Anchors Aweigh [RMA Journal, The]

**Stay afloat when financing workboats in the Gulf of Mexico.

The marine transportation industry1 in the Gulf of Mexico presents many unique issues for lenders. But while the industry can be extremely lucrative, it can also crash- seemingly overnight. Lenders must consider many special issues when underwriting, insuring, and foreclosing a vessel. A thorough understanding of industry risks and the means of mitigation will allow for a profitable lending relationship.

Understanding the Industry

A highly specialized industry, marine transportation1 in the Gulf relies heavily on the oil and gas industry and is subject to strict government regulations.

Marine vessels of all shapes and sizes, including cruise ships, private yachts, ferryboats, water taxis, dinner boats, and fishing and shrimp boats, operate in the Gulf of Mexico. The issues presented here will pertain primarily to workboats.

The major types of workboats currently operating in the Gulf of Mexico and adjacent waterways are tugs and towboats, which operate inland and offshore, as well as supply, crew, and utility boats used primarily for work on offshore rigs. The main source of revenue for workboat operations in the Gulf of Mexico comes from charters supporting oil and gas rigs.

Charter Types

Workboats typically operate under four types of charters: bareboat charter, time charter, term job charter, and spot job charter. While some larger companies such as Exxon have their own fleet of vessels, most companies rely on contracts with ship owners for their transportation needs.

For bareboat charters, the lessee acts as owner pro hac vice (literally, "for this turn," or for this occasion) during the contractual period. Under this type of contract, the lessee must crew and operate the ship during the period covered by the contract. Meanwhile, the ship owner is responsible only for delivering a seaworthy vessel.

A time charter provides the lessee sole access to the vessel for an agreed-upon period of time, but the ship owner is responsible for crewing and operating the vessel. A voyage charter requires the ship owner to crew and operate the vessel from one point to another. Under a master service agreement, a prearranged contract defines the terms (rates, insurance, length of contract, etc.) so lessees can contact boat owners on short notice for service at any time during the contractual period. Lessees may require the vessel for short or long projects, and the only negotiation required is for the logistics of that particular voyage.

Term job charters typically have a 20-day minimum agreement. Shorter charters, known as spot job charters, run three to five days in a flourishing economy. Given the realities of today's marketplace, however, spot job charters are now often running at a one-day minimum.

Bareboat charters are the least risky for lenders. Their customers, the boat owners, face reduced liability because they are not responsible for providing the workforce. The contract also provides guaranteed income for a set period of time.

Day Rates

Day rates represent the cost per day of usage, with the renter typically paying to replace fuel and lube before returning the vessel to its owner. Day rates are based on size, deck space, speed of the vessel, and length of the contract. On average, day rates have dropped in the past five years, but many in the industry predict a slight increase for 2012. Fluctuation in day rates is tied closely to the oil industry. Currently, day rates for crew boats range anywhere from $2,600 to $3,800, depending on vessel size. This has dropped dramatically from day rates five years ago, as depicted in the following table:

Lenders need to be aware of current day rates and projected trends because day rates represent a key element in a borrower's repayment ability. When analyzing the cash flow of prospective borrowers, lenders need to consider the volatility in day rates as the industry changes.

Effects of the Oil Industry on Marine Transportation

Many workboat companies rely heavily on the oil industry since work on the rigs constitutes a great portion of their day-to-day business. Approximately 80% of crew boats (smaller, faster vessels typically used to transport crew members to and from the rigs) operating in the Gulf of Mexico work in offshore oil, while approximately 60% of offshore vessels (bigger, slower boats used primarily to transport supplies, fuel, and water) in the Gulf are involved in the oil business. Although this business can be very lucrative for ship owners, government regulations, such as the drilling moratorium and strict requirements for obtaining drilling permits, can slow work in the Gulf. When drilling slows, fleet utilization drops and workboat companies must fight for a limited number of available jobs. This situation creates huge fluctuations in business for workboat companies as the oil industry experiences booms and busts.

Know Your Customer

As with any loan consideration, lenders strive to learn as much as possible about their prospective borrowers, and this is especially important when lending in the marine transportation industry. Workboats can cost upwards of several million dollars, and the value of these vessels varies greatly based on their condition and the state of the market that drives demand.

A 150-foot crew boat may have sold for $3.5 to $5 million five years ago, but may sell for significantly less today given less-than-favorable market conditions, especially if it has not been maintained properly. In addition to the cost of workboats, their revenue source is subject to extreme fluctuation. Ship owners are constantly facing new and improved technology and changes in government regulations. Success for large and small organizations depends on a sound understanding of the industry and the implementation of a solid business plan, regardless of fleet size.

Borrower's Business Background

Lenders need to be aware of a prospective borrower's experience in the industry and the specifics of the operation, as well as the background and reputation of the company and its owners. Many small, family-owned companies are passed down from one generation to the next. The owners and operators of these companies often have strong connections within the industry and a solid understanding of the inner workings of their company. However, a reputation for poor service or a history of accidents should raise a red flag and demand further investigation by the lender.

Training programs such as the Responsible Carrier Program, offered through the American Waterways Operators, are available to ship owners and operators. Accordingly, lenders should research training programs in which potential borrowers participate. Accidents and injuries cost companies lost time and financial penalties, some of which could be avoided with thorough training initiatives.

Competition

Both large international shipping corporations and small mom-and-pop companies operate in the Gulf of Mexico. This coexistence creates stiff competition, but each organizational structure has unique perks to offer customers. Many boat companies, large and small, run their office and operations in different locations. Lenders should know which ports borrowers plan to run their vessels from and then develop an understanding of the competition within that market.

Creditworthiness

Lenders should look at both current and past financial standing when reviewing a prospective borrower's financial statements. In the period between the Great Recession and the Deepwater Horizon disaster, many marine transportation companies faced difficult financial times. Borrowers must be able to explain how changes in the oil and gas industry have affected their ongoing operations and how their company is planning for unexpected changes in the future.

Some factors to consider when analyzing a company's ability to survive unforeseen changes in the oil and gas industry are leverage, liquidity, and diversification of operations. More diversified companies are better equipped to survive downturns. Highly leveraged companies are extremely susceptible to a financial crisis when downturns hit the oil and gas industry, even if their operations are diversified. Prudent lenders analyze the liquidity and leverage positions of prospective borrowers in order to understand their ability to absorb market downturns.

Underwriting

Lending standards within the marine transportation industry vary from one lending institution to another, but lenders overall have become more conservative in recent years. Indeed, they must take several factors into consideration when underwriting a workboat loan. The borrower's background and success within the industry affect underwriting, but lenders also need to focus on specific terms of the loan, the borrower's source of repayment, and collateral.

A debt-to-worth ratio of at least 4:1 is desirable when lending in the marine transportation industry. And with a current ratio of 1.5:1 or less, companies are better prepared for shrinking liquidity during a slowdown in business. Cash and cash equivalents are the key to reducing exposure in a down market.

Loan Structure

Loan structures vary among lending institutions financing marine vessels, but the average term within the industry is 15 years. Some lenders prefer to use a five-year balloon to reevaluate the credit while maintaining a 15-year amortization. Shorter amortization periods help mitigate the risk of a slowdown in business and can be extended in the event of market downturns. Equity requirements also vary from one lending institution to the next.

Richard Paine of Marine-Finance.com explains that, in the past, lenders could justify 100% financing; however, credit has since tightened.2 Today, most financial institutions require a minimum of 25% equity. Lenders will finance up to 75% of the lower of cost or value. Requiring a larger down payment, shorter terms, and a balloon payment at maturity all contribute to reducing credit risk.

Source of Repayment

All lenders attempt to gain an understanding of a borrower's source of repayment, and lending to the marine transportation industry is no different. Borrowers typically repay loans using cash flow from operations; however, in the case of marine transportation, operations vary, depending on the borrower's charter agreements. Regardless of charter type, income from operations fluctuates as day rates move up and down and the standard lengths of charter agreements change.

Debt service coverage is especially important when lending to the marine transportation industry because highly leveraged companies may face difficulty meeting all debt obligations if business slows. The industry average for current and historical debt service coverage ranges from 1.25X to 1.5X using a 15-year amortization period. Given the volatility inherent in the oil and gas industry, successful organizations will have minimal debt and a business plan that prepares the company for unforeseen market downturns.

Collateral

Workboats are expensive pieces of equipment, and owners should be very familiar with the care and upkeep required of the vessel. With proper maintenance, steel vessels (typically slower-running supply and crew boats) can last 40 years or more and aluminum vessels can last up to 20 or 30 years. However, vessels made of any material can deteriorate quickly if they are not well maintained. In addition to the financed vessel, borrowers may also offer collateral such as other vessels or pledges of liquid assets, which can help boost credit and further secure risky loans.

Insurance

Despite the lack of federal or state laws requiring commercial boat insurance, lenders should ensure that all financed vessels are adequately covered. Lawsuits arising from accidents or injuries onboard a vessel, if not insured properly, can financially devastate even the most solid company. At the very minimum, borrowers should insure the full value of the vessel as determined by an accredited marine surveyor and list the bank as loss payee on the insurance policy. Most companies that charter boats to work in the Gulf require a minimum of $10 million of liability insurance.

The three most common types of coverage are hull, protection and indemnity (P&I), and cargo. Physical damage to the vessel is covered under hull insurance. P&I covers employee injuries sustained onboard the vessel as well as collision liability issues. Cargo liability, which is usually included in the P&I section of an insurance policy, covers lost or damaged cargo resulting from negligence by the crew. A single policy typically incorporates hull, P&I, and cargo coverage.

Informed lenders also require breach-of-warranty coverage. Most policies restrict the vessel to operations within a certain area, and insurance companies can deny claims on any loss or damage sustained outside the territorial restriction. Breach-of-warranty coverage comes at an additional premium.

Legal Considerations and Documentation

The marine transportation industry is highly regulated and answers primarily to the U.S. Coast Guard, which runs the National Vessel Documentation Center. Companies of all sizes must follow safety requirements and building standards and stay current on documentation and certificates.

Flag and Certificates

Maritime flags represent the country in which a vessel is registered. In order to fly the U.S. flag, a vessel must be built in the United States and be owned by a U.S. citizen. Under the Jones Act, only U.S.-flagged vessels can transport goods from one domestic port to another.

U.S.-flagged vessels are documented by the Coast Guard, which, upon successful inspection, issues a Certificate of Documentation citing owners, restrictions, entitlements, and other critical information about the vessel. Some boat owners choose to register their vessels in a foreign country, known as a "flag of convenience," often for tax or operational purposes. For a vessel to work in the Gulf of Mexico, it must be documented by the U.S. Coast Guard. Therefore, bankers should ensure that any boat they finance is documented; otherwise, the vessel is not legally authorized to work in the Gulf.

Title and Survey

An Abstract of Title shows liens that currently exist on the vessel and outlines ownership of the boat. Lenders need to make certain the Abstract of Title lists the lender as the mortgagee. A condition and valuation survey summarizes the vessel's condition and lists the estimated value. Condition and valuation surveys also provide lenders with details of the vessel's classification. Classification societies set standards for the construction and operation of offshore vessels and periodically check to ensure that vessels meet these requirements. Borrowers should provide documentation proving the vessel is in class and meets all requirements.

First Preferred Ship's Mortgage

When lending for the purchase of a vessel, the lien is detailed in a First Preferred Ship's Mortgage. This mortgage requires the owner to properly insure the vessel, maintain certificates, remain documented under U.S. laws, and allow the mortgagee complete access to the vessel. The borrower should be listed as the vessel owner and the lender as mortgagee.

One important consideration when financing a new vessel is that a lien cannot be taken on a vessel during the construction period-a restriction that raises several security interest issues for lenders. However, lenders can protect their interests with vessel title insurance or through the use of state law lien provisions.

Collection Activities

If a borrower fails to make payments and the possibility of foreclosure approaches, the lender may face several unexpected issues regarding the vessel's value. First, if the vessel has been docked, looters and lienholders may have stolen valuable equipment from it. Second, vessels require a great deal of maintenance. Without proper care, they could deteriorate and require costly repairs to become seaworthy. And third, dockage rates accrue each day the vessel sits, leaving the lender with an additional cost once the time comes to sell or move the vessel. When lenders make the decision to commence collections, they have two methods available: judicial seizure and commercial seizure.

Judicial Seizure

In order to remove the vessel from the borrower's possession, a lender may choose to file a claim with the courts for a judicial seizure. This is an ex parte procedure, so the borrower does not have to be notified of the seizure until it actually occurs. Once the vessel leaves possession of the borrower, it is placed in the custody of the U.S. Marshal. Lenders can ask the court to grant a substitute custodian, but usually this proves financially beneficial only if the lender has several vessels in custody at once. While under custody of the U.S. government, the vessel cannot be moved unless the court grants an order that allows the vessel to be shifted for operational purposes.

Once the lender has filed the complaint against the vessel, its owner has a limited time in which to file an answer. If no one steps forward on behalf of the vessel within the allotted time, notices to lienholders are published and the lender can request permission for an interlocutory sale. In an interlocutory sale, the vessel is sold and converted into money before assets are divided among creditors. The interlocutory sale helps creditors sell the vessel at maximum value, because the longer it sits idle, the more value it will lose.

When proceeding with a judicial seizure, banks should request that the sale of the vessel occur quickly. Not only do lenders face the possibility of the vessel losing value over time, but they also incur custodial charges for each day the vessel spends in the custody of the U.S. Marshal. Lenders can petition the court for an appraisal of the vessel for purposes of setting a minimum bid at the judicial sale and/or for the opportunity to credit bid up to the amount of the indebtedness. In the right circumstances, this method allows the lender to maximize the sale price of the vessel without the risk of tying up additional funds.

Lenders typically prefer judicial seizure to commercial seizure because all liens are released once the judicial seizure is finalized. However, judicial seizures are costly; custodial charges add up quickly and attorneys' fees can easily reach $100,000 or more.

Commercial Seizure

In a commercial seizure, the lender takes control of the vessel without using the court system. The lender has ownership, and therefore liability, once the vessel is in its possession. This procedure requires more paperwork than a judicial seizure, but the lender avoids going through the legal system.

One risk that accompanies commercial seizure is that liens against the vessel may be unknown. Only with a judicial seizure does the vessel become free and clear of all outstanding liens. Also, the lender may be required to pay a dockage fee if the vessel was held at a dock prior to collection. In this case, lenders may choose to negotiate dockage fees first and then take an assignment on the outstanding portion owed.

Conclusion

Financing workboats in the Gulf of Mexico presents many risks and uncertainties, but lenders can mitigate those risks with conservative underwriting and a thorough understanding of the industry. Government regulations as well as natural and man-made disasters can quickly change the economic environment of the marine transportation industry.

Since revenue is derived from charters with the oil and gas industry, lenders must understand and monitor day rates because a change in these rates can impact the borrower's repayment ability. Loan agreements are suggested that govern minimum liquidity of at least 1.5:1 current assets to current liabilities and maximum leverage ratios of no more than 4:1 debt to worth. Borrowers with significant liquidity and low leverage are obviously better prepared to weather volatility.

The inherent risk in lending to this industry can be further mitigated by requiring a minimum 25% down payment and shorter amortization terms of 10 years or less, which can be extended to reduce debt service in the event of a downturn. Finally, monthly financial reports should be required to help lenders monitor their borrowers' changing financial conditions.

Prudent lenders can help protect their collateral by ensuring that the borrower adequately insure the vessel with a policy that includes hull, protection and indemnity, cargo, and breach-of-warranty coverage. The First Preferred Ship's Mortgage requires the ship owner to obtain and maintain proper insurance and stay current on Coast Guard vessel documentation regulations. Condition and valuation surveys provide lenders with an estimated value for the vessel as well as details of the vessel's classification. Liens against the vessel and current ownership information appear on an Abstract of Title, and lenders should ensure they are listed as mortgagee on this document.

As lenders learn about marine transportation, develop a thorough understanding of the risks involved, and explore methods of mitigating these risks, profitable lending relationships will develop and thrive.

Success for large and small organizations depends on a sound understanding of the industry and the implementation of a solid business plan, regardless of fleet size.

Despite the lack of federal or state laws requiring commercial boat insurance, lenders should ensure that all financed vessels are adequately covered.

One important consideration when financing a new vessel is that a lien cannot be taken on a vessel during the construction period.

This article is based on Suderman's first-place-winning entry in the RMA Chapters' 2011 Article Writing Competition.

Notes 1. The NAICS code for this industry is 488390.

2. E-mail from Richard Paine, January 18, 2011.

References

Acosta, Trey. Sales and Logistics, Boat Service of Galveston. Personal interviews (November 2010-January 2011).

Barker, Craig. Chief Credit Officer, Moody National Bank. Personal interviews (November 2010-January 2011).

Flanagan, Art. Senior Vice President, HUB International. Personal interview (December 14, 2010).

Glen, Bill. Attorney, Royston Razor. Personal interviews (December 2010-January 2011).

Mencacci, Leo. Sales, Bay Houston Towing. Personal interview (November 8, 2010).Mencacci, Leo. Sales, Bay Houston Towing. Personal interview (November 8, 2010).

Paine, Richard. "What You & Your CFO Should Know." Marine News, June 28, 2010. Available at http://www.marinelink.com/news/ should-your-what334716.aspx.

Paine, Richard. Personal interview by e-mail ( January 18, 2011).

Raia, M. "Marine Insurance 101." Pacific Maritime, 2010, 8, pp. 24-25.

Suderman, Don. President, Suderman Contracting Stevedores, Inc. Personal interviews (November 2010-January 2011).

U.S. Coast Guard website (www.uscg.mil).

Lauren Suderman is a lender at Moody National Bank, Galveston, Texas. She can be reached at [email protected] or 409-765-5561, ext. 5201.

Lauren Suderman is a lender at Moody National Bank, Galveston, Texas. (Her article can be found on page 42)