Equipment leasing in the shipbuilding industry – inherent risks and how to mitigate them
In aviation and other sectors, equipment leasing has long been a recognised tool for companies looking to finance expensive items of equipment. Whilst to date equipment leasing has been less visible in the shipping industry, we are now seeing an increased interest in this type of financing from both shipowners and equipment lessors. However, leasing arrangements do include some inherent risks which the parties should seek to mitigate.
Leasing enables the party leasing the equipment (the “lessee”) to utilize the relevant equipment without capital expenditure, and is used both for long and short term. However, for the party providing the equipment (the “lessor”) the leasing arrangement may entail certain risks. These risks faced by the lessor may vary from jurisdiction to jurisdiction, however, there are some general situations and concepts to which the lessor should pay extra attention.
Acquisitions in good faith
Acquisition in good faith refers to a transaction where a purchaser buys assets in the belief that the seller has a legitimate right or title to sell them and that there are no legal impediments or undisclosed liabilities associated with the property or assets. A typical scenario from the shipping industry is where the leased equipment is located onboard the ship, and the lessee sells the ship voluntarily to a third party. The third party could then claim title to the relevant equipment on the basis of having been acquired in good faith and in the belief that the equipment was part of the sale.
Ship mortgages
The lessee in the shipbuilding industry is normally a shipowner. As part of the financing of the ship, it is very common that the shipowner establishes a ship mortgage in favour of the relevant lenders, so that the lenders may enforce the ship mortgage if the shipowner is in default of its financing obligations. In most jurisdictions however the ship mortgage will include an explicit reference to the mortgage covering the relevant ship as well as all equipment or appurtenances which are onboard and connected to the ship. This especially applies to equipment which is regarded as an integral part of the ship e.g. a crane or drilling rig. Consequently, the lenders under the relevant ship mortgage may refuse to recognise a lessor’s title in the equipment when enforcing the ship mortgage.
Bankruptcy event
In addition to the above, the leased equipment may be at risk in the event of insolvency or bankruptcy proceedings against the lessee. In these situations, unsecured creditors will seek to obtain as much recovery as possible to reduce their losses. In some jurisdictions, the creditors may be entitled to take possession of everything that is within the possession of the debtor, which could include leased equipment onboard the debtor’s ship. A similar concept is where the creditors become entitled to take possession of any de facto assets of the debtor.
Mitigating the Lessor’s risk
The most efficient way to mitigate the risk is to mark the leased equipment with the lessor’s logo or similar signs that clearly evidence that the equipment belongs to the lessor. By doing this, the risk of third party acquisitions or potential creditors taking possession of the equipment becomes significantly reduced.
Where high value equipment is leased to a shipowner, the lessor should also seek to enter into a coordination agreement, intercreditor agreement, quiet enjoyment letters or similar arrangements with the lessee and any ship mortgagee. The purpose of these agreements is, amongst other things, to explicitly state that the relevant equipment is owned by the lessor and to set out in writing what would happen in a default/insolvency situation. Typical clauses to include in these agreements are:
- A statement that the lessor is entitled to remove the equipment prior to the enforcement of the ship mortgage.
- A second priority mortgage upon the ship in favour of the lessor, securing its right to title and/or right to remove the relevant equipment prior to enforcement of the first priority mortgage.
- Assurances that commingling of assets will not happen with the relevant equipment and the ship.
- Assurances that sale of the ship to a third party must include a clause stating the ownership of the relevant equipment, preventing the purchaser from acquiring title to the equipment in good faith (in this regard we would note that the standard industry contract forms used in ship sale and purchase do generally contain provision for lists of hired items to be excluded from the sale).
- Assurances that the shipowner will indemnify the lessor for any loss in connection with any liens being levied over the relevant equipment for reasons that are not attributable to the lessor.
In respect of any leasing arrangement, the jurisdiction for the registration of the ship (and any related mortgage) and the jurisdiction where the ship operates (and thus where a potential third party action may be initiated), are highly relevant and may affect the risks related to a leasing arrangement. Legal analysis as to whether the equipment will be deemed an integral part of the ship increases the need for contractual arrangements involving the ship owner and the financiers of the ship.
Currently, there are no standard leasing agreement or formulae properly developed for equipment leasing within the shipping industry, and careful drafting of the underlying leasing agreement is therefore required to properly protect the parties in a balanced manner.