Introduction
The Canadian Seaspan, one of the world’s largest containership owning companies, saw recently some 98.5% of its more than doubled in two years fleet utilised, most of which leased to major liner operators such as Maersk, Hapag-Lloyd, Cosco, and China Shipping at fixed rates for periods of 10 – 15 years and reported healthy profits while in contrast, its customers (the carriers) have continually teetered on the edge of bankruptcy and other forms of ship finance such as German KG funds are under pressure. On another note, the leasing agreement of ten years signed in London on the 21st October 2015 between ICBC Financial Leasing Co., Ltd., which operates as a subsidiary of Industrial and Commercial Bank of China Limited and BP Shipping Limited involved a total amount of USD869 million and 18 oil tankers and was honoured by Marine Money with the ‘Leasing Deal of the Year Award’. From the above indicative examples, it appears that the debt and equity, as the most common ways of financing ship acquisitions have found a competitor in the ‘leasing structure’, a popular and well-tested concept among airlines and other aircraft operators.
Ship lease operation
The lease ‘separates’ the use and ownership of the vessel. The lessor (the legal owner which in this case can be a bank, a leasing or insurance company etc) hands the property over to the lessee (the operator which in this case is a shipping company) who, in return for regular lease payments is entitled to use it as though it was his own for an agreed period (known legally as ‘quiet enjoyment’)(1). In comparison with the traditional bank financing, the lease financing differs in the sense that the lessor retains the legal ownership of the ship during the lease period which provides the lessor with a built-in security that offsets the absence of a loan agreement and ship mortgage in the lease financing ‘equation’. Despite being the owner, the lessor does not have possession of the ship since such right is retained by the lessee.
The two most common types of leasing structures is the operating lease and the finance lease.
The operating lease is used for hiring equipment and is usually in the form of a short or mid-term bareboat or time charter after which the lessee will return the ship to the lessor. The lease can usually be terminated at the lessee’s discretion, the lease payments do not involve an amortization of the leased property and most of the risk is left with the lessor. Operating lease generally does not appear on the balance sheet and is addressed as an effective way of tonnage supply in ships in a timely manner, albeit not a pure financing vehicle.
On the other hand, the finance lease is longer, typically used for long –term finance of ships, covers a substantial part of the ship’s economic life and is usually fully amortized (including the lessor’s returns on his investment). The lessor, whose main role is as financier, has little involvement with the asset beyond owning it, and all operating responsibilities fall on the lessee who, in the event of early termination, must fully compensate the lessor. Although the finance lease generally appears on the lessee’s balance sheet, its main attraction to shipping companies is that it brings a tax benefit by depreciating the ship’s value against profits and by assisting companies with high profits but no suitable investment of their own to obtain tax relief by purchasing a ship, which they then lease to a shipowner who operates it as its own until the end of the lease, and some of this tax benefit is passed on to the lessee in the form of reduced charter hire. Under the finance lease scenario, the ship, built to the lessee’s specification (if a newbuilding), or chosen by the lessee (if it is a second hand), is purchased by the company providing the finance (the lessor) and leased under a long-term agreement (usually a bareboat charter) to the shipping company (lessee) which may purchase the property at a nominal price after the primary leasing period.
It should be noted that the leasing structure works better for the container sector compared with the dry bulk and taker ones in view of the fact that container lines earn their return from operating a network, somewhat similar to the airline industry, rather that timely purchasing and selling the ship itself.
Incentives for pursuing a lease agreement
The ship lease structure is gaining ground for numerous reasons. Accounting treatment of leases and the tax benefit of the deferral of tax liability on capital allowance that in turn can be used as set offs against taxable profits are uppermost in the minds of corporate decision makers who favour leasing as a financing vehicle in shipping and are frequently keen on ‘disguising’ a finance lease in the form of an operating lease to derive the off-balance sheet benefit. Furthermore, the scarcity of bank financing or other financing options for shipping lines has created a space which was filled by leasing companies which have easier access to capital funds. In such cases, it is of great value for the carriers to have access to diverse sources of capital that will assist them with their fleet expansion and renewal plans by acquiring larger, modern and fuel-efficient vessels and achieving the necessary economies of scale to remain competitive. In a cyclical and very capital intensive industry, such as shipping, the lease can preserve the lessee’s working capital and its financial position through long-term repayment structure (often longer than the one offered from banks) and effective cash management through matching the rental profiles with income streams (cashflow). Moreover, the lease structure permits the leasing companies to lock in carriers to long-term charter arrangements and fixed rates that are oblivious to the volatility of the spot charter market and thus achieve a secure revenue base and higher financial leverage than other investors in the ship financing market.
Considerations against entering into a lease agreement
Looking at the other side of the coin, there are pitfalls and disadvantages in the implementation of the lease that can explain why the ship leasing is not yet as prevailing as the aircraft leasing in the respective market. A significant drawback of tax-based ship lease is that it is a quite complicated transaction exposed to the change of tax laws and regimes (as is the case of a number of jurisdictions which have started rejecting the off-balance sheet depiction) and therefore the tax benefit is uncertain. A counter-argument to the conclusion of a lease agreement could also be that the lessee is committed to a long-term transaction which entails a restriction on asset disposal flexibility, hence impeding the return potential for the operator through a timely asset sale, and on premature termination of the lease agreement since this would obviously be detrimental to the lessor’s interest as it is liable to lose its tax benefit which is central to leasing as a financing vehicle and the lessee would be called upon to compensate the lessor in this respect. Therefore, it turns out that the lease is more appropriate for shipping companies with a well –defined long-term need for ships and secured long-term charters, such as operators of containerships, cruiseships, ferries and gas carriers. In addition, the lessor must be satisfied that the lessee will meet its obligations under the lease. As a result, leasing is not a finance vehicle to solve the real financial problems of shipping companies but on the contrary only financially sound and creditworthy shipping companies are likely to qualify. The potential liability is also another discouraging factor in the sense that the lessor who is the registered owner of the ship and an investor not necessarily familiar with the shipping industry may face liabilities in cases of accidents related to the lessee’s inability to safely operate and use the ship during the lease period.
Concluding remarks
Despite the current downturn and ‘drying’ of the shipping market, there is still an overflow of available finance in the market and a favourable wind blowing in this respect from the Asia- Pacific region. Since the last few years, the leasing business is expanding and the leasing transactions have upsurged with mainly Chinese commercial banks, banks’ subsidiary leasing companies, hedge funds and financial institutions fuelling this growth and becoming major capital providers to the shipping industry with an intention to further expand and diversify their portfolio of ships and establish their presence in Europe and America. It can be argued that the lease structure highlighted the polarisation of the shipping business (especially in the containership segment) pursuant to which the pure asset players, such as the lessors, have strengthened their financial position while the carriers have become weaker and changed the traditional notion of the ‘shipowner’ as we knew it in the sense that the leasing companies are evolving as large shipowners. Being a sophisticated structure, the ship lease works as efficiently as the parties’ intentions and credibility permit and depends on their operational decisions and market status. Whilst its restrictions, the prospects of the finance lease seem promising given the growing trend in outsourcing of asset management services of shipping companies. As a relatively new player in the international financial arena, ship lease is still developing and tested and its future is challenging to be foreseen.
ENDNOTES
(1) Stopford M., Maritime Economics (3rd edn, Routledge 2009) 307- 309.
ABOUT THE AUTHOR
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Iliana Koukoutsi is an Associate in the Shipping Department of Dingli & Dingli Law Firm, Malta. Her scope of work focuses on registration of commercial vessels and yachts, incorporation and legal support of shipping companies, ship sale and purchase and ship financing and mortgaging. |
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