Shipping banks will seize the opportunity to expand their business model beyond direct asset and commercial lending and also focus on high-yield and investment grade bonds as well as hybrid forms to finance shipping companies.
With more than 100 ship funds in insolvency and more than 100 bn € of bank debt under fire, the German[ds_preview] shipping industry, including ship financing banks, is in the midst of a sea change. What trends will we look at on legal and tax level, and which prospects will shippings companies, banks and international investors see in the years to come?
Consolidation
Corporate and transformation tax laws, in combination with a worldwide system of tonnage taxes, allow for an association of shipping companies (by way of platforms, joint ventures, holdings and mergers). In particular within Europe, crossborder reorganizations are achievable fairly easily. Obviously, change-of-control clauses in credit agreements have to be considered, but the banks have been standing on the bridge for quite some time now anyway – much to their dislike. There is a boost towards consolidation: As an alternative to classical single asset KGs, larger portfolios may be managed much more efficiently and may serve as an exit strategy once the banks have taken over ownership of the assets, either legally or at least de facto. Larger portfolios could become more attractive to private equity investors.
But consolidation does not flag down single asset Schiffs-KGs only. To the contrary, midsize and even large shipping companies are ready to be called about considering business combinations. Covenant breaches and negative financial forecasts give the banks an excuse to steer the borrower into a new harbor. This is particularly true at a time when corporate borrowing is hardly available to shipping companies without a compelling business plan, and when asset lending is under financial stress. A clear cut can be accomplished on the basis of the new insolvency laws which allow for a reorganization under the creditors’ supervision. As a result, the banks start triggering consolidation much earlier. Key market players take a look not only at individual companies but at the entire industry (with the effect also that some banks consider pulling out of the market entirely, or have done so already). And consolidation of larger market participants seems to be in the offing as well: Full 360° integration with critical mass around the globe is likely to be one objective of major shipping liner companies. Alliances have their limitations. Charter shipping companies are at the back end and struggle with the financing of the next vessel generation.
As regards the creation of new pooling vehicles, in which either non-performing or certain other vessels with specific criteria are joined by way of contributions in kind, the rationale is to create large and tradeable units capable of being newly financed. With such new financing then being partly used to repay a certain percentage of the existing debt and partly to finance new Capex and other necessary investments. To allow the formation of such new platforms in a consensual way, all important stakeholders of the existing KGs have to be on board, i.e. limited partners have to agree on the transfer, shipping banks have to release security and to accept structural subordination for their remaining claims (if any) in consideration of certain upfront-payments, and other stakeholders have to agree on transferring their contractual relations to the new pooling vehicle. In addition, complex tax and restructuring measures have to be implemented to allow the KGs to stay out of insolvency and avoid certain tax disadvantages. If such consensual restructuring cannot be achieved, other means will have to be used to achieve it, including enforcement of security over the ship and/or use of U.S. Chapter 11 or other insolvency laws, including, in particular, the revised German insolvency regime.
Alternative Financing
Will private equity come in? In fact, it has been coming in for quite some time, but not necessarily in Germany. But we see a new attempt of international funds at buying distressed ship financing in Germany as well. Private equity is generally looking for high-growth, high-margin businesses, so the shipping industry may not necessarily fall into their sweet spot. But the aforementioned consolidation pressure provides for special opportunities as well.
As in every corporate restructuring in which the value breaks in one of the debt tranches and equity is out-of-money, the main focus of new investors concentrates on acquiring debt in order to get control over equity – be it on a consensual or a non-consensual basis. The traditional instruments for implementing a non-consensual debt-to-equity strategy, however, face some structural limitations in the German shipping industry. In particular, acquiring shares by way of credit-bidding in the course of a share pledge enforcement which has become the means of choice for a series of large German corporate restructurings in recent years is not a feasible tool in the typical KG structure as the (limited) partnership interests are usually not pledged in favour of the shipping bank. Thus, this only remains an option in very few cases and in particular if the vessel is not owned directly by the Schiffs-KG but held by a subsidiary in which the shares are pledged.
Nevertheless, non-consensual debt-to-equity strategies can still be implemented even for complex group structures, e.g. by way of a pre-pack enforcement of certain ship mortgages in parallel or by way of pre-pack DIP proceedings, i.e. a debt-to-equity swap implemented by an insolvency plan within formal insolvency proceedings of certain single asset KGs in parallel. While the proceedings under Chapter 11 of the U.S. Bankruptcy Code have become the preferred route to go for in-court-solutions in the shipping industry, the revised German insolvency regime under the so-called ESUG (Code for the Facilitation of Corporate Restructurings – Gesetz zur Erleichterung der Sanierung von Unternehmen) presents interesting alternatives: The main reason for stakeholders to choose Chapter 11 is the high degree of transaction certainty and predictability of the outcome, together with flexible economic solutions, including debt-to-equity swaps or debt deferral. Under ESUG, the former uncertainty as to the choice of the administrator has been significantly diminished. A debt-to-equity swap can now be implemented through an insolvency plan even against the opposition of the existing shareholders. The main obstacle to German proceedings vis-à-vis their US model is the limited time frame of three months for submission of an insolvency plan and a number of smaller technical issues. But still, first experience with the new regime is promising.
Consensual solution
In principle, any debt-to-equity swap results, at least pro forma, in gains of the relevant entity which may result in taxation under German tax law. Due to lack of funds, such taxes may result in the company having to file for insolvency. Any insolvency of the KG is likely to result in severe disadvantageous tax consequences for the limited partners. This may not stop the bank from implementing it, but serve as an incentive for the limited partners to agree on a consensual solution. However, from a tax perspective, the restructuring decree is still available in practice and may serve as a basis for tax-neutral debt-to-equity conversions. This would come on top of tax shelter which should typically be available under the tonnage tax system anyway. A Schiffs-KG is deemed to maintain a permanent establishment for international income tax purposes, and the exemption method should be available under many tax treaties so that profits sheltered by the tonnage tax system should not be taxed in the home jurisdiction of the shareholder unless the credit method applies as e.g. under the U.S. treaty. The profits can be withdrawn free of withholding tax, provided certain requirements are satisfied.
Finally, discussions with relevant market participants lead to the conclusion that shipping banks will use the opportunity to expand their business model from direct asset and commercial lending and focus also on high-yield and investment grade bonds and hybrid financings of shipping companies, and eventually even on IPOs in the equity capital markets. Here, of course, international, corporate and tax law implications have to be considered as well.
Frank Grell, Götz T. Wiese
