While the rise and rise of Chinese leasing companies has stolen the headlines, the Japanese Operating Lease with Call Option (JOLCO) has been gaining popularity as a means of financing and refinancing vessels in recent years. In this article we explore the basic structure of a JOLCO, the reasons for the rise of JOLCO structures in the maritime sector, as well as the risks associated with this form of alternative financing.
Under a typical JOLCO transaction, the vessel in question is sold to an offshore-registered special purpose vehicle (SPV), which will cover any "flag of convenience" benefits required and pay 100% of the value of the asset. This entity, in turn, will sell the economic interest in the ship to a second, usually Japan-registered SPV. Both the offshore and Japan-registered SPVs are usually controlled by a Japanese lessor (sizeable lessors include the publicly-listed Fuyo General Lease Co., Ltd, NTT Finance Corp and Financial Products Group Co., Ltd, amongst others).
The Japanese SPV will raise capital to finance the transaction, usually under the "usual" 70/30 split between debt and equity. Debt providers will be provided with security including the vessel mortgage, insurance assignments and charter hire assignment. The equity portion is raised from Japanese investors, primarily small and medium enterprises, who benefit from offsetting taxes on the profits of their core businesses against the losses/costs incurred by the SPV, including accelerated depreciation. Finally, the vessel is leased back to the operator/charterer (or its SPV).
JOLCO structures come with a call option to purchase the asset prior to the end of the lease to protect the investors from open-ended asset risk; while not compulsory, under JOLCO structures, lessees are very much expected to exercise the call option.
Since 2016, there has been an increasing trend of traditional Japanese tonnage providers opting for shorter charter terms, seemingly in response to a series of defaults or rates renegotiations by supposedly blue-chip ship operators/charterers. This has undoubtedly impacted the traditional Japanese ship finance model, creating uncertainties in employment and potential future cash flows.
These challenges have come against a backdrop of tighter lending terms by traditional ship financiers, or complete withdrawals of lending in certain cases, which have contributed to the popularity of alternative financing. JOLCOs have also benefitted from the demand from Japanese investors for improved returns from a wider range of investment products.
For asset sellers, the JOLCO structures often compare favourably with the Chinese leasing models, with 100% financing provided at attractive terms, generated by the added tax/depreciation benefits for Japanese investors in the funds. Chinese leasing models, in comparison, can offer more flexibility, particularly with regards to options, with less pressure to buy the asset at the end of the lease period.
With the various parties to JOLCO agreements locked into an arrangement which could be as long as 10 years in duration, JOLCO arrangers have a significant forward risk in terms of their counterparties, in addition to residual value and interest rate concerns. Due to this, the products are strictly regulated in Japan, and relatively inflexible with regard to terms. JOLCO issuers tend to be highly selective when it comes to onboarding deals, not least due to the need to ensure the asset can be certified to meet the aforementioned specialised tax depreciation benefits. However, the seemingly greater appetite of Japanese investors for shipping-related JOLCO projects that involve foreign lessees, and arguably less transparent, and potentially higher-risk, options, is worth monitoring.
JOLCOs themselves are also a relatively complex financial instrument, often involving multiple onshore and offshore-registered parties of which little is known. With Japanese private companies not required to file details of shareholders, such structures present challenges to compliance departments seeking to establish Ultimate Beneficial Ownership, for example. It is also worth noting that the SPVs used to hold legal and economic title to the ship(s) tend to be transaction specific and, barring an exceptional input from the Japanese arranging house, have no means of supporting themselves financially - i.e. if the lessee/charterer defaults, the SPVs are also likely to default on their obligations to lenders and investors. The lenders are likely to repossess the vessel concerned. Whether the lender will be able to recover funds from the charterer will depend on the security provided when the transaction was entered into.
Despite the strict regulations surrounding JOLCOs, the products are not immune from the complexities of the shipping markets. An example of such complications can be found in the case of the newbuilding containership mv MSC Bianca. The vessel was commissioned by SinOceanic Group Ltd on the back of a long-term charter to MSC Mediterranean Shipping Company SA. The vessel was subjected to a JOLCO financing upon its delivery, with legal ownership transferred to FPG Shipholding Liberia 16 SA, a company regarded as having been established by controlled by Financial Products Group Co., Ltd. While all of these parties are well known, press reports stated that the mv MSC Bianca was reportedly delivered with construction finance debt unpaid and was arrested at sea by coastguards in Chinese waters. SinOceanic Group Ltd, MSC and Financial Products Group Co., Ltd were reportedly unaware of the claims, which resulted in significant operational disruption.
As the use of JOLCO financing increases, it will be critical for parties exposed to the transaction (directly or indirectly) to keep abreast of the risks involved. Infospectrum has been asked on many occasions to provide meaningful assessments of the counterparties in JOLCO transactions, with our AsiaPacific and European offices building up strong contact networks in this area.