“It is good that I make you build the hull, decks, and mast of this ship that will sail on the sea, and then on a sunny day, like a wedding day, I have you clothe her in sails and gift her to the sea.”
There are a multitude of motivations for ordering new vessels, whether it is due to one’s poetic character, as Antoine de Saint-Exupéry suggested, or for more practical reasons. Some shipowners do so to meet specific trading needs or to take advantage of better credit and tax opportunities, while others want to switch to new fuels and technology, take advantage of market rates as they repeatedly set new all-time highs, or expand or diversify activities; and sometimes for a combination of the above. Shipowners are continually looking for financial partners to help with the capital demands connected with newbuilds, from cruise ships to containerships, tankers and bulk carriers, and offshore vessels. Various projections predict that the shipbuilding business will expand in the next years, thanks to the industry’s efforts toward custom crating and logistics and the ever-increasing appetite for seaborne trade.
Financiers will have options to provide short-term or long-term financing to help with these projects. However, some of these may be refuted by the risks associated with shipbuilding. Indeed, our traditional asset financing instincts are tested because there is no income to harness (at least for the time being) and, in many cases, no asset to mortgage (although we will show that this is not always the case). So, whether as a bridge financier of a portion of the shipbuilding instalments or for those willing to obtain a full term pre-delivery financing of the vessel, how can financiers find comfort while financing a vessel’s construction instalments?
Typical risks connected with construction finance
Financiers participating in vessel construction often face two major risks: insolvency – of the shipyard on one hand, and the shipowner on the other – and the shipyard actually building a vessel conforming to requirements within an agreed-upon timeframe.
Shipyard insolvency is a real possibility; in fact, shipyard insolvencies are quite common. Recent examples of shipyards flirting with insolvency have included enterprises in Asia and Europe, involving both huge state-backed shipyards and smaller private operators. As a financier, it is less than ideal to face the threat of a halt in the vessel’s construction where part funding of the instalments has commenced, with the actual risk that the vessel’s construction would never be completed. Thankfully, this risk may be managed, most typically through effective due diligence on the shipyard, careful examination of the terms of the shipbuilding contract, and the right inclusion and writing of refund guarantees. The dangers may be greater where the shipyard is new or where the design and technologies are untested.
On the other hand, a breach by the shipowner of their commitments under the shipbuilding contract generates a risk for the financier. If the breach is severe enough, the shipbuilding contract may be terminated, and the shipyard may retain any previously paid payments and refuse to deliver the vessel. Of course, this can be addressed in a variety of ways, including the facility agreement, the lender making direct advances to the shipyard, and the creation of a corporate silo for the eventual owner of the vessel to shield it from the parent shipowner’s wider insolvency. We will now go over the various instruments that can be used to mitigate this outcome and protect a financier’s interest when assessing a prospective newbuild loan.
The shipbuilding contract, predictably, will be the focal point of these activities. Shipowners are understandably hesitant to give prospective financiers a say in shipbuilding contract discussions; it is a matter of know-how, timing, and overall sensitivity. After all, shipowners are under enormous pressure to secure shipyard slots in a highly competitive environment. However, adequate due diligence on the shipbuilding contract would be required by any financier, and a wise shipowner will frequently consult its advisers to ensure that it is “finance friendly” prior to the engagement of any financier. Particular attention should be paid to the assignment limits, cancellation and refund rights, return guarantee provision, insurance coverage requirements, and general instalment schedule and mechanics, which will, among other things, govern the drawdown timeline under the facility agreement. Typically, 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 confident in the supervisor’s abilities, including where they are also providing post-delivery financing. The investor will also be interested in who is taking any design/technology risks.
Financiers should also take some type of security on the shipbuilding deal. Shipyards are used to – and generally accommodate – such constraints. The type and form of security should be consistent with the law relevant to the shipbuilding contract and, as shown below, the location of the vessel under construction. Relevant legal advice should be sought to ensure that financiers benefit from any refund mechanisms, insurances, guarantees, and indemnities provided by the shipyard; and are involved in (or have authority over) claims against the shipyard for breaches of their obligations under the shipbuilding contract.
Furthermore, lenders involved in newbuild funding would ideally want a form of “step in rights” that would allow them to step into the shoes of the failed shipowner and assume their liabilities (essentially, to pay instalments). This is easily accomplished by an adequately worded English law assignment and acknowledgement or a tailor-made “direct agreement” between the shipowner, financier, and shipyard. Of course, this is not an ideal situation because the remedy ultimately rests on finding a new owner for the vessel at delivery, which will be fraught with uncertainty. As project financiers are well aware, taking the asset all the way to completion is sometimes the most economically sound route out of a default position.
To address the risks of insolvency at the shipyard level, it is common practise for a prospective shipowner to seek a guarantee to ensure that their instalments are refunded in the event that the shipyard breaches any of their obligations, entitling the shipowner to cancel the shipbuilding contract or is subject to insolvency proceedings. This is generally offered by the shipyard’s bank, in that bank’s home template, and the shipyard will be charged a fee for the service. Financiers should, of course, benefit from the reimbursement guarantee, either directly or through assignment. Relevant counsel’s assessment should always be obtained to confirm that the promise has the intended impact under its governing law and in its likely enforcement location.
Interestingly, shipyards are in a strong position in the current market, and we have seen instances where they are unwilling to provide guarantees and/or are 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 willing to take the risk and reserve the slots.
Nonetheless, it is in both the shipowners’ and their financiers’ best interests to press for this guarantee on reasonable conditions. Finally, it is always the shipowners’ risk to bear, provided that the financiers have enough alternative securities in place (e.g. corporate guarantees from a shipowner’s credit-worthy holding company and/or cross-collateralisation with other boats already built and engaged). In any case, refund assurances remain entirely typical in the vast majority of cases and are part of the shipyard’s contract proposal.
Construction Loan on a Vessel
When does a pile of steel transform into a vessel? This is a practical issue for financiers when a vessel is being built in a jurisdiction that takes mortgages before delivery. It is worth mentioning that this will not be the case for the three shipbuilding superpowers of Korea, China, and Japan, making this a more improbable prospect. In truth, this is largely achievable in civil law background countries (e.g., France, Belgium, and Germany), where ship registries may approve the registration of vessels under construction, opening the way to obtaining mortgages over them. The mortgage will be granted either 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 the continuous incorporation of new material as part of the construction process.
A mortgage seems pretty pleasant to any financier. It gives them all of the typical mortgagee rights and some amount of security against insolvency on both sides, shipyard and shipowner. However, it is critical to determine the actual benefits for the mortgagee in each circumstance. Local counsel will be essential in properly understanding the position of any such mortgagee against the shipyard, their suppliers, subcontractors, and any third party with a lien over the vessel, as well as how this financier’s position relates to a complete refund guarantee regime.
To begin, registration of the vessel under construction will be possible only after the vessel reaches a certain level of “completeness” (e.g., keel-laying date in Belgium, France, and Germany), implying that some initial instalments will have already been paid at this stage prior to any mortgagee protection being in place. Second, enforcing rights over a vessel under construction will be of little value if there is no possibility to acquire completion of the building or repayment of the instalments – a court sale of a vessel under construction is usually not the most profitable way out in such instances. Following the insolvency of a shipyard in Germany, the vessel under construction was sold for scrap. Of course, where available, a mortgage is a good thing to have – we’re still talking about asset finance here. Taking a mortgage on the vessel under construction if this is possible under the vessel’s flag may not be as effective where the vessel is under construction in a different jurisdiction – the local position must be examined.
A shipowner will frequently sign into a shipbuilding contract in exchange for a long-term charter. For example, gas (LNG) businesses and oil majors are frequently involved in such transactions. These charterers will also be involved in the construction, as the vessel must meet their specifications. These charterers do not want to acquire equity in the vessel and be the direct purchaser under the shipbuilding contract for liability reasons or simply for business reasons. They leave this to the shipowners. Charterers may contribute to the cost of the shipbuilding contract, but in any case, this employment contract considerably improves the financier’s chances of getting out in the event of a defaulting shipowner.
Any financier must benefit from such a charter assignment. Third-party charterers typically have far stronger credit than shipowners, but most crucially, they share a common interest in seeing the construction through to completion. In the event that something goes wrong, benefiting from the charter means that there is visibility in terms of vessel employment at the time of delivery, which ultimately alleviates one of the financier’s main concerns when considering using their step in rights (see above) and completing the vessel in place of the owner.
Financiers and charterers will negotiate what occurs in those instances, either by an acknowledgment of the notice of assignment under an English law arrangement or through a separate direct agreement between them when the law of another jurisdiction applies. In an ideal world, financiers and charterers would agree that if the shipowner/manager of the intended vessel fails, the financier (or its nominee) would take over construction with the shipyard, the charter would be maintained, and the management of the vessel would 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 conclusion, providing newbuilding predelivery finance includes a number of inherent risks, but a comprehensive analysis of the shipbuilding contract, cautious planning, and some timely drafting modifications could minimise these risks. Among other things, including a refund guarantee and creating a proper security package can assist financiers reduce their risk exposure and mitigate the repercussions from any prospective counterparty default, with several escape routes in such a case. Of course, there are few watertight rules in this field and a plethora of determined legal issues that should be considered, which this paper does not have time to discuss. Meanwhile, maybe this has given you some food for thought on this intriguing topic!