Law firm Watson Farley & Williams (WFW) partners David Osborne, Patrick Smith and George Paleokrassas explain some of the legal issues that occur with sale and leaseback financing
Sale and leaseback deals, including those involving Chinese leasing companies, are an increasingly important source of finance for tanker owners. Many if not most such deals are documented under English law. This article briefly looks at some legal issues which shipowners should be aware of in documentation – and in some cases during the term sheet or structuring phase.
Some of the issues addressed below arise from a fundamental point: a lease is not a loan in a different form but gives rise to a different type of legal relationship. English law, unlike US law, only re-characterises leases as loans in unusual circumstances, which can be ignored for current purposes.
The English courts have developed protections for an owner which grants a mortgage over its asset. Among these protections are certain duties imposed on a mortgagee when realising its security, most importantly an obligation to sell for the best price reasonably obtainable.
A lessor is not under similar duties, at least not so clearly or to the same extent. This means that a lessee needs to try to achieve some measure of equivalent protection in the lease document. Lessors might not be sympathetic to a lessee seeking to obtain protections which operate when the lessee is in default.
However, in any lease which has the features of a finance lease the lessee will expect the lessor to sell the vessel, apply the proceeds against the lessee’s obligation to pay the termination sum and account to the lessee for any surplus proceeds. In addition or instead, the lessor might agree that it will transfer title to the lessee upon payment of the termination sum.
Such protections are especially important to the lessee where the sale and leaseback is not a 100% financing, ie where the lessee has provided ‘equity’, usually in the form of an advance payment of hire. Lessees should be especially wary of any default termination regime which obliges the lessee to pay a full pay-out termination sum but which contemplates that the lessor can also retain the vessel or its proceeds.
The lessee has an interest in the identity of its lessor counterparty, so should seek to impose some restrictions on the lessor’s ability to sell the vessel and to assign or transfer the lease. Conversely, the lessee will want to have the flexibility to exit the lease by early voluntary termination – and without having to pay an early termination fee, or at least an exorbitant fee.
Since legal title to the vessel will be vested in the lessor, the lessee is exposed to the risk of liens arising against the vessel through the action, or failure to act, by the lessor. This risk should be addressed in the lease. In this context, it is relevant whether the lessor company owns and leases vessel to other lessee groups. The lessee is also exposed to the risk of insolvency proceedings in respect of the lessor. This can give rise to complex issues, which will depend on the jurisdiction where any lessor insolvency proceedings take place.
As can be seen from the points above, there are important obligations of a lessor in a lease; it is not a document in which all obligations go one way, from the lessee to the lessor. The lessor may be a special purpose company or a company of limited financial resources, in which case it would be prudent for the lessee to try to obtain some support for its obligations from a company of substance in the lessor’s group.
The identity of the company giving lessor parent support and the terms of that support are a matter for negotiation. Some Chinese leasing houses are reluctant to give lessor parent support as a matter of policy; there is in any event a Chinese legal and regulatory issue with guarantees issued by PRC companies.
Lessors frequently wish to be able to finance their acquisition of the vessel by way of a loan secured by mortgage – and if this is not done at inception they will frequently wish to have the flexibility to refinance by way of ‘back financing’ in the future. This presents a number of potential risks for a lessee, which should be covered off in documentation. Most obviously, a lessee will want a quiet enjoyment agreement with the lessor’s financiers, ensuring that the financier (as mortgagee) is not able to interfere with the lessee’s quiet use and possession of the vessel for as long as the lessee is not in default under the lease.
This should operate to cover the lessee’s right to receive surplus vessel proceeds following default termination (see above) and the lessee’s rights in respect of insurance proceeds. The terms of any purchase option which the lessee has in the lease should be expressly respected by the mortgagee. The negotiation of quiet enjoyment agreements can give rise to some difficult issues.
If future ‘back financing’ by the lessor is permitted, it should be conditional on the execution of a quiet enjoyment agreement satisfactory to the lessee – or in pre-agreed form.
If the vessel is subject to a time charter entered into by the lessee it should be checked that a change of the vessel’s registered ownership does not require the charterer’s consent. The time charterer might itself be in a position to require that it receives quiet enjoyment assurance from the lessor and any lessor financier.
In any sale and leaseback deal, the lessee will need to negotiate the usual issues which arise in any financing. The issues flagged above are among the main ones which are specific to leases rather than debt financings.