What to consider when negotiating shipbuilding contracts
22 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.
Typically, a shipbuilding contract provides for termination by the buyer in three circumstances. The principal one is delay, but also if the vessel is non-compliant (beyond agreed tolerances) and, often, if the builder becomes insolvent. In practice vessel non-compliance usually ends up as a delay cancellation (unless the builder knowingly presents a non-compliant vessel for delivery before the time limit expires). Meanwhile, the insolvency regime governing shipyard insolvency may prevent a buyer exercising a contractual right of termination on insolvency (such regimes typically do this to allow an insolvency administrator to decide unilaterally whether to perform the contract or not) such that any eventual termination will also ultimately depend upon the termination for delay provisions (unless the administrator rejects to perform the contract). Hence it is advisable to concentrate on the termination for delay provisions, but also to look at local law in the jurisdiction of the shipbuilder to ensure that insolvency provisions tie in with local regulations and practice.
On its face, a right to cancel for an agreed period of delay is relatively straightforward. It is not “fault-based” in the sense that there is no requirement to show the cause of the delay (and therefore no need to show it was caused by fault of the builder), and so on its face it merely requires a day count. This is then complicated by a number of factors which are typically added to the time limit. The simpler factors include late payments by buyer (i.e. fault-based), late delivery of buyer supplies (again, fault-based), and weather delays affecting sea trials. More problematic are (i) delays caused by failure to agree on drawing approvals or supervision issues during the construction process (this may be a failure of the parties to reach agreement between themselves, but we have also seen delays in the builder obtaining approvals from the classification society) and (ii) the alleged occurrence of force majeure delays. Ultimately, the real problem for the parties is uncertainty. That is to say, if there is uncertainty as regards whether force majeure or other events have occurred which extend the delivery time limit (and, if so, by how much) a buyer is in a difficult position. If a buyer gets the delay calculation correct, it can cancel and claim its payments back with interest. If it gets it wrong, and as a result cancels before the right to terminate for delay has arisen, it will be in default, with no right to a refund of instalments paid, allowing the builder to terminate the contract and claim any shortfall (after taking in to account any instalments received and the proceeds of selling the ship). For this reason the standard contracts need to be adapted to provide for clear and immediate determination of force majeure delays as they arise and to make clear that drawing approval and supervision disputes do not give rise to permitted delays (or provide for prompt determination of them as they arise so as to avoid delay, but note this can be undermined where the determination process requires mutual cooperation between the parties rather than being capable of unilateral implementation).
Even with these adaptations, exercising a right of cancellation remains high risk for a buyer but shipbuilding contracts offer no alternatives to this all or nothing approach, such as a right to take delivery and reserve a right to bring claims separately. Once delivery is accepted the only remedies are generally those in the post-delivery guarantee (see below). For this reason it is important for a buyer to protect its position in the event that it cancels incorrectly and is thereby in breach. In these circumstances its biggest risk is that the builder will dispose of the vessel at less than its market value, and thus will increase its claim against the buyer. The buyer’s best protection is to provide that the buyer must be permitted to participate in any disposal process as a potential buyer. Shipbuilders will typically object strongly to this, regarding a buyer in breach as being morally culpable and therefore having abrogated any rights. This is not something recognised in law and also ignores that the most likely cause of breach is the difficulty of ascertaining permissible delays accurately, rather than moral culpability.
One point to note in relation to delay termination clauses is that it can be immensely frustrating to see a project going wrong and knowing that there will be no remedy until it reaches the often long drawn out time limit set in the contract, especially if this limit is (or may be) also extended by force majeure (sometimes there is a combined maximum which is higher than the individual limits for non permitted delays and force majeure delays respectively, but lower than their aggregate). This can be addressed by agreeing milestones during the contract negotiation process, such that the delay cancellation rights can arise upon a failure to achieve agreed milestones by agreed dates (plus tolerance period and permitted delays such as force majeure). This is not standard practise, and determining exactly what the milestones shall be can be difficult, but this type of provision can save years of waiting to cancel a failing project and to receive a refund.
One relatively new factor to consider is whether force majeure permitted delays should be extended to include circumstances where the buyer’s representatives cannot participate in supervision of construction due to pandemic restrictions (either preventing them travelling or restricting their access to and within the shipyard). In these circumstances should the builder be prevented from carrying on construction, thus extending the time for delivery but otherwise without compensation? Typically, shipbuilding contracts do not recognise that force majeure may affect the buyer but this has become apparent and the possibility, and consequences, should be considered for inclusion.
In commercial shipbuilding, the provision of refund guarantees issued by banks in support of the builder’s refund obligations have long been standard practice, although one still sees shipyards suggesting otherwise (and not just where the shipyard has credit support from an investment grade parent company). There are alternatives which can be considered, such as passing of title during construction, but this requires a great deal of legal due diligence at the contract stage to determine whether it will be legally enforceable and effective (there is little point in agreeing this option, only to find that the vessel remains caught up in the builder’s insolvency or is otherwise subject to claims of its creditors) and even if it works legally, taking a half finished ship elsewhere to complete it creates enormous practical difficulties which would challenge the resources of many buyers. Nevertheless, in yachtbuilding and the cruise industry, where designs are more “personal” to the buyer, one sees clauses passing title during construction (sometimes together with refund guarantees rather than in place of them).
Apart from agreeing that a refund guarantee is to be provided, the content of the guarantee is often left to be agreed later, which can lead to problems. These can range from builders proposing to have the guarantee issued by worthless entities, through to guarantees which expire before they could be drawn, or which limit interest cover to a period well short of the time which a buyer may have to wait to enforce a claim. If the form of guarantee is not to be agreed at the same time as the shipbuilding contract, these issues should at least be addressed in the shipbuilding contract itself. One would also expect the basic format to be agreed at building contract stage, which is generally an “on demand” guarantee with a provision that the obligation to pay will be deferred if, before the deadline to pay the demand expires, the builder commences proceedings to dispute the underlying obligation to pay. In these circumstances the guarantor’s obligation is deferred, and its liability will be limited to the builder’s liability as determined in those proceedings. Note that the essence of being “on demand” is that the guarantor cannot itself defend a claim under the guarantee by disputing whether the underlying payment obligation has arisen and so, if the builder itself does not trigger the deferral by commencing proceedings within the specified time frame, the guarantor has no alternative but to pay (in the absence of fraud).
A further flaw in many refund guarantees is that the right to claim under them is specifically linked to express termination rights in the shipbuilding contract. This creates the possibility that if termination is based on a legal right to terminate which is not expressly specified, the guarantee will not secure the resulting claim. This most commonly occurs when a shipbuilder repudiates a shipbuilding contract (in other words, through its actions or deeds it makes clear that it will not perform the contract). This gives rise to a right of termination under English law (the most common governing law for international shipbuilding contracts) but is not usually listed as one of the express grounds for termination in the shipbuilding contract and may therefore fall outside the scope of the refund guarantee unless the wording is adapted accordingly, such providing for claims under the guarantee in any circumstances where the shipbuilding contract is lawfully terminated by the buyer.