Ship Finance Essentials Professor Alkis John Corres

Shipping is a capital intensive activity....therefore the need for investment capital is ever present slackening and intensifying with the downs and ups of the shipping cycles. The aim of this presentation is to provide a vade-mecum for the various types of financing available to address the needs of commercial shipping. The short analyses following the main types of financing are only intended to identify what is there and therefore are quite short. The readers of these slides are encouraged to read further about the means of financing they wish to know more about.

I. Bond Financing (1) Bonds were originally developed to finance states for various purposes. This type of debt investment is today used widely also by companies to finance projects. The procedure to raise funds through bonds requires a bond issue and an IPO (Initial Public Offering) in a stock exchange. Investors buy the bond at the par price in the day of the IPO, thereafter the bond is trading with its daily price reflecting its status. While the owners of bonds (bond holders) are in fact creditors to the company that has issued the bond, the funds raised through the bond issue are considered as company equity in cases where other types of borrowing are also present. Although the duration (term) of a bond is fixed, the interest payable may be fixed or variable. Short term bonds are for periods up to five years, medium term from five to twelve and long term for more than twelve years.

I. Bond financing (2) Company bonds generally offer higher yields compared to government bonds to compensate bond holders for a higher risk of default. The two main types of corporate bonds are Convertible and Callable bonds. A Convertible bond can be redeemed for company’s equity at predetermined times if the bond holder so wishes and this in effect constitutes a form of stock option. A Callable bond instead can be redeemed at the discretion of the issuing company before maturity, usually at a premium. This type of bond offers the possibility to the issuer to take advantage of lower interest rates through calling the higher interest bonds and re-issuing new lower interest ones. Bonds are tradable. In the past many high yield shipping bonds fell in the category of ‘’junk bonds’’ – i.e. BB rating or lower - due to the high risk they represented for the bond holder.

II. ‘’Plain Vanilla’’ Bank Loan Bank loans are the oldest form of asset financing and by far the most common method in shipping. The lender provides funds to the borrower on basis of a Loan Agreement. Prior to a loan agreement, a Commitment Letter is sent by the bank to the borrower where the main terms, conditions, covenants and so on are laid out. A Commitment Letter assumes legal status after the recipient has signed it, indicating his basic agreement. Thereafter the parties will need to contact their legal counsels in order to start discussions in preparation of the Loan Agreement. Loan agreements are flexible instruments that can be cut to measure according to the wish of the contracting parties, yet, these contain a substantial number of common terms.

II. ‘’Plain Vanilla’’ Bank Loan…continued All loan agreements make mention of:  the duration of the facility (tenor),  the applicable interest rate (fixed or floating),  the bank fees payable for the management of the loan,  the collateral(s), i.e. liquid or fixed assets which the lender can access in case of a default, and  the covenants, i.e. certain conditions the borrower must satisfy and the rights of the lender in case of a default in repayment. These basic requirements are followed by a detailed list of provisions which describe what needs to be done and how. These however lay outside the scope of this introductory presentation.

III. Ship Leasing and S+LB In countries where ship leasing is allowed, leasing arrangements provide an alternative to traditional ship financing. Banks will generally consider it favourably given that the position of the ‘’lender’’ is stronger compared to loan financing. As banks are generally unwilling to become involved in ship management the most usual method used takes the form of a ‘’ Sale and Leaseback’’ where a shell company owned by the lender ( lessor) becomes the owner of the vessel and enters into a bareboat contract with the lessee who takes over both the commercial and the technical management. The lessor will typically have a first preferred mortgage on the ship. This triangular arrangement has considerable advantages, but also serious disadvantages, for the lessee which we shall briefly review.

III. Sale and Leaseback (S+LB) The main advantage of a Sale and Leaseback solution for the lessee is the ability to expand the fleet under his own control with the minimum of equity. The main disadvantage is a quite complicated, inflexible and inequitable leasing contract replete with covenants in favour of the lessor. S+LB is a back to back arrangement where the lease is paid over a number of years through charter hire involving three parties, the owner of the vessel, the bareboat charterer and the lessor. As in all leasing contracts one finds a ‘’ Hell and High Water’’ clause which nullifies the possibility of the borrower to pay only interest and remain within the spirit of the agreement, as the case is under a loan agreement. Installments therefore have to be paid in full and by the due time or else a charter termination event may be triggered.

III. S+LB …continued THE OWNERS SIDE: Generally the interests of the Owner and the Bank are coordinated, yet at an arm’s length. The Owner for example will always welcome a clause whereby loan repayments will need to be made only subsequently to charter hire payments and that the bareboat Charterers will be under obligation to respect mortgage covenants. Similarly, the position of the Owners vis-à-vis the Bank will be strengthened if events of default concerning their own loan agreement could only take place following a breach from the side of the Charterers. In case of problems regarding the proper course of lease repayment the Owners are the party to take measures against the bareboat Charterers to safeguard the interests of the lessor. These measures will typically include the right to replace the Charterer, the right to seek a buyer for the vessel and other stop-gap measures which will ensure that a non-performance from the Charterers leading to a charter termination event does not end up as an Owners’ default.

III. S+LB…continued In case of delays in charter hire payments leading to a charter termination event, the Owners will need to see clearly what their rights are concerning the ‘’Charterer’s Deposit’’ i.e. the lessee’s capital contribution to the deal. THE CHARTERERS SIDE  In a similar, albeit inverse way, the Charterers will be keen to see they own ‘’ Charterer’s Deposit’’ to be as protected as possible.  Will need to see a clear term sheet delineating their rights and obligations.  Will need to see purchase options at specific dates.  Will review the interpretation of the ‘’Hell and High Water ‘’ clause and will want to make sure mortgage covenants do not impact their rights under the bareboat charter party.

IV. Blank Check Companies and SPACs According to the Securities and Exchange Commission ‘’a blank check company is a company that has no specific business plan or purpose, or has indicated as its business plan to enter into an unidentified merger or acquisition. These companies often involve speculative investments …’’ A Special Purpose Acquisition Company (SPAC) is a corporation formed by private individuals in order to raise funds through an Initial Public Offering. Typically the money raised is committed to a Trust until either an investment is made, or a certain time period has lapsed. During that period the staff managing the SPAC are not allowed to receive salaries. If no deal is made by the deadline, the funds are returned to the investors together with allowances for bank or broker fees.

V. Syndicated Loans When capital requirements exceed the credit ceiling of a bank to a single customer, banks form a syndicate whereby each one of the covers a portion of the total facility, The syndicate has a leader. The leader is in charge of negotiating the terms and conditions between the syndicate and the borrower. After this stage is completed the lead bank manages the flow of credit from the syndicate members to the borrower and vice versa during the stage of repayment. Syndication has advantages for both sides and it is the ultimate weapon of bank financing in the battle with other types of finance in commercial shipping. However, negotiations between syndicate members can last for months and negotiations with the borrower even longer. Therefore, slowness and complication may be the main disadvantages of a syndicated loan in exchange for very high levels of lending.

VI. Export Credit Schemes Many exporting countries facilitate sales abroad by guaranteeing seller’s credit to foreign customers. The exporters extend credit to their customers and the state acts as guarantor to this credit by taking over the risk of default. Seller’s credit has a long history in shipbuilding, however in recent years it has become object of heated arguments in OECD, in WTO and in the EU whether such practices fall within the definition of a State Aid. Central to this debate is whether the interest rate charged is – directly or indirectly – subsidized but other important issues are also examined. Despite these debates export credit schemes continue to exist in an overt or covert fashion, particularly in the Far Eastern markets.

VII. KS and KG Funds This type of financing is found in northern Europe and in its heyday it has enabled the construction of entire fleets. The basic prerequisite for the creation of such funds is national legislation providing for substantially lower taxation to highly taxed profits which invest in such schemes. Historically such schemes have attracted wide interest among professionals of all kind who have regarded them as a way of extending commercial scope and spreading commercial risk. KGs in Germany for example are partnerships where some members have unlimited liability for the debts of the partnership and others whose liability is limited to their contribution. The role of the unlimited liability partner (General Partner) however can be assumed by a limited liability company (GmbH & Co KG). Funds collected in that way constitute the equity side of a financial structure which subsequently seeks additional debt financing from a bank or other institution to purchase a new or second hand vessel.

VII. KS and KG Funds..continued It is evident that this type of financing is not open to everyone as it presupposes location in a country where such legislation exists. The importance of this type of financing for the containership sector cannot be overemphasized. Ships built under these schemes are typically chartered out for long periods and their technical management is entrusted to professional ship management companies. The abundance of equity coupled to the eagerness of the banking sector to provide loans have led to a proliferation of container ships. The bubble burst in 2008 with a dramatic fall in ship values which has put the partnerships under pressure to meet their obligations under the value maintenance clause, leading to ship sales and KG closures.

Islamic Finance

ALTERNATIVE SOURCES OF FUNDS

Exploiting the resources of the company. There are also other methods of financing the acquisition of ships which do not necessitate the participation of financial institutions. Several of them are absolutely legitimate such as: using retained - undistributed -profits, or issuing new company shares, or reinvesting the proceeds from well timed asset play which means taking advantage of the effect of the freight rate cycle on the values of secondhand ships. All these are common considerations of every ship management team and are widely used.

Use of illicit methods of financing Another category of funds- which is rarely mentioned in bibliography - is money from illegal or even criminal activities seeking ways to become ‘’legitimate’’. The list of such moneys is long and it includes cash from contrabade, arms trading, whitewashing under the table commissions from public contracts, gambling, betting, fraud of all kind, people and drugs trafficking, black market deals, and so on. Regrettably, and unlike in the previous category, the involvement of financial institutions – mainly through intermediaries - is not uncommon. The international nature of shipping and its ability to move freely between jurisdictions make it an attractive proposition for those who are seeking to introduce black money in the real economy. This is a shady world which operates secretly in the fringes of international shipping.