The Impact of Choice of Flag on Ship Management

Chapter 20

The Impact of Choice of Flag on Ship Management

Kyriaki Mitroussi and Peter Marlow*

1. Introduction

Ship registration, primarily a requirement under international law, evolved especially after the second half of the twentieth century into an important and at times quite complex commercial decision for ship owners. This change of nature of ship registration from a legal condition to a business choice, largely effected by the absence of universally binding provisions to determine the “genuine link” between the flag state and the ship and by successful and quick industry response to market pressures and opportunities, has had a number of consequences at company, industry, national and international level. Ship owners were presented with an array of flag types and actual flags in which freely to register their vessels; the industry found a means to improve its competitiveness but also ended up with increased and serious safety concerns; some nations came up with a way to earn revenue and gain some political significance, while others were confronted with a national threat along these same lines; at an international level, new sources of supply of labour were developed with transfer of expertise and dynamics changed. The major issue has of course been the proliferation of the open registers regime designed and established to provide mainly a cost reduction service to ship operators in relation to the option of traditional national flags. Today the top 35 maritime countries account for 95.35% of the world deadweight tonnage and 67% of this is under a foreign flag, a figure which drops to 53.7% when the number of vessels is considered (UNCTAD, 2008).

Although other types of ship registration have sprung up, like the second or international registers, the main dichotomy has been between flags of convenience and traditional national flags and the choice between the two has constituted a topical subject for research. Various myths and realities have been widely explored. In the course of research and with the passing of time some have been verified, others have failed to point to safe conclusions and yet for others new scope of thought has been triggered. For example, the significant reductions in crew costs advocated by open registers can be said to be an everyday reality felt by ship owners around the world and manifested clearly in relevant research stipulating that crew cost differences between selected EU flags and lower-cost open registry vessels, for instance, range from +22% to +333% (Anon, 1995). Open registers have conventionally been associated with poorer safety performance than traditional flags and some research results have provided support to this assumption (Li and Wonham, 1999; Alderton and Winchester, 2002). Yet, today some of the most important open registries, like Liberia, Malta, Cyprus, and the Bahamas are on the White List of the Paris MOU together with important traditional flags like Greece, USA and the UK, while the most important open registry, Panama, with 22.6% of the world tonnage registered in it is on the former’s Black List (Paris, MOU 2007; UNCTAD, 2008). The unprecedented growth of open registries has alarmed traditional maritime nations which have seen their own flags retrenching with direct and indirect economic, political and national repercussions. A study by Peeters et al. (1994), however, exhibited another dimension to the problem concluding that 70% of the value added by the Dutch shipping industry actually came from onshore activities related to shipping, a finding which was reflected in the new shipping policy introduced in 1996 in the Netherlands. Overall, the examination of the two types of flags has centred on their costs and benefits, their standing in the shipping industry and, in a wider social context, selection criteria, fiscal implications and safety issues.

The two types of flags have been seen to offer two distinct alternatives to ship operators, each with its own advantages and disadvantages and with its own commercial and operational requirements. It is within these realms that the view is taken that flag choice has a bearing also on various management issues in shipping companies. The argument put forward is that opting for a specific type of flag is in fact a strategic business decision with broader consequences for ship management. The aim of this chapter is to address the issue of choice of flag in the context of ship management with the object of assessing its expected impact on management principles and practices. For the purpose of the analysis the traditional, clear-cut distinction between national flags and flags of convenience has been chosen to form the framework of reference. Their noted features and/or requirements are considered in respect of the way they can affect management decisions and the adoption of management approaches. The discussion is based on the case where the flag choice decision is made by the same entity that is both responsible for and also essentially carrying out the management of the vessels. In other words, the analysis relates to the paradigm of the ship owner who is at the same time the ship operator – even if this is concealed by the corporate veil. It does not seek to address the situation where third party ship managers are used and where an association between flag choice and management practice might be differentiated (or not) because of a number of reasons inherent in the characteristics of the service they provide. The subject matter is treated on a theoretical basis developing a rationale founded on critical analysis and appreciating that the influence between the choice of flag and management functions can potentially be twofold and may come from either direction.

Initially, this chapter will set the context of the analysis by looking into the existing literature on ship registration reviewing the different characteristics, conditions, benefits and constraints of the range of ship flags available to ship owners. The authors will then make a case that the choice of flag is a management decision by examining different management dimensions which are related to it. Analytic discussion of the effects of flag preference on managerial aspects will follow; the analysis will focus particularly on the practical impact which the choice between an open register and a national flag is expected to have on management issues relating mainly to strategic management and human resource management. Lastly, an evaluation of the current standing of open and national registries will be presented together with a critical assessment of its effect on contemporary ship management.

2. Literature Review and Background

Since its first significant appearance in the 1950s, flagging out – the change of a vessel’s registry from a national flag to a flag of convenience or open registry – has been a topic of interest in the international shipping industry. This now widespread phenomenon has attracted a great deal of attention for a variety of reasons. First, open registry fleets have expanded at a faster rate than any other fleet in the world. Secondly, it has been felt that the expansion of the open registry has limited the growth of the fleets of other countries and has caused the decline of the fleets of the traditional maritime countries with all the related consequences for their maritime clusters, the balance of payments, and the supply of skilled labour.

According to Boczek (1962) a FoC can be defined as: “the flag of any country allowing the registration of foreign-owned and foreign controlled vessels under conditions which, for whatever reasons, are convenient and opportune for the persons who are registering the vessels”. However, this definition still does not allow the clear identification of an open registry flag. Even the Rochdale Report (1970) did not give a precise definition of flags of convenience but instead suggested a list of criteria which should lead to the classification of these. It defined the FoCs in terms of six common characteristics:

  • the country of registry allows ownership and/or control of its merchant vessels by non nationals;
  • access to the registry is easy and transfer from the registry at the owner’s option is not restricted;
  • taxes on the income from the ships are not levied locally or are low. A registration fee and an annual fee, based on tonnage are normally the only charge made;
  • the country of registry is a small power with no national requirement under any foreseeable circumstances for all the shipping registered, but receipts from very small charges on large tonnage may produce a substantial effect on its national income and balance of payments;
  • manning of ships by non-nationals is freely permitted; and
  • the country of registry has neither the power nor the administrative machinery effectively to impose any government or international regulations, nor has the country the wish or the power to control the companies themselves.

The Report continues that although one or more of the above features may be found in the policies of many maritime countries, it is only when all of these features exist that a country is characterised as being an open register.

Metaxas and Doganis (1976) identified as a FoC: “the national flags of those states with whom ship owners register their vessels in order to avoid the fiscal obligations and the conditions and the terms of employment of factors of production, that would have been applicable if their ships were registered in their own countries.” While Bergstrand (1983) adopted the following definition: “A flag of convenience is a flag of a state whose government sees registration not as a procedure necessary in order to impose sovereignty and hence control over its shipping but as a service which can be sold to foreign ship owners wishing to escape the fiscal or other consequences of registration under their own flags.”

The United Nations Convention on the Conditions for Registration of Ships (1986), for the first time defined the principles to be followed when granting nationality to a ship. The existence of a genuine link between a vessel and its country of registry must be verified on the basis of the following characteristics:

  • the merchant fleet contributes to the national economy of the country;
  • revenues and expenditure of shipping, as well as the purchases and sales of vessels, are treated in the national balance of payments accounts;
  • the employment of nationals on vessels;
  • the beneficial ownership of the vessel.

This chapter will adopt a definition of “open register” which reflects the matters that most concern the ship owners, such as: costs, accessibility of the register and standards enforced by the state of registry. Therefore, an open registry should be identified as a flag which allows:

  1. Lower crewing costs/manning requirements, since registration under a flag of convenience generally means:

    • unrestricted choice of crew in the international market;
    • not being subject to onerous national wage scales; and
    • more relaxed manning rules.

  2. Lower operating costs generated by “lighter” maintenance programmes and less stringent enforcement of safety standards imposed by the register.
  3. Less regulatory control and avoidance of bureaucracy.
  4. The probable avoidance of corporate tax.
  5. Anonymity.
  6. Easy accessibility/exit to/from the registry.

Nowadays, even though traditional maritime countries continue to dominate the ownership of world shipping, the extent of flagging out to Open Registries is such that they account for a greater proportion of the total world fleet than the traditional maritime countries themselves. The share of world deadweight tonnage registered in the major Open Registries has risen from about 4% in 1950 to over 54% in 2008 (UNCTAD, Review of Maritime Transport 2008). There exists no clear definition of “open and international registries” but UNCTAD has created such a group by including the 10 largest fleets with more than 90% of foreign-controlled tonnage. These fleets are Panama, Liberia, Bahamas, the Marshall Islands, Malta, Cyprus, the Isle of Man, Antigua and Barbuda, Bermuda, and Saint Vincent and the Grenadines.

The motivation for transferring a ship from one registry to another is no different in principle from the motivation behind any other strategic decision on the part of a profit-maximising firm. The basic principles of the theory of the firm can be applied to the economics of this behaviour. Shipping companies are assumed to be profit maximisers which strive to reach their objective by seeking the production input combination which allows them to minimise costs. However, their choice of factors of production is constrained by their operating environment. Institutional factors and the characteristics of the market in which they operate condition their ability to make independent decisions. The selection of factors, their quantities, their costs and quality appear to be regulated in most of the so-called developed countries.

However, the existence of open registries creates a sort of dualism in the international maritime transport sector splitting the industry into two segments distinguished by operating characteristics peculiar to the two different scenarios and by lower break-even points. The ship owner like any other entrepreneur must chose the optimum amount of inputs to obtain the desired service output and strives to have the freedom to do so. Flagging out is primarily caused by the desire to minimise costs under a relatively lower cost regime but, as we shall see, the decision to flag out might have an impact on several ship management functions.

Flag selection is a high-level decision usually made, on a vessel-by-vessel basis, at the time of vessel acquisition and is generally based on experience. Different companies perceive different factors as being important to their decision on flag (Bergantino and Marlow, 1998). A flag might be chosen for political reasons, to ensure a supply of skilled labour, for public relations reasons, for historical reasons, because of directives from financial institutions, or for reasons related to the trade routes of the vessel or to its characteristics. In the Bergantino and Marlow study companies which had chosen not to use the national flag gave crew costs as the most common reason for their decision. Other factors which had influenced them were: to escape bureaucratic control, high costs of compliance with standards of the national flag, the unavailability of skilled labour (the need to ensure a supply of same), and fiscal reasons.

In particular, operating costs1 are identified as the ones where significant savings would be achieved by registering the ship in an Open Register. It is in the manning costs area where flagging out policies allow varying degrees of freedom to be obtained from the constraints of Union agreements and national manning regulations. Hence, according to the vast majority of authors,2 shipowners, shipowners’ associations and trade union representatives, the main reason for flagging out is to reduce manning costs. It has been stated by many authors that the adoption of an open registry flag can lead to savings in the following categories of crew-related costs:

  • direct and indirect wages;3
  • stores;
  • maintenance.

The authors share the belief that crew costs can be considered as the main financial reason behind the ship owner’s decision to flag out. The cost of manning a ship can be considered the easiest variable to influence when compared to other ship costs which appear to be mostly fixed internationally, especially in the short run. Stores costs are not as relevant as the other two categories and, furthermore, the adoption of an open register flag does not necessarily imply a decrease in this category of cost. As for the maintenance costs it is argued that while some crews can carry out certain tasks within the vessel, thereby eliminating the use of shore labour, others cannot and the lack of such maintenance and the subsequent neglect may lead to major damage claims and therefore higher insurance costs. Operating efficiency could, therefore, depend on the quality of the crew.

Manning costs have two components which are considered of equal importance: the direct and the indirect wage. The basic wage depends on the standard of living in the country of origin of the seaman, on the current exchange rate of the seaman’s currency against the US dollar, and on international regulation and ITF policies framed to avoid the exploitation of the FoC crews. Indirect wage costs are those which do not represent immediate payment to the employed and are set independently by single national governments with regard to national seafarers (i.e. national insurance payment, leave entitlement, pensions, training, employment taxes, medical expenses, and so on). Therefore, the indirect wage is the element of the manning costs where different national policies could have a strong impact on the ship owners’ decisions regarding flag.

By adopting a flag of convenience the ship owner gains the ability to offer contracts with gross salaries, transferring the responsibility for pension provision, social security costs and coverage of medical expenses to the employee. At the same time employment conditions such as lengths of duty and leave could be re-negotiated on an individual basis. The governments of most of the traditional maritime countries have modified their policies to move them closer to the situation created by the legislation of the Open Registry countries. This has led to the introduction of second or international registers but these will not feature as the focus of this chapter.

A group of factors that might influence the shipowner’s decision, but which have been partly ignored by the existing literature, are the characteristics of the shipping companies and of the ships. It is observed that only some companies of the same nationality decide to flag out, and that the decision to flag out might concern either all or only part of the fleet of the same shipping company. In the next section flag choice as a management decision will be discussed.

3. Flag Choice as a Management Decision

However straightforward the attribution of nationality to a ship may initially sound, the reality described in the previous section clearly shows the variety of alternatives ship owners have at their disposal and the diversity of parameters that have to be taken into account. It is this absence of externally imposed legal conditions, this aspect of informed and educated choice between alternatives that, first of all, makes the preference for a specific type of registry a management decision. Previous research (Bergantino and Marlow, 1998) showed that ship owners are driven in their choice of flag by certain criteria many of which can be seen to be related to management issues, such as marketing considerations or the decision to reduce input costs, i.e. crew costs. However there seems to be another direction in this relationship; the dimensions along which flags differentiate touch upon management issues and therefore flag choice can have an effect on management practices, too. In fact, the direction of such associations can become quite blurred, especially given that the choice of flag tends to be based on different sets of criteria for individual ship owners and individual ships (Bergantino and Marlow, 1998). Within these realms the focus here will be on identifying general management areas which are expected to be influenced by ship owners’ choice of registry for their vessels.

Firstly, the choice of a ship’s flag is very likely to affect the location of the management company itself. Traditionally, the nationality of a vessel has been connected with the nationality of its owner but well-known developments in the international shipping scene have brought about the evolution of the ship registration system and the plethora of registration schemes, procedures and requirements. Although, as already pointed out, there is no international legal instrument that lays down universally accepted registration provisions, the United Nations Convention on the Conditions for the Registration of Ships, 1986 – which is not in force and possibly never will be – provides some useful guidance. Articles 7–10 (UN 1986) call for participation by nationals of the flag state in the ownership, manning and management of the ships; either the ownership or manning criterion has to be satisfied but the management criterion is to be satisfied in all cases. Many nations appear to have indeed taken up – part of – its content at their discretion and to various degrees and today a number of registries require some form of commercial presence in the country. In some cases, such as Liberia, the requirement for a Liberian shipowning company can be easily satisfied by setting it up there only on paper and so it is not thought to have any significant impact on management. In other cases, like the Dutch registry, ships must be managed in that same country, a condition with important management implications. Such implications relate to the general legal framework of company operation prevalent in the country but also to the wider cultural characteristics which should be taken into account. On the assumption that local management companies will be staffed mostly by indigenous expertise, management action should take into account the special features of its human resource as conditioned by cultural differences. Hofstede’s work (1980), on how national cultures can be explained by four key factors, namely, individualism, power distance, uncertainty avoidance and masculinity, has been most influential in this respect. It has shown how nationality affects human behaviour and consequently how it also constrains management practice. For example, he has found that countries which score highly in power distance and uncertainty avoidance are likely to produce forms of organisation that rely heavily on hierarchy and clear orders from superiors, but those which score low in power distance and high in uncertainty avoidance will produce organisations that rely on rules and procedures (Hofstede, 1991). If to the above, the effect of the company’s macro environment is added, i.e. the general national economic situation, the existence of infrastructure and telecommunications etc, the expected impact of management location on management practice becomes even more evident.

Clearly, the legal framework that the different registries offer touches upon a number of dimensions in relation to management. Company laws and financial laws relating to, for instance, the company’s organisation, the disclosure of ownership of shares, or the auditing of the accounts, will obviously be expected to have a bearing on management functions. Open registries are generally believed to encompass more flexible and owner-friendly commercial environments but many shipowning nations, such as Greece and the UK, have also attended to the provision of an attractive commercial context for ship operation. A specific trend between registries may perhaps be difficult to observe but although such items may be rather flag-specific, they nevertheless have important implications for ship management.

The way that open registries and traditional ones have dealt with tax liabilities has conventionally been one of the most fundamental differences between the two. Open registries have led the way with the early introduction of advantageous taxation schemes for both ship’s tax and company tax. Although indeed a significant parameter in ship owners’ choice of flag (Gardner et al., 1984), differing tax systems may be thought to affect management practice to a small and mostly indirect extent. For example, they may necessitate or not the existence of a separate sub-department in the accounts department or require expertise in the form of outside experts or outsourcing. Indirectly they will influence the company’s balance sheets, its cash flow and perhaps ultimately and long-term the investment capability/options of the company. But, unless seen from this perspective, diverse tax schemes cannot be seen to have a considerable impact on management practice. In terms of ship’s tax, one more exception may apply; when the tax system, such as a tonnage tax system, is tied to a training obligation, as in the case of the UK and other nations, then, more obvious implications are developed for the human resource management exercised by the company.

The issue of flag has mainly been related to cost differences. In other words the main differentiating factor between traditional flags and open registries is cost, translated into total crew costs, tax and high costs of compliance with safety standards of national flags. Tax does not really have a dramatic effect on management practices. Nevertheless, the degree of preoccupation with cost as a formative parameter of strategy and the repercussions for crew employment choices that occur with the preference for a flag are the two issues with the most impact on management decisions and these will be explored in some detail in the following two sections.

4. The Impact of Choice of Flag on Strategic Decisions

The choice of flag also affects a number of strategic decisions at corporate level. In the first place, the flag a vessel flies may influence the actual market sectors in which a company engages. Decisions about the fields and industries in which a corporation’s Strategic Business Units (SBUs) will pursue commercial activities are among the most significant decisions corporate executives and top management are expected to make for the success and the viability of every firm. Consider the example of countries, Norway for instance, which offer exclusive employment of vessels flying the national flag in certain protected trades, such as coasting, or when there is a preference for the national fleet for government cargoes, like the case of the USA. Clearly, the flying of a foreign flag automatically prevents the company from involvement in specific market segments. Along the same lines, a firm using reputable and highly recognised flags for its vessels may have built up a respectable and dependable profile and may thus enjoy further business opportunities for involvement in higher risk trades, such as the tanker industry, which it could otherwise perhaps not be provided with. Hand in hand with these strategic choices come also management decisions about the firm’s assets or features of the firm’s fleet especially in terms of ship types and ship sizes, and so the latter can also be seen to potentially be affected by the ship owners’ flag choice. In connection with the above, ship management can also be influenced by the choice of flag at an operational level. Preference for certain trade routes may be effected by a need, for example, to avoid highly regulated geographic regions, such as the USA especially after the introduction of OPA 90, or the EU, or certain countries or strict Port State Control areas if ships are flying a PSC-targeted flag.

Interestingly, and perhaps unexpectedly, flag choice can be seen to have an impact on yet more strategic management issues. The formulation of a corporate strategy can potentially be affected by a specific flag choice when, for instance, flags give attractive incentives for building new ships. Fleet expansion is of course a management decision primarily driven by market conditions, good freight rates, strong cash flows, and optimistic expectations. But more often than not, history in shipping has shown that ship owners in their decision to invest in new ships are also influenced by favourable building incentives, coming either from the yard or the government, to such an extent that this behaviour has been thought to bring ultimately negative results for the freight market (Strandenes, 2002). In other words, although a rational assumption here, the impact of appealing newbuilding support schemes as part of a flag’s regime on a ship owners’ decision to adopt a growth strategy is in fact a noted reality. Growth and fleet expansion can be achieved also through the acquisition of second hand ships. In this case, too, the flag’s effect on the decision to expand can be considerable, especially in situations when the flag provides ship owners with access to loans at better rates of interest within the realms of its industry support plan. On the other hand, the choice of flag does not only have a bearing on whether top management takes up a growth corporate strategy or not but also on the ways in which growth is to take place. A straightforward example relates to the manner in which registries deal with the issue of dual registration. If a flag does not allow dual registration, this affects also the fleet expansion policy as ship owners are restricted with regard to bareboat chartering options under this registry system. On top of that, management decisions on

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