Ship finance without a ship? Addressing the risks of newbuild financing
“ It is good that I make you build, of this ship which shall sail on the sea, the hull, the decks and the mast, and then on a sunny day, like on a wedding day, I have you dress her of sails and gift her to the sea.”
Whether it is, as for Antoine de Saint-Exupéry, a result of one’s poetic nature, or for more prosaic purposes, there are a variety of reasons for ordering new vessels. Some shipowners do so to satisfy their specific trading needs or to take advantage of more favourable credit and tax opportunities while others want to make the switch to new fuels and technology, take advantage of market rates as they repeatedly set new all-time highs or to expand or diversify activities; and sometimes for a combination thereof. From cruise ships to containerships, tankers, and bulk carriers, and offshore vessels, shipowners are always on the lookout for financial partners to assist with the capital needs associated with newbuilds. Various forecasts anticipate that the shipbuilding market will grow over the next few years, off the back of the industry effort towards green shipping and the ever growing appetite for seaborne trade.
There will be opportunities for financiers to provide short or long-term financing to assist with these projects. Yet, the risks associated with shipbuilding may rebut some of them. Indeed, our traditional asset finance instincts are challenged as there is no cashflow to harness (at least not for a while) and, often, no asset to mortgage (although we will see that this is not always the case) in order to limit or secure the financier’s exposure. So, whether as a mere bridge financier of part of the shipbuilding instalments or for those prepared to procure a full term pre-delivery financing of the vessel, how do financiers take comfort when financing the construction instalments of a vessel?
Risks usually associated with construction finance
Financiers investing in vessel construction usually face the main risks, of insolvency – of the shipyard, on the one hand and, on the other, of the shipowner – and then of the shipyard actually building a vessel conforming to specifications within an agreed timetable.
Shipyard insolvency is not a theoretical risk – in fact, shipyard insolvencies are fairly common. Recent examples of shipyards at least dangerously flirting with insolvency have included entities in Asia and in Europe; involving some major state-backed shipyards as well as other smaller private actors. As a financier, it is less than ideal to face the prospect of a stop in the vessel’s construction where part funding of the instalments has begun, with the real risk that the construction of the vessel may never be completed. Thankfully, this risk can be mitigated, most commonly through proper due diligence on the shipyard together with due consideration as to the terms of the shipbuilding contract and with the appropriate inclusion and drafting of refund guarantees. The risks may be greater where the shipyard is new, or where the design and technology is untested.
On the other side of this coin, a breach by the shipowner of their obligations pursuant to the shipbuilding contract creates a risk for the financier. If the breach is serious enough, the shipbuilding contract may be terminated and the shipyard may have the right to retain all instalments already paid and not deliver the vessel. Of course, this can be addressed in various ways, in particular with the facility agreement, by the lender making advances directly to the shipyard and by creating a corporate silo for the future owner of the vessel with a view to protecting it from a wider insolvency of the parent shipowner. We will now briefly review the various securities that can be taken to mitigate for this outcome and protect a financier’s interest when considering a prospective newbuild financing.
Unsurprisingly, the centrepiece document of these transactions will be the shipbuilding contract. Shipowners are, quite understandably, reticent in giving their prospective financiers a voice in their shipbuilding contract negotiations – it is a question of know-how, timing, and overall sensitivity. After all, shipowners are under considerable pressure to acquire slots at shipyards in a highly competitive environment. That said, proper due diligence on the shipbuilding contract will be required by any financier, and a prudent shipowner will often ask its advisers to ensure that it is “finance friendly” ahead of the involvement of any financier. Particular attention should be given to the assignment restrictions, cancellation and refund rights, the refund guarantee provision, the insurance coverage requirements, and the general instalment schedule and mechanics; which will, among other things, dictate the drawdown schedule under the facility agreement. Usually, the shipowner will also enter into a supervision agreement, either internally (with their operating entity) or externally (where they do not have this capability) and the financier will want to be comfortable with the abilities of the supervisor, including where they are also providing post-delivery financing. The financier will also have an interest in who is taking any design/technology risk.
Financiers should also take some form of security on the shipbuilding contract. Shipyards are accustomed to – and usually accommodate – such requirements. The type and form of security should align with the law applicable to the shipbuilding contract, and, as below, the location of the vessel under construction. Relevant legal advice should be sought to ensure that financiers at least get the benefit of any refund mechanisms, insurances, guarantees, and indemnities provided on the shipyard’s side; and be involved in (or even have the direction of) claims against the shipyard for breaches of their obligations under the shipbuilding contract.
On top of this, financiers engaging in newbuild finance would ideally seek a form of “step in rights” that will allow them to step into the shoes of the failing shipowner and take over their obligations (essentially, to pay instalments). This can be achieved quite easily through a suitably drafted English law assignment and acknowledgement or through a tailor-made “direct agreement” between the shipowner, the financier and the shipyard. It is not an ideal position to be in, of course, as this remedy ultimately relies on finding a new purchaser for the vessel at delivery and there will be a level of uncertainty there. Sometimes, as project financiers know best, getting the asset all the way to completion is the most economically sensible way to navigate out of a default situation.
In order to address the risks of insolvency at the shipyard level, it is common practice for a prospective shipowner to seek a guarantee to ensure their instalments are refunded in the event that the shipyard is in breach of any of their obligations entitling the shipowner to cancel the shipbuilding contract or is subject to insolvency proceedings. This is normally provided by the shipyard’s bank, in that bank’s home template and the shipyard will be required to pay a fee for the service. Financiers should of course get the benefit of that refund guarantee, either by way of being the direct beneficiary or by way of assignment. Relevant counsel’s review should always be sought to confirm that the guarantee has the intended effect under its governing law and in its place of likely enforcement.
Interestingly, shipyards are in quite a strong position in the current market and we have seen instances of them being unwilling to provide guarantees and/or being less flexible with regard to the terms of such guarantees – which comes at a cost to them (plus a lack of refund guarantee coverage) – and where shipowners are more prepared to take the risk and reserve the slots.
Nevertheless, it is in both the shipowners’ and their financiers’ common interest to push for this guarantee on acceptable terms. Ultimately, it is always the shipowners’ risk to bear provided that the financiers may have adequate alternative securities in place (e.g. corporate guarantees from a shipowner’s, credit-worthy, holding company and/or a cross-collateralisation with other vessels already built and employed). In any case, refund guarantees remain, in the vast majority of cases, completely standard and are part of the shipyard’s contract proposal.
Mortgage on Vessel under construction
When does an aggregate of steel cease to be just that and become a vessel? This is a question of practical importance for financiers when a vessel is being built in a jurisdiction that accepts mortgages before delivery. It is worth noting that this will not be the case for the three shipbuilding superpowers that are Korea, China and Japan – so this will be a more remote scenario. In fact, this is mostly possible within civil law background countries (e.g. France, Belgium, and Germany) where ship registries may accept the registration of vessels under construction and, as a consequence, opening the door to granting mortgages over them. The mortgage will either be granted by the shipyard itself (which would be unusual), if it retains title to the vessel under construction until delivery – whether because they sought financing themselves or because they agreed to grant one as part of the shipbuilding contract negotiations – or by the shipowner, if title to the vessel is transferred to the buyers over time by a continuous incorporation of new material as part of the construction process.
Instinctively, benefiting from a mortgage sounds very comforting for any financier. It provides them with all the traditional mortgagee rights and provides some level of protection against insolvency on both sides, both shipyard and shipowner. However, it is important to identify in each case what the actual benefits are for the mortgagee. Local advice will be paramount to fully understanding the position of any such mortgagee against the shipyard, their suppliers, sub-contractors and any third party having a lien over the vessel and, more generally, how this financier’s position compares to a full refund guarantee regime.
Firstly, registration of the vessel under construction will only be possible once the vessel reaches a certain level of “completeness” (e.g. keel-laying date in Belgium, France, and Germany) meaning that some initial instalments will have already been paid at this stage prior to any mortgagee protection being in place. Secondly, enforcing rights over a vessel under construction will prove of little value if there is no way to obtain completion of the construction or a reimbursement of the instalments – a judicial sale of a vessel under construction is usually not the most profitable way out in such situations. A recent example in Germany, following the insolvency of the shipyard, resulted in disposing of the vessel under construction at scrap value. Ultimately, of course, a mortgage is generally good to have where available – we are still within the realm of asset finance after all. Taking a mortgage over the vessel under construction where this is available under the vessel’s flag may not be as effective where the vessel is under construction in a different jurisdiction – the local position needs to be checked.
Often, a shipowner entering into a shipbuilding contract will do so on the back of securing a long-term charter. Gas (LNG) companies and oil majors, to take two examples, will often be involved in such transactions. These charterers will also be involved with the construction, as the vessel will need to correspond to their specification requirements. For liability management, or simply reasons of business planning, these charterers do not wish to own the equity in the vessel and be the purchaser under the shipbuilding contract directly. They leave this for the shipowners. Sometime charterers will participate in funding the cost of the shipbuilding contract but in any case, this employment contract significantly improves the financier’s prospects of getting out in the event of a defaulting shipowner.
Benefiting from an assignment of such a charter is a must for any financer. Third party charterers usually have much better credit-worthiness than a shipowner but also, and most importantly, they have a common interest to see the construction through completion. In case something does go wrong, benefiting from the charter means there is visibility in terms of employment of the vessel at the time of delivery, which ultimately alleviates one of the financier’s main concerns when they consider using their step in rights (see above) and complete the vessel in place of the owner.
Financiers and charterers will negotiate what happens in those circumstances, either by way of an acknowledgment of the notice of assignment under an English law agreement or by way of a separate direct agreement between them where the law of another jurisdiction applies. Ideally, financiers and charterers would agree that, in case of failure of the shipowner/manager of the intended vessel, the financier (or its nominee) would take over construction with the shipyard, the charter would be maintained and the management of the vessel be changed (e.g. by reference to a pre-agreed list of acceptable alternative shipmanagement companies, or by merely postponing the appointment of managers to a later stage in the construction process).
In summary, providing newbuilding predelivery finance carries a number of inherent risks, but a proper review of the shipbuilding contract, careful preparation and some timely drafting interventions should mitigate these risks. Among others, the inclusion of a refund guarantee and the tailoring of a suitable security package will help financiers minimise their risk exposure and limit the fallout from any potential counterparty default, with multiple escape routes in such a scenario. Of course, there are few watertight rules in this area and a myriad of decided legal cases that should be taken into account, which this paper does not allow us the time to expand on.. In the meantime, hopefully this has given you some food for thought on this exciting topic!
Source: Reed Smith LLP – Romain Farnoux