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LEASE FINANCING FOR VESSELSENGAGED IN THE COASTWISE TRADES
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Editor’s note: Passage of the Coast Guard Authorization Act of 1996 was to usher in a period where U.S. citizen domestic trade operators would have enhanced access to foreign financing sources through vessel leasing transactions. Instead, it resulted in the creation of non-citizen competitors for these U.S. operators, and fueled a bitter dispute at the U.S. Coast Guard over the extent to which these non-citizen owner-users should be allowed. Was this 1996 optimism misplaced? The author examines the origins this difficult situation and reviews its current state of play. He then suggests that the current dispute, and its vessel financing uncertainties, might best be resolved through the use of a Maritime Administration time charter review and approval process under section 9 of the Shipping Act, 1916. |
The overall purpose of section 1113(d) of the Conference substitute is to eliminate technical impediments to using various techniques for financing vessels operating in the domestic trades. At the same time, the Conferees do not intend to undermine a basic principle of U.S. maritime law that vessels operated in domestic trades must be built in a shipyard in the United States and be operated and controlled by American citizens, which is vital to United States military and economic security.
U. S. Code Cong. and Adm. News, 104 Cong. 2nd Sess., vol. 6 at p. 4325 (1996)
1. Section 1113(d): 46 U.S.C. 12106(e).
The Coast Guard Authorization Act of 1996 (the “96 Act”), “subsection 1113(d), Leasing” amended section 12106 of title 46 U.S. Code by adding a new subsection (e) to permit foreign ownership of U.S. coastwise trade vessels by entities primarily engaged in leasing or other financial transactions. This so-called “Lease financing” provision creates an exemption to the U.S. citizenship ownership requirement of the Jones Act and allows a foreign entity to own a Jones Act trade vessel if the vessel is “leased” or demise chartered to a section 2 citizen for at least three years.
Northern’s Exposure
By Kristen Laird
In June, DVB/Northern Navigation’s joint venture, Navigation Finance Corp. (NFC), purchased 1999-built aframax Pacific Libra (105,000dwt) from Mitsubishi interests for $33.5 million. The equity/mezzanine finance shop NFC immediately put the ship into a five-year bare- boat charter with Sanko for $11,000 per day, giving Sanko a $16,500 breakeven rate at which it can charter out the vessel if it so chooses – about $2,000 per day less than currently available in the market. Navigation Finance apparently faced some tough competition on the deal from the likes of Thenamaris and Teekay Shipping.
DVB and Sanko have a very good relationship. As readers may recall, in September 2002, NFC provided mezzanine financing for a Procopiou aframax new- building on a five-year charter to Sanko. Market sources indicate that Mitsubishi had originally hoped to fetch $31 million for a vessel with a $9,000 per day bareboat back for two years, but encountered resistance in the marketplace. Still no word yet on who will finance the deal for NFC. Since we still get calls from people asking who Northern Finance Corp. actually is, we thought it would be useful to provide some insight and contact details.
Who: Navigation Finance Corporation
What: A joint venture between DVB and Northern Navigation International, whose objective is to identify, structure and execute investments in all shipping and offshore sectors. NFC can provide private equity, preferred equity, sale and lease back structures, mezzanine debt and other products to owners. NFC participates in all types of projects from straightforward equity participations to preferred equity, sale and lease back structures, mezzanine structures and other structures such as guarantees.
Shipping Banks and Tanker Swaps
By Paul Mazzarulli, Mallory Jones Lynch Flynn & Associates, Inc.
It’s no secret that shipping banks are working hard to use their balance sheets less and use their shipping relationships more to generate fee income. But that has proven to be easier said than done. The issuance of public debt and equity securities is fickle, corporate finance advisory mandates, like mergers and acquisitions, are spotty, and tax deals don’t come along every day. Separately, these business areas are small, but together a bank can keep a small and talented staff busy and productive.
One additional area in which banks can leverage their in-house expertise, client relationships and balance sheets is by serving as market makers for tanker swaps. Like lending, there is a very real demand for well- capitalized market makers, especially those who can increase liquidity by mitigating credit risk and assuming some degree of market exposure that they in turn can hedge internally. Moreover, since the whole underlying purpose of swaps is to smooth out the volatility of any one market, shipping finance banks could potentially use these tools to comfort their credit committees and make themselves more competitive with other lenders, in addition to offering risk management services to third parties like shipowners and trading companies. And unlike advisory business, demand for swaps is substantial, reliable and growing; according to Petroleum Intelligence Weekly, 5 years ago about 30 tanker swap deals were concluded. In 2002, that number was 500. Right now, we estimate that 10 – 20 tanker swaps are concluded every week in transactions ranging from 10,000 tons to full VLCCs. In this article, we’ll review the market and outline the opportunity.
The evolution of market sophistication in the tanker business is apparent. The shipping industry, despite deep roots and a straightforward approach to marketing, is advancing in its use of creative strategies for risk management and revenue enhancement. This is evidenced by growing acceptance of floating-rate time charters (i.e., those in which the rate is pegged to assessments by the London Tanker Broker’s Panel, or the Baltic Exchange), COA’s tied to broker panel assessments, and, most importantly, the use of freight derivatives as a hedging and trading instrument.
OGLEBAY NORTON: PosterChild for Illiquidity
By Roger King, Credit Sights High Yield Research
Oglebay Norton learned the price of liquidity in 2002: 18% interest with a second lien.
On the surface it should not have been this way. With a decades-long lead banking relationship at Key Bank and its predecessors, a highly levered but historically stable business, hard assets, and LTM EBITDA coverage of interest and capital expenditures during 2002, it only seemed a distant threat that the bank line would not be refinanced at maturity in 2Q03. However, the banks pulled the plug. They demanded a $75 million paydown to roll out only 18 months into 4Q04. It took 18% interest (13% cash and 5% pay-in-kind) with a second lien on all assets to raise the money in the private market.
The banks have their hands on the ripcord again. First quarter results were weak, but attributed to poor weather in the Southeast and Great Lakes. However, on flat revenues LTM operating income and EBITDA for the first quarter are both down $20 million since 2000. LTM operating income for the Great Lakes segment is off $10 million over the same period. The banks gave covenant waivers until June 15. If results do not rebound by then, they could very well take Oglebay down again. Oglebay is a descendant of an old-line Cleveland industrial enterprise founded in 1854. At one time it milled taconite pellets in Minnesota in partnership with the Rockefellers, and transported them to Great Lakes ports on its ore boat fleet. It owned coal mines, railcars and a barge fleet. The founding family took the company public in 1958 and created a family trust which remains a significant shareholder. Under non- family management, Oglebay exited most traditional business lines while retaining its ore boat fleet; moved into aggregates and specialty minerals in the Great Lakes region to internally generate back hauls for the fleet; expanded this business line nationally; and funded all this with a high yield issue in 1999.
Ship Management’s Effect on Profitability
By Peter Wallace
The technical ship management function is critical aspect to maintaining a profitable and well respected shipping venture. Ship managers control or influence a large part of shipping expenses, but ship managers have the most dominant influence on overall expenses. This team also affects the quality of charters, the quality of crew, the quality of suppliers and the owner’s reputation. The owner’s reputation affects the cost of capital.
Ship Management Business Proposition
In order to understand the ship manager’s invoice, it is important to understand what the technical ship manager’s business proposition is and how the ship manager is compensated. This brings to light what the ship manager can legitimately charge and the areas that an owner must be vigilant to avoid overcharging or fraud.
A typical ship manager can basically only sell their time and services and subsequently charge an annual fee plus extraordinary costs on a standard contract such as the BIMCO Ship Management form. They have essentially no risk when it comes to liability: The ship manager has limited liability–even in cases of gross negligence. Ship managers that have an equity position has a different perspective on the business proposition and have much greater liabilities than “pure” ship managers. Vessel operating costs and costs associated with managing the vessel above the ship manager’s standard services are usually charged to the vessel/vessel owner. Thus, ship managers that have no equity position or not otherwise tied to the performance of the vessel are competing against other ship managers for quality of service. The true operating costs of the vessel are of little consequence because they are passed through and paid with the owner’s funds (it is virtually unheard of for a manager to front an owner funds for any operating costs).
MONITORING TIME CHARTERING PERFORMANCE
By Sydney P. Levine of Shipping Intelligence Weekly
In a time when costs are being scrutinized more closely than ever, the study of a theoretical cost category has yielded surprisingly useful results. We at Shipping Intelligence have calculated the opportunity gains and losses associated with the actual time chartering practice of many of the major participants in the dry bulk and tanker markets. These calculations and the detailed reports that accompany them are proving to be of enormous interest to the boards of directors and managements of the companies themselves but also to banks, investors and competitors, all of whom, for varying reasons, are interested in the efficiency of the chartering function.
Opportunity gains and losses are notoriously difficult to measure. They aren’t “real” in an accounting sense; they don’t appear in financial statements; and they’re rarely used to judge performance. However, when they can be measured they can be very revealing.
One such category is the opportunity gain or loss from time chartering. If a charterer fixes a ship below the current market, he will earn an opportunity gain of the difference between his particular rate and the prevailing market rate – and it will accrue for every day of the charter. Similarly, if his rate is above the current market he will incur an accumulating opportunity loss.
Managing vessel value risk
By Philippe van den Abeele, Clarkson Securities Limited, and Dr. Roar Adland, Clarkson Research Studies
Rightly or wrongly, the shipping industry is still known as a conservative industry that does not lead the way in terms of developing and adopting new and sophisticated tools and technologies. That may not always be a bad thing in light of the recent boom and bust of the dot.com bubble. Certainly, these days, old-industry shipping appears to be one of the few global industry sectors that make decent profits. However, it also means that innovators in shipping may face a long battle to get the industry to use new products and markets. The slow growth of the freight derivatives market is a good example. It took more than 15 years from the inception of the Biffex to get to today’s thriving OTC freight derivatives market, with an estimated annual turnover of $4.0 Billion notional value of freight. Although the plain vanilla swap (FFA) contract accounts for the majority of the volume, more sophisticated option structures are also being traded. While liquidity is still a concern, the market is fairly active for short-maturity contracts. Consequently users of the freight market today have a mature financial tool for managing the risk they are exposed to, and many companies are quickly catching up to the opportunities in the derivatives market. Recently, one listed Scandinavian shipowner even hired a Ph.D. mathematician to supervise the company’s freight exposure in the physical and paper markets. That must surely be a world first in the bulk shipping industry.
With well-developed derivatives markets for freight, currency, interest rates, and bunkers, only one major risk factor cannot currently be managed, namely vessel value risk. In terms of dollar exposure, this is perhaps the most important risk factor to an owner. Highly volatile vessel values, combined with a lengthy S&P process and relatively low liquidity in the physical market, can make market timing difficult and have adverse effects on the return on equity. Some listed shipping companies have even stopped reporting asset values in their quarterly reports. Still, the Net Asset Value remains the primary benchmark for the value of a shipping company. The significant variation in the second-hand value of ships is highlighted in the figure below, which shows the historical values of a five-year- old VLCC and Capesize vessel, respectively, for the period January 1988 to March 2003.
Introducing the FOSVA In order to facilitate the management of asset value risk in shipping, Clarkson Securities Limited (CSL), a pioneer of the original FFA contract, has recently developed the concept of Forward Ship Value Agreements (FOSVAs). Similar in structure to the standard FFA derivative, this is a cash-settled forward contract (contract for difference) on the second-hand value of a generic vessel. In order to establish a truly neutral price index that can be used for settlement purposes, Clarkson Securities has pulled together a panel of eight shipbroking companies from around the world that independently submit their price assessments every two weeks. The task of collecting and processing the brokers’ assessments of the vessel values is expected to be handed to the Baltic Exchange in April 2003. The use of a broad panel of experts and the publication of the indices by an independent third party mimic the well-established procedure in the freight derivatives market. CSL believes that this approach will largely eliminate the possibility of market manipulation and, moreover, that the use of a familiar and proven system will lead to increased confidence in the market and a quicker adoption by users.
Economics of U.S. Maritime Security
By Dennis L. Bryant
It is an immutable law of economics that there is no free lunch. Everything costs something, and maritime security is no different. The cost of enhancing security in the maritime and related industries will be high. For those on the front lines, such as ship and maritime facility owners and operators, the goal is to reduce the cost as much as reasonably possible. For costs that can’t be avoided, the goal is to either pass the expenses to a third party or structure the changes so has to achieve savings in other areas.
Maritime Security Plans
Both the changes to International Convention for the Safety of Life at Sea (SOLAS Convention) and the U.S. Maritime Transportation Security Act require owners and operators of most ships and maritime facilities to develop and implement maritime security plans. Changes to the SOLAS Convention are located primarily in the International Ship and Port Facility Security (ISPS) Code. The U.S. Coast hGuard estimates the first year cost of developing maritime security plans to be $963 million for facilities and $188 million for ships. The Coast Guard concedes, though, that its numbers are very soft, as it had little accurate data from which to work.
It appears that the amount estimated for enhanced security at port facilities is understated, probably by half. The figure for ships, though, is vastly understated, as it includes only U.S.- flag ships. It also does not include costs related to having security resources under contract or meeting other security requirements that are unique to the United States. It is unclear why the Coast Guard estimate for ships only focused on U.S.- flag vessels. One might argue that the agency felt no reason to include the costs associated with foreign-flag vessels, as those costs were somehow tied in with the international requirements. That argument is a thin reed, but is of little moment here, as this is an attempt to calculate the total worldwide costs to ship owners and operators of maritime security enhancement.
IMPLEMENTING INTEGRATED FINANCIAL RISK MANAGEMENT
By Finn Dalheim
Some of the typical questions one gets when a shipping company CEO or CFO is convinced of the potential benefits of enterprise risk management for his company, are: “But how do we implement a cost-effective risk management framework within our lean, busy organization? What are the main implementation challenges, and how do we overcome them?”
In order to answer these questions, below collected are some useful advice for a step-by-step, low-cost, best practice, risk management implementation for a shipping company.
The benefits
In a cost/benefit analysis for establishing a risk management framework, the costs consist mainly of spending some more management time thinking about risk. What are the benefits?
Residual Value Insurance, Today’s Reality
By Thomas A. Orofino & Paul D. Dean
It was the shipping industry that gave rise to the world’s most innovative, and for many years, the world’s largest insurance market, Lloyd’s. It all began at John Lloyd’s coffee house as it was there that ship captains would gather before and after voyages to talk shop, trade stories of ships and cargos lost at sea. The insurance business then was a personal one as it was there that gentlemen would gather together with ship captains to negotiate the insuring of a ship’s cargo against loss at sea or a vessel’s final safe passage to its destination. Great care was taken to outline risks insured, undertaken/underwritten, by these gentlemen who pledged their personal fortunes to insure the safe outcome of a ship’s voyage. It was in John Lloyd’s café in London where the phrase “underwrite” came into being. Once the insurance contract was drawn up, the risk to be insured was outlined, the individual or “name” as it is know today, would sign his name and commit his personal fortune under the recitations of the insured agreement; i.e., he would “underwrite” his name to the contract.
Today the decision criteria, motives and the cyclic activity of banks and insurance companies have many similarities with the volatility involved in operating ships and their cargo. The challenge in financing the shipping industry as well as underwriting the future value of vessels is our focus in this article. It is our attempt in this article to draw the similarities between banking and insurance so as to explain how residual insurance is underwritten and why it is underwritten in the manner in which it is. Given the long history between shipping and insurance it is ironic that it is the shipping industry that utilizes the insurance industry’s capital to assist in ship financing the least.
Banking extends credit first and collects premium/interest over time. Insurance collects premium/interest first and extends credit or pays a loss, over time. The business cycles are similar: today’s banking market is characterized by “tight” money lending practices; the insurance markets are characterized as “hard” markets. Both these cycles were preceded by “soft” markets: easy money in banking and lose underwriting in insurance. Enron, Andersen, WorldCom, Tyco, and other events put an end to the soft markets. Both the insurance and banking markets, as well as their shareholders, are paying the price for these practices. Banks are writing off loans with failing borrowers. Insurers are paying millions of dollars in claims on Directors and Officers Policies for corporate entities, Errors and Omissions Policies for professional practices entities such as accounting and law firms and Surety Bond claims to financial institutions. To maintain the stability of the financial markets the Fed (US Federal Reserve) keeps it’s “window open” and lowers interest rate to maintain market liquidity. The lack of regulatory intercession in the insurance markets has produced a deeper and more pronounced market cycle than in banking. What do we learn from these cycles and where do we go from here? Certain lessons are learned the hard way; we have actually seen the aggressive “underwriting” practices lead to the demise of some insurance companies. We do not welcome this demise as it withdraws capital from this market, not a healthy event for the insurance market.
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