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Norton Rose Group has a market leading transport practice with a particular
focus on shipping. This Guide draws on our extensive experience in
conducting and co-ordinating due diligence for corporate transactions in
the shipping sector, to provide a checklist of key issues for investigation
by investors active in, or considering an entry into, this sector.
If you would like to discuss any aspects of this Guide or would like further
information, please contact your usual Norton Rose Group contact or any
of the individuals listed on the contacts page at the end of this Guide.
Given current challenges in securing debt financing for acquisitions of existing businesses and, in particular, the marked decline in the availability of bank lending to the shipping sector over the last three years, a key item to be considered early on in any process is the source and character of any necessary debt financing.
If existing financing is to remain in place, it will be important to review the terms of the financing, swap and other hedging arrangements to identify any unusual covenants which could trigger an increase in the margin or impose impossible operational constraints. Equally important will be establishing that loan to value and other financial covenants in the financing arrangements have not been breached, as well as reviewing any history of covenant breach and the need for any waivers from lenders in relation to such breaches or as a consequence of the proposed transaction. This process will also establish the outstanding amount of the existing financing and so the amount of any additional equity required to be provided by the purchaser. It should also establish the mark to market exposure under existing hedging arrangements.
Investigating title to and condition
of the fleet
Understanding the composition of the fleet, and whether it is owned by the target group or subject to some other arrangement, will drive the due diligence priorities. For example, some or all of the target group’s fleet may be chartered in under bareboat charter, where a third party shipowner provides only the ship to the target group but the target has commercial control over the ship and responsibility for all its operational costs. Many modern fleets have a mix of owned and chartered tonnage and a different due diligence approach is required for each category.
For a fleet of owned ships, key points to check will include:
• the age profile, ship type, size, flag and registered owner – this information will say much about a fleet and its value even before inspection of the Classification Society records for each ship;
• Classification Society records – these bodies provide services to the owners of ships as well as insurers and flag states as regards construction, maintenance and safety. An inspection of class records of a ship will help determine the condition of the ship and its maintenance history but is not always conclusive;
• mortgages and other encumbrances – to what extent does the target enjoy unencumbered use of the ships? In addition to registered mortgages put in place pursuant to the financing arrangements, trade creditors may have unregistered maritime or other liens over the ship which may only become apparent from the seller’s responses to due diligence enquiries;
• trading, arrest and port state control detention history – do the ships have a good compliance history as far as the maintenance, condition and operation of the ship is concerned? Has a ship been arrested by trade creditors recently, which might indicate that others may have claims which are yet to become apparent?
• incident, accident and near-miss reports – whilst this is likely to be an area of primary focus for experts in technical ship management, a review of these records will be a crucial element in any assessment of the competency of the managers, the crew and the approach they take to the safe and efficient operation of the ships. The contents of such reports might be early warning of a fleet that has been deprived of operating and maintenance funding, leading to a general deterioration in the fleet;
• are there any commercial documents granting purchase options over ships owned by the target group in favour of third parties? Such agreements are most frequently seen in charterparties in which the target group has committed the use of ships to third parties. If such arrangements exist, are the purchase terms significantly above or below the current market valuation of the ship?
For ships on bareboat charter to the target, additional points to check will include:
• the terms of the charterparty agreement, the remaining charter term, and the flag of the ship (including any parallel flagging arrangements), as these will determine whether and for how long the target group
has the full use of the ship at its disposal, and whether it is at a charter rate that is economic. Reviewing the remaining charter term will be critical because a seemingly large available fleet may be considerably reduced if a number of charters are due to expire and there is no option to extend the charter or purchase the ship;
• the identity and financial standing of the owner of the ship and, if the owner gets into financial trouble, whether there are sufficient quiet enjoyment rights in the terms of the charterparty to protect the charterer’s position against interference by mortgagees wishing to enforce their security; and
• other key terms of the charter such as the liability of the charterer for defects at the end of the charter term, any rights to extend the charter term beyond the redelivery date (and, if notice can be given to extend, when and how such notice can effectively be given) and whether the charter contains a purchase option.
An important point to establish, both in terms of establishing the scope of due diligence and determining risk apportionment in the transaction, will be the extent to which the seller of the target group might be prepared to “stand behind” or warrant the condition of the ships in the fleet, both owned and bareboat chartered. Although a buyer on a corporate transaction (whether of shares or assets) would usually seek to have the benefit of extensive warranties regarding the underlying assets of the target’s business, this is not standard practice on ship sales. In normal ship sales, the ship is thoroughly inspected before the memorandum of agreement (MoA) is signed and the ship must then be delivered to the buyer in the condition it was in at the time of the inspection, fair wear and tear excepted, but the MoA will not contain warranties as to the condition of the ship, its maintenance, etc. The expectations of a corporate investor and the seller of the fleet are therefore likely to differ in relation to the contractual protection to be offered by the seller.
It will be important to understand the employment profile of the fleet. In other words, for what period and on what terms has the target group been able to find “fixtures” or “charters out” for its fleet and are these on profitable terms? Key points to check include:
• the identity of the charterer and whether it is likely to be able to perform and has performed, particularly by way of hire payments, throughout the fixture;
• the commencement and expiry dates of the relevant charter or contract of affreightment;
• terms of charterparty contracts, including change of control provisions, optional periods, ability to sub-let, charterer termination rights, and whether the governing law and jurisdiction clauses permit reasonably straightforward enforcement of those rights, should this prove necessary;
• the actual performance of ships under the employment contracts and, in particular, off-hire days, excessive demurrage claims and any other disputes with charterers – has any event occurred that might let the charterer terminate the charter or threaten to do so as leverage to renegotiate lower charter hire rates?
• unusual or particularly onerous terms in charters or terms required in certain sectors/by certain customers – eg, trading restrictions, oil majors’ approvals, bribery and corruption procedures/compliance – which may allow charterers a pretext to escape long term charter commitments if the performance of the ships has declined or changes in market rates compared with the rate in the charter mean that that alternative fixtures are available at better rates;
Although a seller will look to the investor to rely on its own inspections in relation to the condition of the fleet, in a large corporate acquisition, rigorous inspection of all the ships in the group may be impracticable. In such circumstances, the condition of the fleet will be evaluated largely from inspection of class records and other documents provided in due diligence by the seller. However (even if the seller is prepared to warrant their accuracy) such documents can only give a snapshot of the condition of the ship. If only limited warranties or other contractual comfort is to be given about the physical condition of the ships, a buyer will need to consider at an early stage what kind of technical inspection or survey it should commission, and whether such a review would extend to every ship in the fleet or whether the logistics and cost of such an exercise may necessitate inspection on a “sample” basis. Such an exercise is likely to be expensive and time consuming, and the time taken to conduct such inspections will need to be taken into account in the transaction timetable.
A buyer should ensure that the scope of the review or survey by technical advisers includes identifying major items of upcoming capital expenditure, including dry dockings, special surveys and any modifications to the ships that may be required as a result of impending regulatory changes. These may include modifications to exhaust gas systems in order to comply with emission control regulations, the fitting of costly ballast water treatment systems and changes which may flow from evolving regulatory requirements (such as the Maritime Labour Convention 2006, which lays down standards for crew accommodation which may require expensive modifications to older ships). It will also extend to reviewing documents relating to the performance of the fleet to identify any technical problems regarding deficiencies in performance as a result of breakdowns, off-hire periods, excessive operating costs and systemic problems which may affect “sister” ships in the fleet.
• details of all forward freight agreements (FFAs) or other hire or bunker hedging arrangements – and whether these are advantageous or have become liabilities;
• the trading routes of the ships, and whether this could cause any issues for sanctions compliance, as discussed below;
• review of any pooling arrangements (whereby ships of different owners and fleets are grouped together to provide economies of scale and maximise earnings and employment), including pool
performance, pool keys (which determine the allocation of pool income among the participating ships), representation by the company on the pool committee, ability of the company to block new entries into the pool, and the ability of participants to leave the pool and on what terms.
Some shipping companies will conduct full technical and commercial management of their owned and chartered ships for their own account; others may engage independent third party ship managers for either or both commercial and technical management of their fleet. Ship managers, who may manage hundreds of ships, are able to take advantage of economies of scale that a smaller operator cannot achieve. For instance, an owner may retain responsibility for commercial management in house – that is, the negotiation of charters and contracts of affreightment, but delegate technical management – namely the day to day operation and maintenance of the ship – to a technical manager. Some owners may only outsource crewing management of the ships. Where ship managers are employed, due diligence on the terms of these arrangements would typically include:
• a review of the management agreements and the scope of the services being provided. Who is the third party technical
manager – are they considered reputable in the industry and known as having high operating standards and access to good crews? If the target group is delegating only some parts of the ship management services (such as crewing or technical management) how are the other services being provided in-house by the target group, and how do these elements interrelate with duties of the third party ship manager? Do the arrangements in place make commercial sense and do they operate well in practice?
• a review of management fees to determine whether there is value leakage from the target group – could management be undertaken more efficiently and cost effectively?
• identifying all commissions payable to management, related companies, third party managers and third party brokers, including commissions for the sale and purchase of ships, commissions for chartering ships, bunker commissions and address commissions. Are these all properly accounted for and legitimate (particularly where the services are provided by service providers related to the target group)? Are they at normal market rates?
• identifying any exposure of the target group to crew social security payments and severance pay, notice periods and termination fees;
• assessing the quality of fleet management, which may include an audit by technical advisers of the target group’s operating procedures, safety management system, records of emergency response drills, and other key performance indicators, such as, for example results of the Tanker Management and Self Assessment (TMSA, a voluntary best-practice guide for enabling tanker owners and operators to assess their management systems).
• any delays in construction and delivery which have led to a right for the buyer of the ship to receive liquidated damages – has any cap been reached on these damages which would mean that no further amounts are payable even if there is further delay? What other remedies are available if this is the case?
• technical or performance problems with any ships delivered earlier in the series, including poor quality coatings and anti-fouling, vibration, shaft alignment issues, excessive fuel consumption, deficiencies in the service speed, cargo capacity or capacity of cranes; and
• the extent of the yard’s responsibility for remedying defects after completion. How long is the warranty period? Are consequential losses able to be claimed for loss of time/business?
Ethical and regulatory issues
Those active in, or considering entry into, the shipping industry will no doubt appreciate the challenging nature of the global operating environment. The instances of risk are obvious: interaction with public officials (such as customs and port authorities), a reliance on third party agents to source and maintain business and trades which may of necessity include countries with “customs and practice” at odds with the constraints of the Foreign and Corrupt Payments Act of the US or the UK Bribery Act. Facilitation payments are outlawed by the UK’s Bribery Act but are a common and often unavoidable currency in the shipping world – usually required to get officials to perform their duties properly and in a timely manner. Refusal to pay can result in delays, unmerited claims for damage to infrastructure and unofficial blacklisting.
Due diligence will be an essential part of testing the culture and compliance record of the target group and identifying practices which will need to change once the acquirer gains control of the business.
Where the fleet includes ships under construction, the following key areas of concern must be reviewed:
• the quality and track record of the shipyard. Where is the shipyard located and can contractual remedies be enforced effectively against it?
• the key terms of the shipbuilding contract (including the contract price and payment terms), instalments of the price paid to date, rights of the builder to subcontract, quality of subcontractors, construction progress reports, the specification of, and the quality of suppliers of, machinery and equipment specified in the maker’s list and owner’s supplied items (those items that the owner will supply during construction, such as specialist equipment). Is the shipbuilding contract well drafted so that disputes and disagreements over its terms are limited and it protects the buyer of the ship sufficiently? Is the ship being built to the building schedule or have any permissible delays occurred (such as force majeure events which will cause delay without compensation)? Finally is the shipbuilding contract subject to a reliable choice of law and dispute resolution mechanism (eg an arbitration process with a recognised arbitration body).
• in relation to the refund guarantee (ie a guarantee of the shipyard’s refund obligations under the shipbuilding contract), the credit worthiness of any bank or other refund guarantor and terms of the refund guarantee, expiry date, and any required registration with any national authority (such as SAFE for Chinese newbuildings);
• quality of the supervision team on site, including technical advisers conducting an audit of inspection records, quality of steel work, welding, coatings and oufitting and performance of the Classification Society.
It is important to find out how the target company deals with the issue of sanctions compliance and how it ensures that it is not in breach of sanctions laws, especially as these are constantly evolving. Is there an effective system to deal with this important issue? What records are there and do they record the following:
• any blacklisting of ships by the Arab League, including any trading of ships to Israel;
• any trading to Iran, North Korea, Myanmar, Libya, Iraq, Syria and other countries which are the subject of sanctions. Where such trading takes place, what due diligence is done to identify counterparties and ensure they are not in fact fronts for sanctioned entities?
It will also be important to confirm that no officers, directors or shareholders of the target group:
• appear on the Specially Designated Nationals and Blocked Persons List of the US Office of Foreign Asset Control; or
• appear on any EU or UN lists of designated person in relation to sanctions; or
• are identified as a “designated terrorist organisation” under the US State Department’s terror list (or support any such organisation).
The owners and/or operators of ships may be subject to both civil and criminal liability for damage caused to the environment by such ships.
It is therefore advisable to engage
appropriate technical consultants to review environmental policies and procedures, pollution incidents, spills, ongoing claims and fines. It will be necessary to look at P&I Club claims records, the provision of Certificates of Financial Responsibility (COFR)
and the identity and competence of spill response providers when trading to the US.
Regulatory compliance and
Given the international nature of the shipping industry, the target’s ships are likely to visit all types and nationalities of port and will be scrutinised by port state control and other national inspection agencies (eg, quarantine, customs and immigration) as well as non-governmental bodies such as the International Transport Federation (essentially an international seamen’s trade union). Where failures or non-conformities are found, the ship may be detained. Commercial entities, such as mortgagees (who have priority as a secured creditor) and suppliers of goods and services to the ship (unsecured creditors in most part, although their status changes depending on which jurisdiction the ship is in), also have the right to detain (arrest) the ship to secure their claim. It is vital that details of any arrest, port state control detention or material claims in respect of each ship are obtained and considered as these give a good “snapshot” as to how the fleet is performing and the nature and number of obstacles that may impact on the future efficient use of the fleet. This is particularly important if the owner of each ship in the fleet will not change because the claims will remain with and against the owner and the ship may be arrested by trade creditors to obtain security for those claims.
The shipping industry generates a large number of disputes – small and large. London and Singapore arbitrations are commenced for surprisingly small claims through the accelerated and cheap “small claims procedures”. A busy fleet may have many of these ongoing which may or may not be a sign of problems in the management of the fleet.
Other disputes (such as shipbuilding disputes) will be more complex, costly and time consuming, and will need proper risk and legal management. Is the target group resourced for this? Are good claims thrown away and other claims paid which need not be due to a lack of legal or other resource? Are there any major claims being brought against the target and what merits do they have? It may be necessary to review the legal advice provided to date or even ask for counsel’s opinion to be sought in order to assess the merits of the claim and the likely exposure of the target group. If the dispute is lost, will the principal sum and costs be covered by insurance? It will be important to review carefully all material litigation claims currently underway or threatened/suspected.
Reliance on a parent group
Many shipping groups are organised on the basis that each ship is owned by a separate special/single purpose company (SPC) usually incorporated in the flag state of the ship. This is designed to stop major liabilities incurred by one ship from spreading to the whole fleet. These companies are then beneficially owned by a parent which may, in turn, be a subsidiary of a parent company. SPCs, because of their nature, will usually require the support of a parent by way of guarantee for any contracts it enters into. The extent, nature and total exposure must be considered and whether replacement of such guarantees will be necessary.
Where a subsidiary/group is separated from its parent, separation issues may include loss of pooled assets or services of the group eg, real estate, HR, IT, and (importantly in the shipping context) group purchasing of the group’s requirements for commodities such as fuel oils, lubricating oils, and spare parts. Other separation costs may include rebranding, changing names, funnel markings, colour schemes and badging on ships. Determining the cost of sourcing necessary goods and services on a stand alone basis may be a significant issue for the financial modelling of any transaction.
Over 100 jurisdictions around the world now have competition or anti-trust laws. Whether acting for a buyer or a seller, it will be important to establish at an early stage whether the buyer requires competition clearance under compulsory notification procedures because of the size and the geographic reach of the buyer and the target business. Even if there are no substantive competition issues that arise from the transaction, the requirement for the preparation of a compulsory filing and the time period for any clearance will need to be built into the transaction timetable.
It will be apparent from the above that in addition to the usual requirements for legal and financial due diligence, on a shipping transaction it will also be necessary to co-ordinate external technical consultants on a number of aspects of the technical due diligence including inspections of ships, a review of class records and ship operating records, and assessment of the condition of machinery and coatings. Only technical consultants with a wide experience of all types of due diligence exercise will understand what is required.
Additional action required by the technical inspection team will include writing to the classification society authorising the technical advisers to access classification records for the ships and obtaining consents and permissions by the builder and the owner’s site supervisor to allow inspection of any newbuilding(s).
It is advisable that insurance advisers be appointed to advise on the terms of insurance policies, and the quality of the security provided under those insurance policies. The claims record will also need to be assessed as prompt payment of claims is important to the solvency and cash flow of a fleet. Are claims being scrutinised unduly and is this taking too long? This may be a
result of the choice of underwriter or the result of the underwriter being concerned about the level of claims being generated by the fleet. An experienced insurance adviser will be able to look through the data to give a true picture. He will also identify old claims made which are yet to be paid and may be able to provide “windfalls” for the buyer if these claims are paid after the deal is closed.
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