Insolvent Horizon refits old Jones Act ships in foreign shipyards
by Michael Hansen, President, Hawaii Shippers Council
Financially troubled domestic ocean carrier Horizon Lines Inc. announced May 10th that it has again posted significant losses from continuing operations; and, in a direct rebuff to U.S. shipyards, it will refit three of its ageing containerships in Asia hypocritically skirting the so-called “second proviso” of the Jones Act in an attempt to upgrade their fleet.
Horizon is a Jones Act common carrier operating fifteen elderly U.S.-built U.S.-Flag containerships in three domestic trades – Alaska, Hawaii and Puerto Rico – averaging 35 years of age (compared to a 12 year average age for the international fleet). In the domestic Hawaii trade, Horizon is the number two carrier with approximately a third of the volume, and Matson Navigation Company Inc., is the dominate carrier with about a two-thirds share.
April 2012 Restructuring
Only a month ago, in April 2012, Horizon announced that it had completed a comprehensive financial restructuring: (i) essentially wiping out their existing shareholders and issuing them a token 1.4% of the restructured company; (ii) converting existing bond holders to equity as share or warrant holders and issuing them an additional 5.1% of new stock; and, (iii) terminating their long term bare boat charters of five Foreign-Built U.S.-Flag containerships (2824 TEU each built Korea 2006 and 2007) that they had been employed in their Trans-Pacific / Guam service which was terminated in November 2011.
The latter transaction incurred a significant penalty: the original owners of the five ships, Ship Finance International Limited, will receive as termination compensation $40 million in second lien notes issued by Horizon Lines and warrants exercisable into ten percent of the common stock of Horizon. All told, the restructuring reduced Horizon’s total funded debt from approximately $593 million as of March 31, 2012 to approximately $404 million.
To put their current debt after restructuring in perspective, Horizon reported for the full fiscal year ended December 25, 2011, operating revenue from continuing operations of $1.03 billion ($1.0 billion for fiscal 2010) and a net loss from continuing operations of $53.2 million ($35.6 million for fiscal 2010). At March 31st, Horizon’s total liabilities of $828,580,000 significantly exceeded its total assets of $640,746,000 making it balance sheet or accounting-wise insolvent with a debt ratio of 1.29 (a debt ratio over 0.5 is considered highly leveraged).
First Quarter 2012 Results
Horizon posted losses from continuing operations for the first quarter of 2012 that increased 28.0% from same period last year. While operating revenue rose 9.1% year-over-year operating expenses increased almost as much at 7.3%. This suggests that Horizon is having some difficulty containing its operating costs and would seem to portend continuing losses at least through the end of this calendar year.
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Horizon Lines Inc. – Comparative First Quarter Financial GAAP Results
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Description
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Q1 2012
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Q1 2011
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Difference
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Increase
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Operating Revenue
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$263,354,000
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$240,700,000
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$22,654,000
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9.1%
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Operating Expenses
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$269,418,000
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$250,076,000
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$18,342,000
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7.3%
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Other Expenses
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$30,130,000
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$22,700,000
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$7,430,000
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32.7%
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Net (loss) from continuing operations before taxes
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($26,505,000)
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($20,706,000)
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$5,799,000
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28.0%
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After three straight years of losses, unless Horizon can turn their operation around and become profitable, their extraordinarily heavy debt load combined with continuing losses can only mean that the company will ultimately not be successful.
In addition to achieving profitability, Horizon also desperately needs to replace its ageing fleet with modern containerships to remain an operating company. However, they cannot afford U.S.-Built new construction prices, which are typically three times those for ships built in a Japanese or South Korean shipyard. And, they cannot build foreign because it’s prohibited by the Jones Act. As a result, Horizon appears to have adopted a strategy of refitting their elderly ships in foreign shipyards.
Foreign Rebuilding
To address the problem of the ageing ships, Horizon also announced that it would send three of its four containerships currently employed in the Puerto Rico trade to dry-dock in Asia for major refits. It is likely those refits will border on rebuilding as defined by the Jones Act second proviso. The four ships, which average 40 years of age, are shown in the following table:
Horizon Lines Inc. – Domestic Puerto Rico Trade Fleet
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P Elizabeth NJ / S Juan PR
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This announcement came only a fortnight after a statement released by Horizon on April 27th, in which its President Stephan Fraser reaffirmed their support for the Jones Act in generic boilerplate language that left most observers wondering what its purpose was.
In retrospect, it now appears clear that Mr. Fraser was attempting to inoculate his company from their forthcoming announcement that they would be sending three ships to Asian shipyards skirting the so-called “second proviso” of the Jones Act, which would be sure to raise the hackles of the U.S. shipyards and perhaps other Jones Act shipowners, especially Pasha Hawaii Transport Lines LLC who are currently building a ship in the U.S. for the Hawaii trade.
Jones Act industry interests invariable state that they support U.S. ship repair yards. However, sending three ships for what amounts to a major refit if not rebuilding in Asia does not indicate strong support for that part of the Jones Act which applies to foreign rebuilding known as its “Second Proviso.” In fact, despite their statements to the contrary, the U.S. shipowners’ support for domestic ship repair yards has weakened substantially over time. As the curmudgeonly Tim Colton, a respected expert in U.S. shipbuilding, said in his Colton Company – Maritime Memo blog on May 11th Horizon’s action is utterly hypocritical in view of their recent statement.
To successfully effect the foreign refits, Horizon’s technical staff will have to be very careful not to exceed Jones Act prohibitions on foreign rebuilding of a coastwise vessel. If the work is more extensive than allowed by current law and regulation the vessel could lose its coastwise privileges and no longer be allowed to engage in domestic Jones Act service. Other Jones Act shipowners including Matson have been challenged in court by the U.S. shipyards when extensive work was carried out in a foreign yard; typically the challenges seek to strip the ship of its coastwise privileges claiming the work exceeded the limits and it can no longer be considered U.S.-Built, a key Jones Act requirement.
Regarding a previous foreign refit of a Matson ship in a Chinese shipyard, Rajesh Joshi reported in Lloyds List on November 23, 2006, there was, “domestic outrage over Jones Act shipowners getting 'cheap' repairs at foreign yards, and still reaping the cabotage law's commercial reward…..” He further explained, the Shipbuilders Council of America Inc., “wants Jones Act ships to be repaired in US yards, and to prohibit owners such as Matson from charging higher cabotage freight rates on ships repaired overseas. While repairing ships overseas is cheaper than corresponding US prices, charter [and freight] rates on the protected Jones Act routes are much higher than in global lanes.”
Jones Act Second Proviso
First enacted in 1956 (P.L. 84-714) to stop U.S. shipowners from “rebuilding” their Jones Act vessels abroad and subsequently operating them in the protected coastwise trades, and later amended in 1960 (P.L. No. 86-583) and 1988 (P.L. No. 100-239), the so-called Jones Act Second Proviso was codified in 2006 at 46 U.S.C. §§ 12101 (a) and 12132 (b), and provides:
§ 12101. Definitions
(a) REBUIILT IN THE UNITED STATES. – In this chapter, a vessel is deemed to have been rebuilt in the United States only if the entire rebuilding including the construction of any major component of the hull or superstructure was done in the United States.
§ 12132. Loss of coastwise trade privileges
(b) REBUILT OUTSIDE THE UNITED STATES. – A vessel eligible to engage in the coastwise trade and later rebuilt outside the United States may not thereafter engage in the coastwise trade.
The most recent regulations implementing the Jones Act Second Proviso were adopted in 1996 and is at 46 C.F.R. § 67.177 and includes a two-part test to determine whether a vessel has been rebuilt foreign and procedures for vessel owners to apply for rebuild determinations.
A vessel is deemed rebuilt foreign when any considerable part of its hull or superstructure is built upon or substantially altered outside of the United States in determining whether a vessel is rebuilt foreign, the following parameters apply:
(a) Regardless of its material of construction, a vessel is determined rebuilt when a major component of the hull or superstructure not built in the United States is added to the vessel.
(b) For a vessel of which the hull and superstructure is constructed of steel or aluminum –
(1) A vessel is deemed rebuilt when work performed on its hull or superstructure constitutes more than 10 percent of the vessel’s steelweight, prior to the work, known as discounted lightship weight.
(2) A vessel may be considered rebuilt when work performed on its hull or superstructure constitutes more than 7.5 percent but not more than 10 percent of the vessel’s steelweight prior to the work.
(3) A vessel is not considered rebuilt when work performed on its hull or superstructure constitutes 7.5 percent or less of the vessel’s steelweight prior to the work.
There is a good deal of ambiguity in these regulations. While hull and superstructure are well defined in regulation, major component is not and by past practice, the U.S. Coast Guard has adopted a 1.5% of discounted lightship weight rule for any single piece. And, there is a discretionary range for all foreign work performed between 7.5% and 10% of discounted lightship weight to be considered a rebuilding, which has come to be known as the “grey area.”
Matson’s 2006 Mokihana Foreign Refit
The process of refitting a Jones Act ship in a foreign shipyard is fraught with problems and the risk of the ship losing its coastwise privileges, which the following case will demonstrate.
In 2004 Matson launched a program to refit three of its containerships earlier acquired from American President Lines (APL) -- the Mokihana, Mahimahi and Manoa -- in a Chinese shipyard. The ships were built as fully cellular containerships in New Orleans in the 1980’s with Construction Differential Subsidy (CDS) funds to operate exclusively in the foreign trade, but became eligible for the coastwise trade after turning 20 years old.
Prior to initiating the foreign work, Matson obtained the necessary authorization from the U.S. Coast Guards (USCG)’s National Vessel Documentation Center (NVDC), which administers these matters. The NVDC issued a preliminary rebuilding decision that determined Matson’s proposed conversion to combination ship with partial roll-on/roll-off (Ro/Ro) multi-deck car garages aft would not contravene the Jones Act Second Proviso based on the technical data Matson submitted stating the work would constitute 6.7 % of steelweight.
Reportedly, conversion of the three ships would double Matson’s vehicle carrying capacity in the Hawaii trade, when Pasha Hawaii Transport Line LLC was beginning operation with its newbuilding a pure vehicle carrier, the Jeane Anne, and were considering construction of a second vessel, the Marjorie C, a combination vehicle-container carrier, in the U.S.
The first of the three ships scheduled for conversion in China – the Mokihana –arrived at COSCO Shipyard Co. in the Chinese port of Nantong in November 2006. The ship sailed April 2007 to Alabama, where the remainder of the $17-million project was completed by Atlantic Marine. The Mokihana entered Matson's Hawaii service in the summer of 2007 with a vehicle carrying capacity of 1,340.
On November 16, 2006, The Shipbuilders Council of America and Pasha Hawaii filed a suit in U.S. District Court for the Eastern District of Virginia against the U.S. Coast Guard, the National Vessel Documentation Center and the Department of Homeland Security alleging that the foreign work will exceed 12.3% of the steelweight and asked the court to declare the ship as rebuilt in a foreign place and not eligible for the coastwise trade if the conversion work is carried out in China. The USCG obtained a dismissal because its preliminary rebuilding decision did not constitute the agency’s final action.
Subsequently, after the foreign work was completed, the USCG found the overall steel work constituted 7.3% of the discounted lightship weight, which is just within 7.5% limit, and the largest single new piece added to the ship weighed 0.22% of the discounted lightship weight, which was well within 1.5% rule. Had the USCG found the overall steel work was just 0.2% greater, Matson would have been facing the grey area between 7.5 and 10.0% and the ship’s coastwise privileges would have been at risk.
Foreign Repair Entry and Duty
Foreign shipyard and ship repair work performed and equipment installed on U.S.-Flag vessels outside of the United States is subject to declaration, entry and payment of a 50% ad valorem duty upon arrival at the ships first U.S. port of entry after the repairs were made. This requirement will apply to the work performed in Asia to refit Horizon’s ships.
As the Marine Log reported on May 11, 2012,”it [Horizon’s foreign refit plan] is likely to be viewed with concern by U.S. shipbuilders who will undoubtedly closely monitor how much U.S. duty the Jones Act operator pays on the work involved.” The U.S. shipbuilding and repair yards will want to ensure that Horizon pays all the relevant duty on its proposed foreign refitting in retribution for avoiding their services.
The application of duty to foreign equipment and repairs was first instituted by Section 466, Tariff Act of 1930, as amended and codified at 19 U.S.C. § 1466, and aims to provide opportunities for U.S. shipyards by assessing a high rate of duty on all repairs to U.S.-flag vessels in foreign yards. The Tariff Act of 1930, commonly known as the Smoot Hawley Tariff, is widely thought to have been one of the key causes of the Great Depression during the 1930’s.
Shipowners are required to declare all equipment, materials, and parts purchased for and repairs made to the vessel upon her first arrival at a United States port. Within 10 calendar days, the vessel must file a formal entry and may subsequently file an application for relief from the duty for items falling within allowed exemptions. The repair duty requires substantial compliance efforts by shipowners and represents a burdensome cost disadvantage to U.S. shipowners, many of whom nevertheless opt to repair their vessels outside of the United States because of the cost and perceived quality advantages of foreign yards.
The vessels subject to these requirements include those documented under U.S. law for the foreign or coastwise trades, as well as those which were previously documented under the laws of some foreign nation or are undocumented at the time that foreign shipyard repairs are performed, but for which the owner intends to engage in those trades
Conclusion
In all likelihood, Horizon doesn’t have any other option other than refitting their ships in foreign shipyards, given their precarious financial position, the very high cost of U.S.-Built ships, the restrictions of the Jones Act, and need to modernize their ageing fleet of 15 containerships.
There will be long and expensive voyages to deliver the ships from Puerto Rico to a shipyard in Asia, and return them to their operating area in the Atlantic. As Horizon’s Fraser said in his May 10th press release, “Although dry-docking our vessels in Asia will add considerable transit expense in 2012, it will also facilitate extensive maintenance and high-quality enhancements that are instrumental in helping maintain service integrity in the Puerto Rico market."
Despite all the costs – transit expense, duty on foreign repairs, and the risk of legal challenges to the ships coastwise eligibility – Horizon and other Jones Act shipowners still find it more advantageous to send a Jones Act ship halfway around the world to a foreign shipyard in Asia to refit it. All of this is to avoid the high cost of U.S. shipbuilding and repair.
None of this makes any practical sense. Extending the life of ships that are already long past the end of their useful life is not a wise option for these shipowners or their customers in the noncontiguous jurisdictions of Alaska, Guam, Hawaii and Puerto Rico. Horizon’s refitting of 40 year old ships may add another five years or so of useful life.
Horizon’s refit costs will certainly be similar if not greater than Matson’s cost to refit the Mokihana in 2006, which Matson disclosed was $17.0 million. And, this number may not include transit expense and duty. For less than twice Matson’s cost to refit the Mokihana in 2006 – perhaps in the $25 to $30 million price range – these U.S. shipowners could purchase efficient modern newbuildings in Japan or South Korea with a full life ahead of them.
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