What to consider when negotiating shipbuilding contracts
15 November 2021
Shipowners are back in the market ordering new vessels, so it seems like a good time to put out a reminder of key points to consider when negotiating shipbuilding contracts.
We have covered the most important issues and pitfalls in a series of three newsletters.
They say that if all goes well, you sign a shipbuilding contract, put it in the drawer and never look at it again. The ship gets built, delivered, goes in to service and everyone is happy.
In the real world, things do not always go that smoothly. The shipowner experience divides in to two parts; problems prior to delivery and problems after delivery. The shipbuilding contract covers both. A shipowner needs to be confident that when it comes out of the drawer it will provide solutions and protect their interests. This is not always the case.
First, a reminder of the limitations (literally) of modern shipbuilding contracts: Market practice normally dictates that if the contract is cancelled because of builder default, a buyer will be entitled only to a return of any money paid to the builder, plus interest and the return of any equipment supplied by the buyer. There will be no compensation for the cost of obtaining a substitute ship, and there will be no compensation for the costs which the buyer has incurred in the construction process, such as supervision costs and financing costs, nor for loss of future income. If the ship is late or does not meet the agreed performance specification, but not so badly that there is a right of cancellation, only limited compensation will be available, usually well below the additional cost or loss incurred by the buyer as a result of the defect or delay. Similarly, if the ship is found to be defective after delivery, the buyer’s remedies will be limited to the repair of defects discovered within an agreed guarantee period, typically 12 months from delivery, with no compensation for losses or additional costs incurred by the owner as a result of the defect. After that there will typically be no remedy, save to the extent that individual suppliers such as the engine manufacturer or coatings manufacturer are prepared to offer longer warranties on the items supplied by them.
Although it may be possible to negotiate limited adjustments to these limitation provisions, such as monetary compensation for buyer supplied items instead of their return, or an extended guarantee period, it is rare to achieve material improvements, so any shipbuilding contract negotiation must recognise these constraints. That puts pressure on the need to get the specification and supervision processes right in order to minimise the risk of defects. But there is also typically considerable input required in order to get the termination and refund mechanism right, and to make the mechanism for claims and remedies under the guarantee practicable. For owners who are linking their purchase to a charter contract there is also a need to minimise the extent to which owner’s liability under the charter may exceed its right of recovery under the shipbuilding contract in the event of cancellation or delay in delivery, or defective performance and/or guarantee repairs being required.
Specifications and supervision
Typically, shipbuilding contract discussions focus on the plan approval process plus the number of supervisors a buyer can have at the shipyard and the facilities which are to be made available to them. These are important, but what is often neglected is the degree of access which the supervisors can have, particularly where significant elements will be constructed off-site. It is common to see shipbuilders seeking extensive freedom to construct off-site rather than at the main shipyard site. We have seen builders proposing that they should have unrestricted freedom to construct whole blocks anywhere in the world, provided their own crane facilities will be big enough to handle them on arrival at the builder’s shipyard. Before agreeing this a buyer needs to consider whether its supervision team will have the capacity to supervise at these other locations and, if it will not, either restrict the locations where work may be carried out or restrict the extent of such works so that they can adequately be inspected at the shipyard before being incorporated in the vessel.
What is frequently ineffective is the way supervision and drawing approval arrangements tie in to the dispute regime provided in the shipbuilding contract. On any point of disagreement, if a consensual and timely compromise cannot be agreed, what is needed is a procedure for providing a solution quickly without a delay in the construction programme. Dispute provisions are commonplace in shipbuilding contracts, typically comprising English court or arbitration proceedings but with an option of a more rapid process for resolving technical disputes. However, the mechanisms for triggering the use of the simplified processes are often such that it can be difficult to do so without cooperation between the builder and the buyer. Cooperation can often be in short supply when there is a dispute, such that the “quick solution” mechanism cannot be triggered and problems are left festering without being resolved. Hence the practicality of the dispute mechanism needs to be addressed at contract stage.
Also neglected tend to be the liability regimes for the actions of individual personnel. Issues like who is liable if a supervisor’s error causes loss or injury to the shipbuilder or its personnel, and how can this be controlled in law? And similarly for the liability of the shipyard or its personnel for loss or injury to owners’ supervisors? These are areas of law which have technical quirks which need to be understood and taken into account if the liability regimes are to work as intended. If they don’t, then there is a significant risk that liabilities will fall outside of insurance cover too. This is rarely addressed properly in the first draft of a shipbuilding contract emanating from a shipyard and therefore needs attention from the buyer in contract negotiations.
In parallel to the shipbuilding contract negotiations, but often in the background, the buyer’s technical team will work with the shipyard’s technical team to finalise the specifications. This process needs to be coordinated very carefully. Technical teams have a history of what may best be described as “early onset Stockholm Syndrome”, where they mistakenly believe the shipbuilder’s team are their friends, leading them to agree wording in the specifications which says the opposite of what the buyer wants, based largely upon assurances from their counterparts at the shipyard that it does not mean what it says and “of course the yard will do the right thing“. Leaving drafting of the specs to the technical team is like leaving the engineering content to the lawyers. Some yards have become so aware of this that they even “hide” contract provisions in the specification in order to avoid proper legal review, particularly as regards building standards. Buyers should be aware of this and make sure the review process is not somehow sidestepped in this way.