, Single Purpose Companies within a shipping company operated independently, managed by separate entities, with cross-collateralization achieved through complex arrangements of second or third mortgages. Nowadays, many shipping companies incorporate a parent/holding company that owns shares in its Single Purpose Company (SPC) ship-owning subsidiaries, simplifying the linkage of various entities.
- Typically, the loan is extended to the SPC (or multiple SPCs) jointly and severally for several ship financings), with a guarantee from the Parent/Holding Company. Sometimes, the loan might be extended to the parent/holding company itself. However, as this entity does not own the ships, an upstream guarantee from the Single Purpose Company (SPC) is necessary to connect the borrower to the asset.
Drawdown Profile
- For Secondhand Ship Purchases, the drawdown is straightforward, with the loan drawn in full upon the ship’s delivery.
- For Newbuilding Ships, assuming the bank offers Pre-delivery Finance, the drawdown can be more complex. For instance, if a shipbuilding contract requires five 20% payments at various construction stages, the bank may agree to fund 60% of the contract price. It’s less risky for the bank if the Borrower covers the initial payments, allowing the bank to fund the latter stages. Alternatively, each 20% payment could be funded 60% by the lender and 40% by the Borrower, though this exposes the bank to the risk of the Borrower failing to meet their share, potentially leading to contract cancellation and the loss of security over a completed ship. This risk is mitigated if the lender has a strong relationship with the Borrower or clear visibility of their capacity to fund their equity installments.
Repayments

The structure of the repayment schedule is critical to a loan’s viability, with several reference points used by lenders to ensure appropriateness.

Initially, it’s determined whether repayments will be Fixed (providing certain amortization) or Variable (allowing amortization to align with the ship’s cash flow), or a mix of both. Consider a ship operating in today’s low, volatile market on a spot trading basis; it might struggle with large fixed repayments. The Borrower would likely prefer variable repayments based on the Ship’s Earnings (Pay As You Earn – PAYE) after covering voyage and operating expenses. Often, a compromise involves agreeing to minimal fixed repayments, with additional payments on a PAYE basis if market conditions improve.

For ships on fixed-term employment, fixed repayment schedules are more appropriate as the Borrower receives steady charter hire payments.

Repayment Schedules typically occur quarterly, but this can be adjusted to monthly to align with charter hire receipts, or extended to semi-annually for Borrowers with sophisticated centralized treasury operations.

Loans usually amortize by a fixed amount on each repayment date, reducing the Borrower’s debt service obligations over time as interest payments decrease with the reducing loan balance. This decrease is often offset by rising operating costs, keeping the Borrower’s total costs relatively stable. However, for ships on Long-term Bareboat Charters, where operating expenses are not the Borrower’s concern, a flatter debt service cost line is preferable, allowing repayments to cover equal portions of capital and interest, similar to a home mortgage. This structure means early payments cover more interest, delaying significant capital repayment, which can increase Lender risk. Nonetheless, a strong counterparty often mitigates this risk.

Balloon Repayments and loan profiles are crucial. It’s vital for the lender and Borrower to agree on a realistic repayment schedule and term that suits the project without extending beyond the bank’s risk or funding comfort levels. Sometimes, a shorter loan term with a balloon payment at maturity might be the solution.

5. Prepayments

Terms for prepaying the loan must be agreed upon. If the Borrower wishes to voluntarily prepay part or all of the loan, it should be specified in what amounts (e.g., minimum US$1,000,000), on which dates (non-rollover dates may incur breakage charges), and at what cost (whether the bank will charge prepayment fees).

Terms for Compulsory Prepayments, such as upon the sale or total loss of the financed ship, also need to be clearly defined.

6. Pricing, Costs, and Expenses

The main pricing elements of a transaction include:

Loan Margin: This is the premium over the base interest rate that the bank charges for the loan. Modern banks use sophisticated risk and pricing models to determine the appropriate margin for each borrower and transaction, reflecting not just the risk but also the capital and liquidity costs that the bank must cover to profit. This margin is notably higher in today’s financially strained environment.

Arrangement Fee: Charged at the loan’s commencement for setting up the facility. For syndicated loans, this also compensates for underwriting.

Commitment Fee: Charged from the issuance of the committed offer letter until the loan is drawn and the margin begins to be paid. This fee compensates the bank for maintaining capital against an undrawn loan, which is set at 50% of a drawn loan’s capital requirement.

For revolving credit facilities, commitment fees apply to undrawn amounts and are typically calculated and invoiced on interest payment dates.

Other Costs and Expenses incurred by the bank in providing the loan, which are typically passed on to the Borrower, include:

Legal Fees: The bank appoints maritime lawyers to document the facility, and these lawyers may need to engage correspondents for foreign law issues.

Insurance Consultant: To review the ship’s insurance arrangements to ensure adequate protection.

Survey Costs: For older ships or other considerations, an independent survey may be conducted.

Mortgagee’s Interest Insurance (MII) and Mortgagee’s Additional Perils Insurance (MAPI): To protect the bank’s loan against various risks, including the failure of the ship’s insurance to pay out.

7. Interest Rates and Interest Periods

Interest rates for most ship finance loans are typically pegged to US$ LIBOR (London Interbank Offer Rate), although other indices are used for different currencies. Given the current financial crisis, where banks often can’t borrow near LIBOR Rates, loans might be based on the bank’s cost of funds, protecting the bank’s interests but potentially costing the Borrower more.

Increased cost clauses allow lenders to recover costs if they cannot borrow at the stipulated rates. Recent trends include setting a LIBOR floor, ensuring the Borrower pays a minimum interest rate regardless of LIBOR fluctuations.

Fixed-rate Loans or Interest Rate Swaps are considerations to mitigate risks, especially if the ship has long-term fixed employment. However, these can create significant mark-to-market liabilities if the transaction is prematurely terminated.

Ship Credit Assessment

Several acronyms have historically aided shipping finance lenders in focusing on crucial factors during credit assessments.

These include the six Cs (Character, Capacity, Capital, Company, Conditions, and Collateral) and CAMPARI (Character, Ability, Margin, Purpose, Amount, Repayment, and Insurance), which address similar considerations essential for evaluating a proposal.

While these are helpful mnemonics, credit decision-making in modern financial institutions involves more complexity, with grading templates and rating models specifying what factors to consider and how to weight each one.

The next section provides a detailed overview of the various complexities involved in a shipping finance transaction that must be assessed.

1. Risks and Mitigants Evaluation

When considering a transaction, the ship finance lender should conduct a thorough credit assessment to ensure the proposed financing is sustainable, offers an attractive solution to the borrower, and minimizes risk to the lender:

The subsequent discussions will focus on the primary risks typical in shipping transactions and the appropriate assessment methods.

2. Customer Analysis

Type of Borrower

The nature of the Borrower is crucial. For instance, a large, well-funded company or group with a substantial fleet and diverse funding sources typically represents a more attractive opportunity than a smaller entity with limited fleet size and financial options.

While smaller operations might inherently pose higher risks, these can be mitigated by adjusting the Leverage Ratio or influencing the employment of the financed ship(s). Financing a single ship is riskier since any off-hire situation halts all cash flow. Conversely, with multiple ships, the impact of one being off-hire is less severe.

Track Record

A borrower’s history is critical. A history of defaults will raise initial concerns. Lenders use their network of contacts, including other banks, lawyers, brokers, and insurers, to uncover any negative history. Modern communication tools make it difficult for a poor track record to stay hidden. Lenders are increasingly vigilant about high levels of insurance claims, unresolved legal issues, and unpaid creditors. They also routinely check the ship’s history of port state control inspections and detentions to assess management quality.

Experience

The Borrower’s experience in operating and managing the proposed ship(s) is vital. Even the best transaction on paper can fail if the borrower lacks experience in the relevant market. While experience can be transferable and purchased, lenders are cautious about borrowers shifting abruptly to different market sectors.

Existing Relationship with Lender

If the Borrower has an existing relationship with the lender, the financing process tends to be smoother, particularly in the current financial climate where many lenders prefer to finance only their core existing clients. If the Borrower is new, the lender may rely on its network to gather necessary information.

3. Ship Analysis

Type of Ship

The type of ship significantly influences the availability and conditions of finance. For example, financing standard designs from major dry bulk or tanker markets allows for a thorough market assessment due to abundant available data.

Specialized ships like LNG carriers or offshore construction vessels pose more challenges in assessment due to their unique nature. The more specialized the ship, the smaller the potential buyer pool if issues arise, likely affecting the sale price.

Standard ships may attract various owners with relatively flexible conditions regarding the ship’s employment. In contrast, financing specialized vessels often requires either long-term employment contracts that amortize the loan to a negligible residual value at maturity or backing by a significant entity capable of covering potential defaults.

Ship History

As with Borrowers, Lenders today can easily access the history of a particular ship through modern information resources and their contact networks.

The focus for Lenders includes significant insurance claims, which may indicate substantial past damage to the ship, and high levels of port state control detentions, which suggest poor maintenance.

Previous ownership/management is also scrutinized because Lenders may have existing concerns about the management capabilities of certain companies.

Ship Condition

Condition is critical for a Lender, as a ship in poor condition is more likely to break down and go off-hire, becoming unable to earn freight. Lenders may consider purchasing a subpar ship if there is a comprehensive plan to restore it to an acceptable standard.

Unless the ship is very new or familiar to the Lender, it is common to commission an independent survey (at the Borrower’s expense) to ensure the ship is in good condition.

Ship Age

Lenders generally prefer to finance newer ships because they have a longer remaining useful life, which is advantageous if the loan needs to be restructured or extended.

Conversely, older ships may have a lower capital cost and better cash flow, allowing for faster loan amortization.

Though many Lenders impose age limits on financing (either at inception or maturity), some are willing to finance older ships at higher loan rates as long as the loan value does not surpass the ship’s scrap value— a feasible approach given high scrap prices today.

Ship Speed, Consumption, and Emissions

Lenders are paying closer attention to ship speed, fuel consumption, and emissions due to high bunker prices and upcoming IMO emissions regulations.

Both Lenders and Borrowers should consider a ship’s fuel efficiency, as those with high consumption may be less appealing to charterers, leading to reduced utilization and profitability. Increasingly, top-tier charterers, especially those in developed countries, prioritize the environmental impact of their logistics chains, making less efficient or high-emission ships less desirable over time. Retrofitting ships with emission-reducing technology is an option, although the financial viability varies.

Ship Valuation

A ship’s market value is determined by what someone is willing to pay, influenced by its age, build year, design, condition, speed, and consumption, among other factors. Most Lenders require an appraisal from their chosen valuer, which forms the basis for the loan. The prevalence of transparency and instant communication means valuation discrepancies are becoming less common. However, if a Lender’s appraisal is lower than the purchase price, the Lender’s valuation will prevail, and the loan will be based on this lower value (e.g., a maximum of 60% of the valuation).

Ship Class and Registry

Most Lenders require that the ship be classified by a member of the International Association of Classification Societies (IACS), and some may only accept ships from specific IACS members. This ensures the ship providing security is maintained properly.

Lenders also prefer ships registered in established jurisdictions or well-known flags of convenience like Panama, Liberia, and the Marshall Islands, ensuring that the maritime law governing their mortgage is robust and tested.

Ship Insurance

Lenders mandate that the ship’s main insurances (hull and machinery, war risks, protection and indemnity) are sufficient and meet specific criteria, often exceeding 120% of the loan amount or ship’s market value. Lenders frequently hire external insurance consultants to evaluate the proposed insurance arrangements, reducing their risk exposure.

Ship Employment

Lenders’ credit assessments focus heavily on the ship’s employment arrangements. In today’s market, many Lenders require some guaranteed term employment before financing.

If the ship’s earnings, even at historically low freight rates, can cover the breakeven level of the facility, Lenders might allow the ship to operate in the spot market.

Despite their risk aversion, Lenders recognize that locking a ship into low-paying term employment at market lows, without the potential for upside, is economically disadvantageous for both Lender and Borrower.

In the past, a charterer’s reputation alone might suffice, but following numerous defaults by previously First Class Charterers (FCC), Lenders and shipowners now intensively vet Charterers’ Creditworthiness through financial reviews and specialist credit reference agencies. The objective is to avoid long-term charters that might fail during market downturns, negating the benefit of guaranteed income.

4. Transaction Analysis

• Transaction Type

Shipping finance transactions are categorized into three primary types:

a- Corporate Unsecured

These transactions are rare and typically available only to the largest and most robust shipping companies with substantial stock-market listings and/or investment-grade ratings. As implied, these loans are granted on an unsecured basis, with minimal or no amortization over the loan term, trusting the Borrower to manage and renew their fleet with minimal interference from Lenders.

The main controls in this transaction type for the Lender are financial covenants imposed on the Borrower (e.g., minimum net worth, maximum gearing, and minimum liquidity) and a negative pledge that prevents the Borrower from pledging its assets (ships) to any other Lender, ensuring asset availability to cover loan obligations in case of liquidation.

In these transactions, the Lender’s recourse is only to the Borrower (not the ship(s) or their cash flow), offering a single exit strategy.

b- Corporate Secured

This is the most prevalent transaction type in shipping finance, applied to Borrowers of varying sizes and standings.

Typically, a loan is granted to one or more single-purpose companies, each owning a ship, under a group holding company. The standard security package includes a ship mortgage, assignment of earnings and insurances, plus a corporate guarantee from the group holding company, which contains financial and other covenants providing the Lender with sufficient assurance.

This transaction type allows the Lender to access the ship(s) through the mortgage, the cash flow via the earnings assignments, and the financial resources of the group holding company through their guarantee, offering multiple exit strategies.

c- Cash-flow Lending

Often referred to as project financing, this type is selected for projects where the employment is strong and long enough to amortize most, if not all, of the loan. For instance, an LNG carrier may be on a long-term charter to an investment-grade energy company for ten years at rates that amortize the loan to a manageable balloon.

In such cases, despite the strong backing company, the Lender might opt for non-recourse lending, relying on the steady cash flow from the charter to amortize the loan.

Security for this type of transaction would include a ship mortgage, assignment of earnings and insurances, along with a specific assignment of the ship’s long-term charter, providing the Lender with dual exit strategies.

• Breakeven Calculation and Comparison

A critical metric for Lenders is the breakeven requirement of the ship, calculated by summing the total debt service (repayment installments plus interest) and forecast operating expenses for each year, then dividing by the number of likely operating days. This daily breakeven rate is compared with historic rates to assess if the ship’s earnings can cover its costs over the loan’s tenure.

• Loan to Value (LTV) Comparison

While cash flow is the primary focus for loan repayment, the Lender also ensures the loan is well-secured by the underlying ship. Projecting the likely Loan to Value (LTV) coverage forward is crucial. Although ship values are volatile, the only certainties are the current value and the estimated scrap value. Lenders often project the ship’s depreciated value on a straight-line basis based on its expected useful life and scrap value.

• Balloon Comparison

Most transactions have a longer profile than term, resulting in a balloon payment at maturity. The Lender needs to ensure this can be met by either selling the ship or refinancing the loan, comparing the balloon amount to the value of similar-age ships at loan maturity.

• Transaction Cash-flow Projections

After verifying that the proposed facility meets breakeven, Loan to Value (LTV), and balloon criteria, the Lender prepares cash-flow projections under various scenarios. While proprietary models exist to forecast future ship earnings and values, the multitude of unpredictable shipping factors means these forecasts can become outdated quickly. Thus, most Lenders create projections based on base and worse-case scenarios, expecting the reality to fall somewhere in between.

The accumulated cash flow is managed as agreed between the Lender and the Borrower, potentially used to prepay the loan balloon through a cash sweep, maintained in a bank account pledged to the Lender, or distributed from the borrowing entity as dividends.

5. Borrower/Guarantor Analysis

Depending on the type, size, and the existing relationship with the Borrower and/or Guarantor, the Lender will conduct a thorough analysis of the company to assess its financial strength. This evaluation may include:

Financial Statement Analysis: The Lender typically reviews the past three years of financial statements to calculate key metrics such as gearing, net worth, and liquidity of the company.
Financial Projections: Financial Projections on a group basis are often prepared, similar to the cash-flow projections, covering all ships and financings within the group.
Credit Ratings and Internal Models: If the Borrower or its parent company is large enough to be rated by agencies like Standard & Poor’s or Moody’s, the Lender will review these ratings. Additionally, the Lender will use its internal rating model to determine an internal grade and estimate the Probability of Default (PD). Following the implementation of Basel II, Lenders using the Basel II foundation approach are required to develop internal rating models to determine the Probability of Default (PD) for the transactions they manage. Those utilizing the advanced approach have developed more sophisticated models capable of estimating not only the Probability of Default (PD) but also the loss given default and expected loss on a transaction.

6. Charterer Analysis

The recent industry downturn and numerous defaults by charterers have prompted increased scrutiny by shipowners and their Lenders on the financial stability of Charterers. It is now insufficient to solely rely on the reputation of charterers or regard them as first-class without comprehensive due diligence. Typically, it is necessary to review their financial statements and external rating reports (if available), and assess them using the Lender’s internal model before deeming them a suitable counterparty.

Ship Loan Documentation

Once the indicative term sheet has been agreed upon by the Borrower and Lender, approved by the Lender’s credit authority, and a committed offer letter has been issued, it is crucial to meticulously and comprehensively document the facility.

Numerous law firms globally have partners with extensive experience in documenting shipping finance transactions. The Lender will typically appoint their maritime finance lawyer to handle the documentation (at the Borrower’s expense, as mentioned previously). Depending on the Borrower’s familiarity with shipping finance documentation, it is common for them to also engage legal representation. The next chapter will cover the more technical legal aspects of ship registration, mortgages, and litigation.

Governing Law

Before appointing lawyers, it is essential to determine under which law the transaction will be documented. Regardless of the Lender or Borrower’s location, English law is often preferred due to its comprehensive maritime legal framework and depth of expertise. However, other jurisdictions such as New York, Norwegian, French, and Dutch laws may be chosen for various strategic reasons, such as accessing US capital markets or specific export credit arrangements or tax structures.

It is important to note that choosing an uncommon legal framework may limit the availability of experienced maritime legal professionals, and some aspects of the chosen country’s maritime law might be relatively untested.

Loan Agreement

The loan agreement is the central document that governs the operation of the loan, encompassing all obligations, restrictions, and requirements of both the Borrower and the Lender. It is not unusual for this document to undergo several revisions as it is negotiated between the Lender, Borrower, and their respective lawyers until all parties are satisfied and ready to sign.

Security

The type of security required varies depending on the transaction type (corporate unsecured, secured, or cash-flow financing):

1– Ship Mortgage

The Ship Mortgage typically serves as the primary security for the Lender and receives significant attention. The Borrower may have a preferred ship registry, which should be agreed upon in advance during the indicative term sheet phase with the Lender. There are many ship registries globally, each with legal nuances affecting their operation. Common international flags like Panama, Liberia, and the Marshall Islands are well-established and generally accepted by Lenders. Other recognized flags include the UK, Isle of Man, Norway, Malta, Cyprus, Singapore, and Hong Kong. Sometimes, due to cabotage laws, other registries may be necessary, but these should also be agreed upon in advance with the Lender.

Exercising Ship Mortgage

By granting a mortgage, the Shipowner provides the Lender with direct access to the ship in the event of the Borrower’s default. If the Borrower defaults, the Lender issues a default notice, followed by an acceleration notice stating that the loan is due for immediate repayment. If the loan remains unpaid, the Lender is positioned to enforce their security, including exercising the mortgage.

With assistance from their legal team and possibly external advisors, the Lender will approach the admiralty court in the jurisdiction where the ship is located. Sometimes, Lenders wait for the ship to enter a jurisdiction favorable to mortgagees before acting or, if necessary, take possession of the ship, directing it to a suitable port.

Often, a ship might be arrested by other creditors by the time the Lender acts, giving the Lender the option to join the arrest or negotiate a settlement to free the ship and move it to a more favorable jurisdiction for re-arrest.

Ultimately, the admiralty court typically mandates an auction of the ship, allowing creditors to file their claims. Following the auction, the admiralty marshal organizes the creditors according to their priority, with court costs, local port charges, and crew wages typically taking precedence.

In mortgagee-friendly jurisdictions (such as the UK and its dependencies, Netherlands, Singapore, USA, etc.), the first mortgagee—usually the financing bank—ranks immediately after mandatory expenses, followed by other secured creditors, with unsecured creditors like bunker suppliers and shipbrokers rarely receiving any payout.

In less friendly jurisdictions, some unsecured creditors may rank above the mortgagee, making it crucial for the Lender to ensure the ship is seized or relocated to a jurisdiction that is favorable from their perspective.

2- Assignment of Earnings

Typically, the Lender will require a general assignment of earnings from the Borrower, granting them entitlement to the earnings of the ship and specifying that these earnings be deposited into a ship’s earnings account held by the Lender. If the ship is under a long-term contract, such as over 12 months, it is standard to have a specific assignment of that charter. In these cases, it is routine for a Notice of Assignment to be issued to the Charterer, informing them of the assignment to the Lender and requesting an acknowledgment of this notice to ensure they comply with its terms.

3- Assignment of Insurances

The Lender will also necessitate an assignment of the ship’s insurances from the Borrower, allowing them access to the proceeds from any insurance claims. To simplify the process, there is often a set threshold below which the insurance proceeds are directly transferred to the Borrower without needing the Lender’s intervention. Similar to earnings assignments, it is necessary for insurance providers (including Hull and Machinery, War Risks, and the P&I Club) to receive a Notice of Assignment and to acknowledge this notice to the Lender. Additionally, the insurers are required to provide a Letter of Undertaking, agreeing to notify the Lender of any cancellations, unpaid premiums, or other significant changes. Insurers might also be asked to include the Lender as an assured on the policy and to incorporate a loss payable clause that directs any payouts above the set threshold directly to the Lender instead of the Borrower.

Common documents usually cover both insurance and earnings assignments.

4- Guarantee

In scenarios where the Borrower is a Single Purpose Company (SPC) under a Group Holding Company, a guarantee is typically involved to affirm the guarantor’s obligations towards the Lender. This document will incorporate various covenants as outlined in the loan agreement that restrict and mandate specific actions by the Guarantor. If the loan is extended to the Group Holding Company itself, not only will the Single Purpose Company (SPC) provide a mortgage to support the loan, but also an Upstream Guarantee of the Borrower’s liabilities. This guarantee, if provided by the Parent Company/Group Holding Company, contains the financial covenants upon which the Lender relies; otherwise, these are included in the loan agreement.

5- Share Pledges

The Lender may require a pledge over the Borrower’s shares, which is facilitated through a Share Pledge document. This arrangement provides the Lender with an alternative method of securing their investment by assuming control of the company owning the ship, rather than enforcing the Mortgage directly. This approach can be more efficient and may not disrupt any existing charter agreements, which might include clauses that terminate the charter if the ship changes ownership.

6- Account Pledges

The Lender typically requires the Borrower to maintain specific bank accounts, likely including:
a) Earnings Account: All charter hires are received here, and from this account, all costs, including voyage and operational expenses and debt service, are deducted. A minimum balance is often required.
b) Retention Account: A portion of the future installment is transferred monthly, ensuring sufficient funds for upcoming debt services.
c) Drydocking Account: Regular transfers fund the expected costs for Intermediate Surveys and Special Surveys, acting as a sinking fund for anticipated future expenses. These accounts are pledged to the Lender.

7- Newbuilding Security

For newbuilding transactions, specific securities are needed, different from those for ships already in operation:
a) Assignment of the Shipbuilding Contract allows the Lender to take over the project if the Borrower fails to take delivery of the ship, ensuring the ship’s completion.
b) Assignment of Refund Guarantees from the Shipbuilder’s Bank to the Buyer is crucial, and it is essential to have the Lender’s approval on the form of the guarantee to ensure it serves as acceptable security. Not all banks are considered reliable guarantors, and the Lender’s approval is vital before proceeding.

Ship Registration

Requirements for Registering a British Ship

Registering a British ship is a right, not a duty. Applications for registration, covering merchant ships, pleasure ships, and bareboat charter ships (Parts I and IV of the register), can be submitted by:

British citizens or nationals from other European Union member states established in the United Kingdom, as defined under article 52 of the EC Treaty (Treaty establishing the European Economic Community, Rome, March 25, 1957) and the Treaty on European Union (Maastricht, February 7, 1992) Title II art G(l);
Citizens of British Dependent Territories;
British overseas citizens;
Individuals who are British subjects under the British Nationality Act 1981;
British nationals (overseas) as defined by the Hong Kong (British Nationality) Order 1986;
Corporate entities incorporated within any European Union member state;
Corporate bodies established in any relevant British possession with their main place of business in the United Kingdom or such possession; and
Economic interest groupings that are properly formed and registered in the United Kingdom (according to EC Council Regulation 2137/85).

A non-qualified individual can co-own a ship registered on part I of the register if:

the majority interest (more than 33/64 shares) is owned by qualified individuals; and
the ship is listed on part I of the register. Part II of the register pertains to the registration of fishing boats.

Residence Requirements

If none of the qualifying owners reside in the UK, a representative must be appointed who is either an individual residing in the UK or a company incorporated in an EEA country with a business location in the UK. If there are multiple owners residing in the UK, one must be designated as the managing owner to facilitate communication with the registry. The managing owner acts on behalf of all other owners and serves as the main contact for the registry in the UK, although this role is commercial and does not necessarily mean they manage the ship. These registration stipulations are vital as they establish a legitimate connection between the state and the ship owner. Some countries enforce stringent requirements to ensure a strong genuine link, while others may have more lenient standards. Apart from the UK tonnage tax regime entry requirements, there seem to be no specific mandates for managing ships registered under Parts I and IV from within the UK.

Flag States – Registering in Different Countries

Several decades ago, certain countries began offering their National Flag for the registration of ships from other nations, allowing these ships to be registered under their laws without any stringent requirements for beneficial ownership or control. Instead, they only required the formation of a nominal owning company for registration purposes, with no demand for a genuine link between the country of registration and the actual country of ownership.

The primary reason shipowners sought registration under Foreign Flags was to evade high taxes and strict regulations imposed by their home countries. This practice gained significant traction post-World War II, as unsubsidized fleets from Western nations struggled to compete in global markets against the state-owned or controlled fleets from the Soviet bloc.

Additionally, the laws in a shipowner’s home country might mandate the employment of only national seafarers, which could be prohibitively expensive and negatively impact the profitability of the ship. Some countries still enforce this requirement.

The United Kingdom adopts a more lenient approach and does not require British nationals to exclusively fly the British Flag. Countries that offer registry without restrictions to shipowner nationals from any nation include, among others, Panama, Liberia, Honduras, and Costa Rica.

This system will persist as long as international law allows each sovereign state the freedom to decide the terms under which it grants its nationality/flag to foreign-owned merchant ships.

It is important to note that during wartime, the actual ownership of a ship is a crucial criterion for determining enemy status. Thus, ships registered under Open Registries, when owned by a nation at war, would be considered enemy ships by the opposing sides. In such cases, the international norm granting the country of registration the right to protect and potentially requisition its registered ships may be altered, with the real and effective ownership assuming the protective rights. Shipowners with vessels under open registries can thus maintain trade during conflicts and embargoes.

Open Flag States have been increasingly pressured by international opinion to enforce effective jurisdiction and control over ships bearing their flags and to uphold high standards of safety regulation.

Initially, Open Registries were utilized by US merchant ships flying the Portuguese flag to circumvent the British fleet. British ships also flew the flags of lesser-known German principalities during the Napoleonic shipping blockade. The concept of open registries originated in 1920. Panama became a haven for US ships, helping them avoid stringent boiler and hull inspections. Honduras was established to provide the US-based United Fruit Company an economical way to transport bananas, and the Liberian flag was initiated by former US Secretary of State, Edward Stettinius, aiming to maintain a neutral fleet in case of Soviet aggression. Open registries now represent 50% of global tonnage, with the Bahamas, Liberia, the Marshall Islands, and Panama all included on the white list of the Paris Memorandum of Understanding (MOU) or port state control.

This reflects significant shifts in the maritime industry and notable enhancements to Open Registries. Since the late 1980s, traditional registries have faced competition from other types of ship registries, which blend characteristics of both traditional and open registries. An example is the offshore flag, such as the Isle of Man, which attracts foreign-registered British tonnage by offering employment of crews at rates from their countries of origin and providing tax concessions to national crews, thereby posing a challenge to both traditional and emerging independent registries.

Mortgages

In the case of Downsview v First City Corp [1993] AC 295 at 31 I, Lord Templeman defined a mortgage succinctly as ‘a mortgage whether legal or equitable, is security for repayment of a debt. The security may be constituted by a conveyance, assignment, demise, or by a charge on any interest in real or personal property.’

Most ships are purchased or constructed with the help of financing that is secured by the ship itself, typically through a mortgage.

A mortgage establishes a charge over property, created by the Borrower (the Mortgagor) in favor of the money Lender (the Mortgagee).

The Merchant Shipping Act 1995 and the Merchant Shipping (Registration of Ships) Regulations 1993 regulate the granting and registration of ship mortgages under UK law. According to this legislation, it is possible to mortgage any or all of the 64 shares in a ship.

It is improbable that a bank would extend a loan to a Shipowner without securing a mortgage over a ship. This arrangement is feasible only if the ship is properly registered in a manner that also allows for the mortgage to be registered. All ships listed under part I of the registry can be mortgaged.

To register a mortgage, the Mortgagor must sign a deed as prescribed by the Registrar General of Shipping and Seamen. This deed is then filed with the Registry of Shipping against the ship’s registry. Multiple mortgages can be held against a ship, and they are prioritized based on the registration sequence of each mortgage.

A mortgage can be discharged or released by signing the discharge section of the deed and submitting it to the registry, or the registry may accept a discharge letter from the mortgagor. The mortgage is then canceled, and any remaining mortgages will move up in priority. A transcript of the registry can be requested to check if a ship has any registered mortgages.

Registering a mortgage in this manner grants the mortgagee merely a bare legal mortgage. Typically, the Mortgagee seeks additional assurances and will obtain a deed of covenant from the Mortgagor, which includes further security measures. This deed, a private document, usually stipulates that the Mortgagee receives income generated from the ship and is listed on the ship’s insurance. It also requires the shipowner to maintain the ship in good condition, ensure it is insured, and so on.

Failing to register a mortgage does not invalidate it, and an unregistered mortgage can still be enforced against a buyer who was unaware of it, as established in The Shizelle [1992] 2 Lloyd’s Rep 444.

Mortgagee has the legal right to sell the ship, a right that is typically included in the deed of covenant. The bank must issue a demand in line with the mortgage agreement’s terms.

If the Shipowner does not comply with the demand, the mortgagee can assume control of the ship if the mortgage document explicitly permits this action, known as Entry into Possession. Mortgagee may also organize a private sale of the ship or initiate its arrest and judicial sale.

While the bank’s right to a private sale is recognized at Common Law, it is usually specified in the mortgage document. Advertising a ship for sale often leads to a distress sale, which can attract other creditors to secure their claims by arresting the ship, hindering its sale until their claims are settled. Furthermore, the bank is obligated to achieve the highest reasonable price and might face challenges from the shipowner regarding physical possession.

If a commercial sale is unfeasible, the bank may arrest the ship and sell it through court proceedings, ensuring a clear title for the buyer as all previous claims are extinguished and transferred to the sale proceeds. Cooperation from the Shipowner is not required for a court sale. The bank need not settle accounts with any other creditors, as the sale proceeds are distributed among them according to a court-ordered priority, with mortgages ranking relatively high.

Banks and Shipowners can negotiate terms for the bank to receive Freight or Hire Payments, tailored to suit their mutual conditions at the time.

Equitable Mortgages

A mortgage not executed in the legally mandated form, such as a foreign mortgage, cannot be registered and is therefore, under English law, considered only an Equitable Mortgage and not a Legal Mortgage.

An equitable mortgage grants the Mortgagee an equitable interest only and can be established in several ways:

On an unregistered British ship or a share in such a ship;
On foreign ships;
On ships that are still under construction.

An Equitable Mortgage can be established through the deposit of a ship’s legal deeds or through an agreement to create a legal mortgage as part of a loan arrangement. This type of mortgage remains in effect until a legal mortgage is formally established.

In terms of priority, Equitable Mortgages are ranked by the order in which they were created. It’s crucial to understand that a mortgage takes effect from its creation date, not its registration date. However, the order of priority is determined by the registration date.

Equitable Mortgages are always subordinate to statutory registered mortgages, even if the registered mortgages were created after the equitable mortgage. An Equitable Mortgage cannot be enforced against a purchaser of a ship who acquires the ship without knowledge of the existing mortgage. Conversely, registered mortgages are enforceable against a buyer, regardless of the buyer’s awareness.

While there is no mandate to register a mortgage, registration confers significant benefits. Notably, a registered mortgage takes priority over any earlier unregistered mortgages, later registered or unregistered mortgages, unregistered debentures created previously, and additional advances on earlier mortgages that cover both present and future lender advances.

Registration serves as a global notification, and although failing to register a mortgage does not invalidate it, the lender must defer to subsequently registered encumbrances. Remember, the registration date is critical as it establishes the priority order, not the date the mortgage was initially created.

Admiralty Jurisdiction

Admiralty jurisdiction pertains to the authority of courts dealing with maritime matters, allowing them to address claims against ships or other maritime property, or against a shipowner in their personal capacity. This discussion focuses on English Law.

It’s important to note that admiralty law is integrated with other legal disciplines; it isn’t isolated from them. Key principles from tort and contract law significantly influence admiralty law. However, admiralty law also includes a distinct set of legislation, primarily under the Merchant Shipping Acts, starting in the 19th century and culminating in The Merchant Shipping Act 1995, which consolidates many previous acts.

The rights of courts to handle maritime issues are specified in The Senior Courts Act 1981. It’s crucial to differentiate between procedural law, which governs the process of hearing cases, and substantive law, which applies to the actual claims.

The Senior Courts Act 1981 specifically addresses procedural law, which is largely codified, contrasting with the combination of common law and statutory law that governs substantive legal disputes. Sections 20 to 24 of The Senior Courts Act 1981 outline the procedures for admiralty actions, either in Personam (against the person) or in Rem (against the thing). The specific types of claims or disputes within this jurisdiction are detailed in section 20(2) of the Act.

The Civil Procedure Rules (CPR) of 1998 and 2013, along with Practice Directions, also guide the procedures for pursuing or defending a claim, whether in Rem or in Personam.

The 1981 Act differentiates between two types of actions available in admiralty proceedings:

Action in Personam (against the Person); and
Action in Rem (against the Thing).

In Personam

This procedure allows a party to issue and serve a claim form upon another party, the defendant, who they intend to sue. This is a straightforward process when the defendant resides within the jurisdiction, specifically in United Kingdom. However, serving a claim form on a defendant residing outside the jurisdiction can be challenging. There are rules governing the service of a claim form outside the jurisdiction, and in many instances, it may not be practical or even possible. Additionally, even if the claim form is successfully served on a defendant in another country, it may be realistically impossible to compel a response or court appearance.

In Rem

The in Rem procedure offers a valuable alternative to the in Personam procedure for maritime and aviation disputes. As stipulated by Section 742 of the Merchant Shipping Act 1894, this procedure is accessible to anyone who may have experienced harm, loss, or damage due to the actions of a ship.

Fundamentally, the in Rem procedure allows the claimant to issue and serve their claim form on the res, or the ship itself. It is crucial to understand that the ship is not the sole res or entity against which action may be taken. For admiralty claims, res is defined as maritime property, which could include cargo, freight, or proceeds from a sale.

The practical implication of the in Rem procedure is that it permits the arrest of the ship involved in the action. The ship is arrested and prevented from leaving the jurisdiction, similar to the arrest of a person.

The regulations for applying the In Rem procedure are detailed in sections 20-24 of The Senior Courts Act 1981. Section 20 establishes the admiralty jurisdiction of the High Court, and section 20(2) outlines the specific circumstances covered by admiralty jurisdiction. Section 21 details the mode of exercising admiralty jurisdiction, while Section 20(1) confirms that an action in Personam may be initiated in all cases mentioned in section 20(2). Sections 21, Articles 2, 3, 4, and 5, dictate when an action in Rem may commence, covering nearly all claims under section 20(2), typically those involving damages from maritime disputes. Some claims, however, can only be enforced through an action in Personam.

Although the in Rem procedure personifies the ship, it is essential to remember that the actual defendant is the person who would be liable in Personam concerning the claim. Thus, the In Rem procedure complements rather than replaces the in Personam action. The relevant person, as mentioned in section 21 (4)(b), could be the Shipowner or the Demise Charterer. The intent behind the In Rem action is to compel the person or persons to appear, allowing for an in Personam claim to proceed.

A significant and practical outcome of initiating an admiralty action in Rem is the issue of priorities. This term refers to the ranking of various creditors against the funds in court generated by the ship’s sale. If the sale yields a sum sufficient to satisfy all creditors’ claims, there are no issues.

However, the issue of priorities becomes crucial when the sum is insufficient to cover all creditors’ claims. The fundamental rule of priorities is that a creditor’s right to claim against the fund depends on the nature of their claim.

Under English law, claims that attract Maritime Liens include the Damage Lien, the Salvage Lien, and the accrued wages of the crew and Ship Master, along with disbursements.

There are other maritime claims which may be granted the status of a Maritime Lien by the laws of the country where they arose or where the contract was formed. As a ship moves from one jurisdiction to another, the priority of a mortgagee may be at risk, leading to a conflict of laws issue. The court must then determine the validity of the foreign lien before deciding on the priorities for distributing the proceeds from the sale of a ship.

Under English law, and in jurisdictions following similar statutes, the priority of a mortgage is recognized over other statutory rights in Rem, but not over a Maritime Lien.

One Ship Company to Prevent Ship Arrest

In The Looiersgracht [1995] 2 Lloyd’s Rep 411, it was established that using a one-ship company is a legitimate strategy to shield various assets from arrest under Maritime Claims. This type of corporate structure, which includes a Parent Company and several subsidiaries each acting as separate entities, is allowed provided there is no intent to perpetrate a sham, fraud, or facade. For a Claimant to succeed, they must demonstrate a clear link between the Maritime Claim, the ship, and the ship’s owner. In The Eschersheim [1976] 2 Lloyd’s Rep 1, at 7, Lord Diplock clarified this as follows: “A ship can only be liable to arrest if it is not just the property of the defendant in the action, but also distinctly connected to the claim that initiated the action (or is a sister ship of that ship). The relationship between the ship and the claim must reflect what is specified in the corresponding phrase in the Convention; that is, the specific ship concerning which the maritime claim arose.”

The structure of a one-ship company complicates the identification of the true beneficial owner. For a ship to be arrested, the person liable in Personam must be the actual owner or the charterer, not just in possession or control of the ship. If the ownership of the ship or shares in the ship rotates among various one-ship companies, it complicates the successful arrest of the offending ship. This stance was maintained in The Aventicum [1978] Lloyd’s Rep 184, at 189 and reiterated by Lord Donaldson in The Evpo Agnic [1988] 2 Lloyd’s Rep 411 at 415:

“The Plaintiffs’ main assertion is that Mr. Evangelos Pothitos, who identifies himself as a Greek shipowner, or his company, Pothitos Shipping Co. S.A., truly owns both ships and indeed all the ships in the Pothitos fleet. This implies that the registrations are shams. I am as pragmatic as most Judges who have served in the Commercial Court, but I see no commercial benefit in creating sham registered ownerships. Mr. Pothitos undoubtedly has a legitimate interest in operating these ships as a fleet, and he can achieve this by managing a series of genuine one-ship shipowning companies collectively.”

Consequently, Lord Donaldson opted not to pierce the corporate veil, confirming that combining the one-ship company model with the 1952 Arrest Convention effectively prevents the arrest of ships or their sister ships. This is typically accomplished by transferring ships among subsidiary companies before any claim is filed. However, these transactions must be conducted at arm’s length and without any intent to defraud, as discussed in The Saudi Prince [1982] 2 Lloyd’s Rep 255.

Utilizing a one-ship company structure has proven to be an effective strategy for protecting ships from arrest, offering significant incentives for shipowners when selecting a corporate framework.

Arbitration

Typically, one party appoints an arbitrator, notifies the other party of the appointment and the start of the arbitration, and requests that the other party appoint its own arbitrator within 14 days. Occasionally, the parties might agree on a sole arbitrator, or the arbitration clause may stipulate one.

If the tribunal consists of two arbitrators, they may have the authority to appoint a third arbitrator or an umpire if they cannot agree on a decision. If the opposing party fails to respond or ignores the request to appoint an arbitrator, provisions in the arbitration clause may allow the initially appointed arbitrator to act as the sole arbitrator. If there is no such provision, an application may need to be made to the High Court to appoint an arbitrator for the opposing party or to appoint a sole arbitrator.

Once the tribunal is established, the claimant serves claim submissions to the other party and the tribunal, often including supporting evidence and documents. The respondent then drafts and serves defense submissions, possibly with evidence. If the respondent believes it has a claim against the claimant, it will serve defense and counterclaim submissions. The next step is a reply to the defense (and defense to counterclaim, if applicable), typically without introducing new arguments, though this rule is sometimes overlooked, leading to further rounds of submissions.

After the exchange of submissions is complete, the pleadings are closed, and evidence disclosure occurs. The complexity of the case and the amount of evidence often determine whether evidence is provided with the submissions.

Most arbitration is resolved based on documents alone, without oral submissions at a hearing, unless the parties agree otherwise. However, complex issues may require verbal submissions and the opportunity to cross-examine witnesses at a hearing.

The arbitration award is issued to the parties after the hearing or after document submissions are closed, with awards typically kept confidential unless the parties decide otherwise. This high level of confidentiality makes arbitration particularly appealing for resolving shipping disputes.

Equity in Ship Finance

Owner’s Equity (OE)

In its most fundamental form, equity refers to the cash funds utilized by a Shipowner. Despite the challenging times in the global economy and shipping markets, there remain Shipowners, whether they are high-net-worth individuals (or families) or sizable corporate entities, who have access to sufficient liquid resources to acquire one or more ships independently of external financing.

Owning a ship outright using cash resources offers several benefits. A primary advantage is the ability to make swift and definite transactions. Like other asset markets, ship sellers often prefer buyers who can pay predominantly in cash. This preference eliminates the uncertainties that can arise from transactions contingent on financing, where the sale depends on the buyer’s ability to secure funding. This scenario is similar to the residential property market, where sellers favor buyers who do not need to secure mortgage financing. Another significant advantage is flexibility, particularly useful in scenarios like ship auctions where a cash buyer can readily increase their bid without needing approval from a lender if the initial price is exceeded. Additional benefits include the freedom to operate without the restrictions of covenants and conditions typically imposed by financing agreements, especially bank loans.

Historically, it was challenging for Shipowners to attract External Equity (Private Equity or Public Equity) due to conflicting objectives. External Equity providers often sought a degree of control over the company they invested in, a condition reluctant Shipowners who were accustomed to making quick decisions based on intuition did not welcome. However, since the early 2000s, it has become more common for Shipowners to partner with external investors. Just before and during the 2004-2008 boom, several companies rapidly expanded with the financial backing provided by external equity, initially through private placements followed by listings on Stock Exchanges, allowing original investors to recoup some of their initial investments.

Although there is still some hesitance among long-established Shipowners to relinquish as much control as partnering with external equity would require, many have become more pragmatic in recent years. The advantages of becoming a larger, more robust entity with the support of external equity have become more apparent. It is now more acceptable for Shipowners to maintain a large platform in conjunction with external equity while also keeping a Private Shipping Company in an unconnected or non-competing area.

The shipping market’s volatility, which had previously deterred traditional External Equity providers like pension and investment funds, has become highly attractive to entities operating managed Private Equity (PE) and Hedge Funds. These investors thrive on volatility and view it as an opportunity to profit (buy low, sell high, short sell as necessary, etc.).

Traditional Equity Providers’ concerns, such as secrecy and Special Purpose Company (SPC) ownership of assets, are typically navigated with ease by Private Equity (PE) and Hedge Funds, as they often employ similar structures in their other investment operations.

Private Equity (PE)

Private Equity (PE) is defined as equity capital not listed on a public exchange. Investments are made directly into private companies by funds and individual investors. Private Equity (PE) firms are usually structured as partnerships where the investors, acting as limited partners, provide most of the capital. The private equity market, known for Leveraged Buyouts (LBOs) where significant debt is leveraged alongside private equity to fund substantial acquisitions, has grown substantially since the 1970s. These buyouts often involve taking publicly listed companies private. The new Private Equity (PE) owners aim to enhance the financial health of the acquired company to eventually resell it to another firm or through an Initial Public Offering (IPO). In the shipping sector, large Private Equity (PE) firms have not only invested in ships but also acquired shipping companies and ports and purchased shipping loan portfolios from banks.

The returns sought by Private Equity (PE) firms generally range from 15%-25%+, with the shipping market’s volatility initially drawing Private Equity (PE) interest in the mid-2000s. This interest led to the formation of several companies to acquire tonnage and subsequently cash out through Initial Public Offering (IPO). More recently, the significant downturn in both shipping and financial markets has sparked interest due to the availability of ships and companies at historically low prices, presenting the potential for substantial future profits.

Since the late 2008 recession, Private Equity (PE) firms have increasingly sought Distressed Transactions, often facing resistance from sectors, particularly banks unwilling to sell assets at desired prices.

As Private Equity (PE) firms have become more acquainted with the shipping sector’s intricacies and better understood the timing and size of potential returns and associated risks, their interest has persisted. A recent survey indicated that around 30 Private Equity (PE) transactions have been completed since the recession began, with the majority occurring in the last three years. As the shipping industry remains beleaguered, Private Equity (PE) interest is expected to continue, with more firms entering or expanding their investments in this sector.

Private Equity (PE) Investment Structure

Private Equity (PE) investment in the industry has embraced various structures, with the Joint Venture (JV) alongside an existing shipping company or management team becoming increasingly favored by both involved parties.

An arrangement is usually formed with a shipowner who has a successful track record in managing ships. A new Joint Venture (JV) entity is then created, predominantly funded by the private equity fund, with the shipowner also contributing capital and continuing to manage the ships acquired.

The shipowner’s contribution, though typically modest at 10%-15%, is crucial as it assures the private equity investor that any potential conflicts of interest related to ship management by the shipowner are minimized, aligning both parties’ interests towards the success of the Joint Venture (JV).

Given that the private equity fund provides the majority of the equity, it generally seeks majority control of the Joint Venture (JV) through board appointments and/or decision-making authority. For a Private Shipowner accustomed to quick, autonomous decisions, this shift may initially seem unusual but has proven manageable.

Other aspects that require mutual agreement and thorough documentation in the Joint Venture (JV) Agreement include:

The rights of the Joint Venture (JV) to replace the manager under certain conditions (e.g., non-performance);
Decisions within the manager’s authority (typically operational) and those requiring Joint Venture (JV) approval (like purchasing or selling ships or signing long-term employment contracts);
Proceeds distribution – whether these will be proportional to each party’s investment, designed to ensure a specific return level for the private equity fund first, or structured to maximize the manager’s motivation to enhance profitability;
Handling of competition issues, particularly if the shipowner/manager has a competing fleet. This is often resolved by granting the Joint Venture (JV) the first right of refusal on ship acquisitions and term employment;
Protocols if a Joint Venture (JV) partner wishes to sell their stake in the JV, often giving the remaining partner the first right of refusal to control with whom they co-invest;
The Joint Venture’s (JV) capability to issue additional equity and the existing shareholders’ rights to participate in such issuances to maintain their shareholding percentage.

Private Equity (PE) Outlook

Private Equity (PE) investors are increasingly becoming well-versed with the shipping industry, and their presence in the market is expected to expand. As shipping markets improve, the engagement of private equity is likely to catalyze more mergers, acquisitions, and Initial Public Offering (IPO) activities as these funds aim to capitalize on their investments through trade sales or public listings of the JVs they are part of. Conversely, a prolonged downturn in markets, such as the dry bulk sector, could prompt early liquidations by Private Equity (PE) investors, potentially driving down valuations further.

Public Equity (PE)

Public equity, unlike investments made directly in private companies, consists of shares that are listed on a Stock Exchange and are tradeable among third parties. Although historically, the shipping industry and the public equity markets were not considered very compatible, recent years have seen a shift, with a significant number of large shipping companies being publicly listed.

The integration has been slow due to several key factors:

The high levels of transparency required for public listings.
Corporate governance demands and the perceived surrender of control.
Limited analyst coverage, which often leads to underperformance in share prices.

However, over the last decade, the shipping industry has increasingly turned to the Public Equity (PE) markets, with many shipowners becoming more accustomed to and accepting of the regulatory demands concerning transparency and corporate governance.

As more shipping companies have entered the market, achieving a critical mass centered around certain Stock Exchanges, analyst coverage has improved. This improvement has allowed potential investors to independently assess the risks and rewards of investing in specific shares and to set realistic expectations for future returns.

Unlike private equity, which can accommodate both small and large investments, Public Equity (PE) typically requires a company to list a substantial number of shares, often exceeding US$100 million, and frequently much more. This requirement is primarily due to the significant costs associated with an Initial Public Offering (IPO) – the first sale of stock by a private company to the public.

The process involves adhering to a myriad of regulations and laws surrounding public share issuance, demanding a team of specialists to ensure compliance. The preparation for an Initial Public Offering (IPO) involves substantial work and due diligence, requiring the collaboration of lawyers, accountants, and investment bankers who pre-sell the shares, accumulating costs into several million dollars.

Once preparations are complete, and the Initial Public Offering (IPO) is ready, a roadshow is typically conducted by the appointed investment bank. During this roadshow, the company’s principals and management present to potential investors, ensuring all due diligence is complete and potential conflicts of interest or peculiarities are fully addressed to confidently deliver compelling arguments about the company’s operations.

As with any investment, whether Private or Public, it is crucial to present an attractive investment proposition. For instance, shares are more readily sold in a company using raised equity to expand a profitable fleet of ships, rather than one primarily seeking to retire significant bank debt.

During the financial and shipping market boom of the mid-2000s, numerous companies went public through Initial Public Offerings (IPOs). At that time, the market was flush with liquidity, making it much easier to issue Public Shares. However, many companies formed during this period for the sole purpose of listing, with pre-identified but unacquired ships and readily available bank financing, allowing principals to establish companies with minimal investment.

Unfortunately, several of these hastily formed companies with poorly conceived business models have since failed, resulting in substantial losses for shareholders. Nonetheless, many well-conceived companies listed during this boom continue to operate successfully today.

Stock Exchanges

Globally, most countries host at least one stock exchange, with larger economies often having more. For broader analyst coverage, listed shipping companies tend to gravitate towards a select few exchanges.

Historical ties or the need to access investors from specific countries sometimes dictate where companies are listed. The most substantial concentration of listed shipping companies is found in New York, split between the New York Stock Exchange and NASDAQ, which attracted the bulk of public equity issuances in the mid-2000s. This concentration has fostered a supportive cluster of market analysts, legal and accounting firms, and investment and commercial banks. Approximately 25% of the publicly-quoted shipping companies are listed in New York.

Norway is another popular location, especially for companies connected to the Norwegian or offshore industries, often listed on the Oslo Bors.

Singapore and Hong Kong are increasingly favored, particularly by mainland Chinese companies aiming for listings outside of China.

These top four locales comprise nearly 50% of all publicly-quoted companies, with many other stock exchanges worldwide hosting listings often related to the nationality of the company’s domicile.

Efforts by regions like Singapore and Dubai to attract foreign companies extend beyond business operations to encouraging listings on their stock exchanges. Singapore, in particular, has successfully drawn foreign companies, aided by its business-friendly environment.

Payout Ratios

During the buoyant shipping and financial markets of the mid-2000s, it was quite common for companies to promote their Initial Public Offerings (IPOs) based on a full payout dividend ratio. Essentially, this meant all of the company’s earnings per share were allocated to dividends. With Freight Rates reaching unprecedented heights, the dividends disbursed were substantial. At the market’s peak, some companies increased their dividend levels by financing their ships through non-amortising bank loans. This approach, which was both novel and transient, deviated from the traditional shipping wisdom that cash is king, and reserves should be built to weather the inevitable downturns.

Alternatively, some companies opted for a less aggressive partial payout ratio, retaining a portion of earnings within the company and distributing the rest as dividends.

During the boom, growth stock companies that reinvested all earnings back into the company for long-term growth, with the hope of an increasing share price, were less common.

The recession necessitated revisions in dividend policies due to diminished earnings, with companies lacking adequate cash reserves or retained earnings having to restructure their balance sheets. Unfortunately, for original shareholders, this often resulted in significant equity dilution or total loss.

Sarbanes-Oxley Act

Enacted in response to major corporate scandals such as Enron and WorldCom, the Sarbanes-Oxley Act was passed into federal law in the US in 2002, coinciding with the early signs of recovery in the shipping market. For shipping companies or any entities aiming to list in the USA, crucial elements of the Act include:

Auditor independence: Sarbanes-Oxley Act Title II sets standards for external auditor independence to prevent conflicts of interest. It mandates new auditor approval processes, audit partner rotation, and enhanced auditor reporting requirements. The provision restricts auditing firms from providing non-audit services, like consulting, to the same clients.
Corporate responsibility: Sarbanes-Oxley Act Title III requires senior executives to personally certify the accuracy and completeness of corporate financial reports. It defines the roles of external auditors and corporate audit committees and mandates that corporate officers ensure the veracity of financial reports. Notably, Sarbanes-Oxley Act Section 302 compels principal officers, usually the CEO and CFO, to certify their financial reports quarterly, with severe penalties for non-compliance.
Enhanced financial disclosure: Sarbanes-Oxley Act Title IV mandates detailed reporting of financial transactions, including off-balance-sheet activities, proforma figures, and corporate officers’ stock transactions. It insists on internal controls for financial report accuracy and requires audits and reports on these controls. It also demands immediate reporting of significant financial changes and enhanced Securities and Exchange Commission (SEC) reviews of corporate reports.

Over a decade into its implementation, the Sarbanes-Oxley Act has fostered a robust industry of experienced consultants skilled in deploying and auditing the necessary controls to comply with the law. While the Act has significantly increased paperwork and audit requirements, it has become a normalized and accepted aspect of conducting business.

Types of Shares

Ordinary Shares/Common Stock

Ordinary shares, or common stock as they are known in the USA, are the most familiar class of share often mentioned in the financial press. Common Stock usually confers voting rights, allowing shareholders to participate in corporate decisions.

The first public issuance of these shares, known as an Initial Public Offering (IPO), occurs when a company goes public. There may also be private shareholders who are listing or selling their shares during this process.

Subsequent issuances, aimed at allowing the company to expand or repay debt, are known as follow-on offerings. These might be similar to the Initial Public Offering (IPO), involving the launch of a prospectus, or they could be managed through an At The Market (ATM) offering, where shares are sold directly at the current market price.

A rights issue offers existing shareholders the opportunity to purchase additional shares at a predetermined price within a specified period. This approach is particularly useful when attracting outside investors is challenging, and existing shareholders are needed to provide additional capital.

Preference Shares/Preferred Stock

Preference Shares, or Preferred Stock in the USA, generally lack voting rights but are prioritized over common stock in dividend payments and during liquidation. Holders of Preference Shares are entitled to receive a set level of dividends before any can be distributed to common stockholders.

Dividends on preference shares may be cumulative, meaning unpaid dividends accumulate and must be paid out before any Dividends can go to Common Stockholders. Some Preference Shares are also participating, which means they not only receive fixed dividends but also share in any excess proceeds along with common stockholders. Participating preference shares are particularly prevalent in the Private Equity (PE) industry.

Convertible Preference Shares/Convertible Preferred Stock

Convertible Preferred Stock combines the features of preferred stock with an option for the holder to convert their shares into a fixed number of Common Shares, typically after a specified date.

Partly Paid Shares

Nowadays, partly paid shares are rare. These are shares for which only a partial payment has been made upfront, with the expectation that further payments will be required as the company calls for more funds until the shares are fully paid.

Special Purpose Acquisition Companies (SPACs)

Special Purpose Acquisition Companies (SPACs) have traditionally been used to acquire technology companies but have occasionally been applied to shipping company acquisitions. A SPAC is a company that is formed, listed on a Stock Exchange, and specifically designed to acquire another existing company. Special Purpose Acquisition Companies (SPACs) have been utilized by entities like Navios (which sponsored the SPACs) among a few others to acquire target companies.

Types of Debt in Ship Finance

Unlike dividends on Shares (or Stock), which are distributed only if a company earns sufficient profits, interest on debt instruments like bonds and loans is a mandatory expense (Fixed Expense). Failure to meet these payments can lead to severe defaults, allowing lenders to accelerate the loan and enforce their security measures. Shareholders, on the other hand, are not guaranteed dividends, and the value of their shares can fluctuate.

Senior Bank Debt

Senior Bank Debt is so named because it takes precedence over other financial obligations of the Borrower. This priority can sometimes be structural—meaning the terms of the loan make it superior to others—but in ship finance, it is typically secured by taking a First Priority Mortgage on the financed ship, which naturally ranks above most other debts.

Market Participants

Prior to the 2008 financial crisis triggered by Lehman Brothers’ collapse, numerous institutions provided Senior Bank Debt to the shipping industry. From 2004 to 2008, as companies expanded and ship prices surged, transactions grew increasingly large.

Historically, European commercial banks, especially after the withdrawal of US banks in the 1990s, have been the main providers of Senior Bank Debt. German banks, in particular, significantly expanded their ship finance portfolios, supported by the domestic KG (limited partnership) industry, primarily within the container sector. At the market’s peak, the largest of these banks managed portfolios approaching US$50 billion—a substantial figure representing a significant portion of their total assets.

Other key providers included Scandinavian banks, particularly Norwegian, which not only focused on growing their loan portfolios but also on arranging syndicated transactions, thereby earning substantial fees. By the mid-1990s, the two largest Norwegian banks had become the leading arrangers of such deals.

Internationally, banks from the Netherlands, France, Japan, the UK, and North America also played significant roles. Domestic banks within major shipping centers supported local industries, such as Greek banks with large loan portfolios for Greek shipping, and Japanese banks serving Japanese shipowners. In recent years, sizable Chinese banks have become prominent supporters of the expanding Chinese shipping sector.

Since the financial crisis began, and with shipping markets in recession, the number of active lenders has drastically decreased. Asian lenders seem less affected than their Western counterparts and continue supporting regional shipowners, albeit at reduced volumes.

Increased regulatory capital requirements and stress-testing for European banks have made capital-intensive ship finance less appealing, compounded by the sector’s weak state.

Many lenders have ceased providing loans to the industry; some now lend smaller amounts only to key clients or in specific sectors like offshore, which remains a bright spot. Others are looking to exit the industry by selling their loan portfolios entirely.

As a result, traditional ship finance has contracted significantly, with only a handful of key players currently active in the market, allowing them to choose only the most advantageous transactions from a risk-reward perspective.

Banks’ Lending Policies

Each bank has its own set of lending policies, though many share common elements and restrictions, including:

Exclusion of certain geographical regions.
Exclusion of certain types of ships or sectors.
Restrictions on financing older ships.
Exclusions of ships registered under certain flags.
Limits on the percentage of finance provided.

Shipowners seeking finance should investigate the ship finance market, possibly with the help of a seasoned financial consultant or broker, to identify potential financiers interested in their projects.

Provision of Larger Loan Amounts

In the mid-2000s, many banks provided large bilateral loans, but it is common for lenders to form a syndicate or club to manage significant loans collectively. This approach helps provide substantial funds to clients while diversifying risk. For example, risk is mitigated with five US$40m loans to different clients compared to one US$200m loan to a single client.

For smaller transactions, banks might club together, with each lender having equal rights, fees, and security shares. One bank would act as the facility and security agent, but all would play equal roles.

Syndicated Loans are typically larger, with different participants performing various roles, including arrangers and underwriters who structure the loan and negotiate with the borrower. Underwriters may guarantee the funds, reducing their exposure by selling participations to other lenders. Underwriters assume greater risk but receive compensation through underwriting fees.

Types of Loan in Ship Finance

Types of Senior Bank Loans

Amortizing Term Loans

Amortizing term loans are standard and widespread types of Senior Bank Finance available globally. A portion of a ship’s value is financed through a loan that the shipowner agrees to repay over a set period in regular installments, often quarterly. The structure of the repayment schedule can vary; for instance, during periods of high Fixed Time Charter Rates, the repayment amounts might be increased and then reduced later, lessening the earnings required from the ship and thereby lowering the transaction’s risk. Conversely, during periods of low rates, the installments might be reduced or even paused initially, and then increased as market conditions improve.

Often, ship financing requires a longer duration than the Lender is willing to offer. In such cases, loans are structured to include balloon payments at maturity. For example, a ship requiring US$10m financing over ten years but where the Lender agrees only to a five-year term might schedule regular repayments with a significant balloon payment at the end of the term. This arrangement satisfies both parties—the shipowner gets the needed financing, and the Lender gets repayment within their timeframe, albeit with the risk associated with a large Balloon Payment.

Revolving Credit Facilities

Revolving credit facilities are typically larger loans that finance multiple ships or even shipping company acquisitions. They are suited to more sophisticated Borrowers who use them as part of their broader cash management strategies. Unlike fixed amortizing loans, revolving facilities allow the Borrower to borrow, repay, and re-borrow funds up to a certain limit, which might decrease over time similar to an amortizing loan. Interest is paid only on the borrowed amount, making it cost-effective, and undrawn amounts incur a relatively lower commitment fee.

Bridging Loans

Bridging loans were more common during the rapid expansion phase of the mid-2000s when companies were building fleets for IPOs (Initial Public Offerings) or bond issuances. These are short-term loans designed to bridge the gap between striking a deal and securing long-term financing, providing immediate funds to acquire ships pending the raising of capital through public offerings or bonds. They typically require repayment in full at maturity, often within 6-12 months, from the proceeds of the equity raise.

Hunting Licenses

While currently out of favor, hunting license loans were quite popular during the buoyant market of the mid-2000s. These loans function similarly to amortizing term loans but are used to finance yet-to-be-identified ships. This type of financing allows a Shipowner to quickly expand their fleet by having funds ready to leverage in negotiations with sellers, offering a significant competitive edge. The ship to be acquired usually needs to meet specific criteria agreed upon between the shipowner and the bank, such as maximum age, builder reputation, and classification standards, allowing the Lender to maintain a degree of control over the investment.

By setting clear parameters for the type and condition of ships to be financed, Lenders can effectively manage the risks associated with these loans.

Types of Senior Bank Loans

Amortizing Term Loans

Amortizing term loans represent the most common and straightforward type of Senior Bank Finance globally available. These loans involve lending a proportion of a ship’s value, with the shipowner agreeing to repay the loan in scheduled installments, often quarterly. Leverage benefits, such as adjusting repayment amounts based on market conditions or charter rates, can be negotiated to suit the economic environment. For instance, during high-rate periods under a Fixed Time Charter, installments might be increased, and conversely decreased during low-rate periods to manage financial risk effectively.

If the repayment period required by the shipowner exceeds the term the Lender is prepared to offer, loans are often structured to amortize over the agreed term with a balloon payment at the end. For example, a US$10m loan needed over ten years but only provided for five would require regular installments with a substantial balloon payment at the end of the five-year period, necessitating refinancing or other repayment strategies by the shipowner.

Revolving Credit Facilities

These are typically larger loans designed for financing multiple ships or even acquisitions, tailored for sophisticated Borrowers utilizing them as part of an extensive cash management system. Unlike the straightforward amortizing term loan, revolving credit facilities offer flexibility in borrowing and repayment according to the shipowner’s cash flow needs, with interest payable only on the amount drawn.

Bridging Loans

Previously common in the buoyant mid-2000s, bridging loans provided short-term financing to support fleet expansions ahead of equity raises through IPOs or bond issues. These loans are structured with few stipulations beyond ensuring repayment from the proceeds of the anticipated public offering, usually within 6-12 months.

Hunting Licenses

Less common in today’s market, these loans were favored during the booming mid-2000s to finance unidentified ships, allowing shipowners to rapidly expand their fleet by securing financing ahead of actual ship acquisition. The loans are structured with specific parameters regarding the ship’s age, builder, and classification to manage the Lender’s risk effectively.

Export Credit Agencies (ECA)

ECAs provide governmental or quasi-governmental financing to promote national exports, including ships. The major ECAs in shipbuilding are from China, South Korea, and Japan, supporting their domestic shipbuilding industries. The terms of ECA support are regulated by OECD guidelines to ensure fair competition in global shipbuilding. ECAs offer attractive financing options, especially when traditional bank financing is scarce, providing loans, guarantees, or insurance to facilitate ship purchases.

Seller’s Credit

In scenarios where a seller has ample cash but the buyer lacks financing, the seller might extend credit directly. This can be structured as a loan with terms similar to bank financing or as a more complex Bareboat Hire Purchase Arrangement, where the buyer gains ownership after making all scheduled payments, effectively turning lease payments into purchase installments.

Shipyard Credit

Previously, some shipyards offered financing to facilitate transactions, especially during competitive periods. This type of financing has declined due to the financial strain on shipyards and the availability of alternative financing through ECAs.

Equipment Manufacturer Financing

Some manufacturers offer financing for specific components, like engines, which can be part of broader financing arrangements that condition the ship’s use of the manufacturer’s products. This niche financing can be advantageous if the shipowner can meet the manufacturer’s conditions.

Private Placements

Though a minor component of available finance options, private placements of debt involve selling debt securities to a select group of investors without a public offering, typically managed by investment bankers. This financing option is best suited for top-tier companies with robust, transparent balance sheets that can attract conservative investors, such as US pension funds seeking lower-risk investments.

Bonds in Ship Finance

Types of Bonds Relevant to Shipping

High Yield Bonds

Often termed Junk Bonds due to their sub-investment grade ratings, High Yield Bonds gained popularity in the late 1990s. These bonds, which may be secured with ship Mortgages or unsecured, typically have a 10-year term and do not usually include principal amortization. They feature incurrence covenants rather than maintenance covenants, which are generally easier to comply with. The interest rates or coupons on these bonds range from 8%-12%, which is attractive, especially considering their non-amortizing nature. Issued in the USA under Rule 144A of the Securities Act, these bonds are tradable between institutions. Despite several high-profile defaults in the late 1990s, High Yield Bonds are still issued today. Due to the fees and expenses involved, they are viable for transactions starting at US$100 million, limiting their use to larger shipping companies.

Norwegian Bonds

Apart from the US high yield bond market, there is a notable market in Norway. While smaller, this market is significant due to Norway’s strong ties to shipping. Norwegian bonds differ from US high yield bonds in several ways: they have a shorter duration (up to seven years), can be issued in smaller amounts (starting at US$20 million), do not require an external rating, and are listed on the Oslo Stock Exchange, enhancing their tradability. These bonds can be established relatively quickly, within two to six weeks, and are available to issuers outside Norway, making them a popular choice for international shipping companies.

Title XI Bonds

Title XI Bonds are issued by US commercial banks but are backed by a US government guarantee, under a program managed by the US Maritime Administration (MARAD) to support the modernization of the US merchant marine and shipyards. These bonds are particularly appealing due to their long tenors of up to 25 years and low-interest rates resulting from the government guarantee. However, they are primarily beneficial to Shipowners involved in the US Jones Act cabotage trades, as the high cost of constructing ships in the USA, compared to other locations, makes them uncompetitive in the global market.

Convertible Bonds

Mainly issued in the USA, Convertible Bonds are debt instruments that include an Equity Option. Like high yield bonds, they offer investors the right to convert their holdings into equity at maturity. This conversion feature is appealing to investors who appreciate the security of receiving a steady coupon during the bond’s term, coupled with the option to convert into equity if the issuing company’s share price is favorable at maturity. If the share price is lower than the conversion price at maturity, investors can choose not to convert and instead have the bond redeemed at par. For Shipowners, convertible bonds are attractive as they provide an opportunity for future equity increases without immediate dilution of current shareholders’ stakes. Convertible Bonds are typically issued by publicly-traded companies and require large issuance volumes.

Other Forms of Ship Finance

Securitization

Though well-established in aircraft finance, securitization has seen limited application in ship finance. A notable instance involved a leading container line operator seeking finance for new container ships. A Special Purpose Vehicle (SPV) was established to purchase the ships, which were then chartered back to the operator on long-term agreements. The SPV issued AAA-rated notes, secured by first-call rights on the ship values and an insurance company guarantee, attracting investment-grade investors due to the high quality of the investment. Additionally, a syndicate of ship finance banks provided a long-term loan under normal commercial terms, subordinate to the AAA-rated note investors but with a conservative total debt financing of 60%. The final portion of the funding was intended from an IPO of the SPV, although this did not materialize. This complex structure, suitable only for very large, high-quality transactions, might see a revival when market conditions improve.

Leasing

Various leasing schemes are applicable to shipping, detailed in subsequent sections.

Tax Leasing

Tax leasing, which has been popular in jurisdictions like the UK, Japan, France, Spain, and the USA, involves a lessor (typically large financial institutions) purchasing a ship and benefiting from capital allowances, which are then passed on to the lessee through reduced lease rentals. The UK was a prominent player until 2006 when changes in tax laws shifted capital allowances to lessees, diminishing the advantages of tax leases. Most tax leasing benefits have been phased out across Europe as governments seek to increase tax revenues, especially during financial crises. These structures were most beneficial when combined with bank debt.

Shipping Funds/Leasing Companies

Specialist companies often engage in Sale and Lease Back (SLB) transactions, purchasing ships from owners and leasing them back for a set period. This allows owners to liquidate their assets while maintaining control. However, the recent withdrawal of many banks from ship finance has compelled these companies to adapt their business models, either by purchasing and operating ships using equity or providing short-term direct loans to shipowners.

Islamic Leasing

Conforming to Sharia law, which prohibits interest, Islamic Leasing (Ijarah) is naturally aligned with leasing structures. Islamic Leasing requires the financier to maintain a genuine ownership interest in the leased asset, posing unique risks. To mitigate these risks, a bankruptcy-remote SPV is often set up to own and lease the asset, funded by Islamic financiers through investment rather than loans. A servicing agent agreement is usually made with the lessee to manage maintenance and insurance, with costs typically offset by corresponding lease rental adjustments. This structure allows for the integration of conventional bank finance through additional leasing layers.

These niche financing products, while less common than mainstream debt and equity solutions, offer alternative routes for securing necessary capital in the shipping industry under specific circumstances.

Kommanditgesellschaft (KG) Financing

This German financing structure was extremely popular from the 1990s up until the shipping and financial crisis of 2008. Initially, it offered substantial tax incentives (which have since been discontinued) that the German government allowed to support and expand the German shipping industry.

The KG is a limited partnership involving multiple investors—often informally referred to as the “doctors and dentists”—who serve as limited partners, and a general partner, which is usually a limited company. In this setup, the investors are only liable up to the amount of their investment.

The KG model is well recognized among retail investors in Germany, with sophisticated sales teams and German banks collaborating to market KG shares.

Although the appeal of KGs for investors has evolved, currently all profits from the operation of the ship, including capital gains from sales, are distributed to investors as dividends, with only German tonnage tax being deducted. This was particularly beneficial during the boom years of the mid-2000s when substantial profits were common.

The German government supports these tax advantages because one of the KG scheme requirements is that the ship managed by the KG must operate out of Germany, thus bolstering local employment and strengthening the national shipping industry.

Typically, KG financing works on a 70:30 debt-to-equity leverage ratio.

Setting up a KG traditionally follows these steps:

The issuing house orders a ship from a shipyard after consultations with the general partner, potential charterers, and managers (often related entities).
The issuing house secures a bridging loan from a bank (typically German) to finance the ship’s construction through staged payments.
As delivery approaches and the project becomes more tangible, the issuing house raises the necessary equity—usually 30% of the project cost—from investors. At this stage, banks would have typically advanced 80% of the purchase price and agreed to finance 70% post-delivery.

This model successfully raised billions of dollars, making Germany the largest owner of container ships globally. However, the financial crisis severely impacted the container ship market, leading to significant losses for banks and issuing houses involved in KG schemes. With banks often advancing payments before equity was raised, drops in ship values created untenable situations, rendering many placement guarantees ineffective and forcing banks to fund remaining installments to secure their loans.

Currently, the KG market remains largely inactive due to these challenges and the need for ongoing capital injections from existing investors to sustain operations.

Kommandittselskab (KS) Financing

The Norwegian KS, while similar to the German KG, has recently resurged as a viable financing option after being popular in the 1980s due to substantial tax benefits. The KS is also a limited partnership but typically involves fewer investors with larger stakes.

A key distinction in KS financing is that equity is raised at the project’s outset, often facilitated by a focus on financing secondhand ships rather than new builds. Another feature is the concept of uncalled capital; investors not only contribute an initial investment (usually 15% of the project cost) but also commit to a similar amount as uncalled capital, which remains unutilized unless the project requires additional funding. Banks providing project financing often secure an assignment of this uncalled capital, enhancing their security.

Debt-Equity Structure of a Shipping Company

Basel Committee

Established in 1974, the Basel Committee is an international regulatory body that sets guidelines for the banking sector worldwide.

The initial regulations required banks to maintain a fixed capital reserve against loans and other assets. These rules were updated in 2004 with Basel II, which introduced more contemporary measures to address the evolving products and risks in the banking sector. Basel II introduced various approaches to capital requirement, including foundation, standardized, and advanced methods, the latter of which allowed banks to hold significantly less capital against certain types of risks.

However, these regulations did not prevent the global financial crisis that began with the sub-prime mortgage crisis in 2007 and escalated with the collapse of Lehman Brothers in 2008.

In response, Basel III was developed between 2010 and 2011, with phased implementation set over the subsequent two to three years. This update mandates significantly higher capital and liquidity levels, which will likely lead to increased lending rates due to the higher costs of maintaining capital. This change is particularly impactful for the shipping industry, which typically relies on large, long-term loans. As U.S. dollar interest rates start to rise from their historic lows, the shift toward alternative financing methods could become more pronounced.

Benefits of Leverage

While financing a ship entirely with owner’s equity has its advantages, it also results in a lower return on investment. Leveraging debt can substantially increase a Shipowner’s returns. For instance, if a Shipowner uses 20% equity to secure 80% leverage for a ship, the saved equity could be invested elsewhere. If these funds were deposited, they might accrue interest; however, investing them in acquiring four additional sister ships could exponentially increase the fleet size and potential returns. Nonetheless, leveraging comes with its own risks, such as potential declines in charter rates and ship values, which must be carefully managed.