What to consider when negotiating shipbuilding contracts
29 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.
Buyer’s Parent Guarantee
Where a shipping group or investor establishes a subsidiary for the purpose of entering in to a shipbuilding contract as buyer, the shipbuilder will typically want the buyer’s payment obligations secured by a guarantee or other credit support from a more creditworthy entity, usually the buying group’s principal holding company. Sometimes a shipbuilder may ask for bank guarantees, although it is far less common to see this being agreed by buyers.
The initial proposal from a builder for a buyer’s parent guarantee will generally request an “on demand” guarantee. Buyers will want to see this amended so as to give the guarantor a right to dispute whether the underlying payment is due, or at least will want to mirror the position under the refund guarantee where the payment obligation is deferred if proceedings are commenced to dispute the underlying payment obligation. Note that in the past it has been suggested that a parent guarantee (as opposed to a bank guarantee) of this type would be unlikely to be interpreted as a on demand guarantee in any event (and hence the guarantor would be able to dispute whether the contract was properly terminated before having to pay a claim under the guarantee) but the courts have recently made clear that they would interpret it in the same way as a guarantee issued by a bank (i.e. in accordance with its terms, without special consideration of the business of the party issuing it).
For most buyer groups, probably the primary commercial issue to be considered in relation to providing a guarantee (apart from whether to provide one at all) is whether it is reasonable to be required to provide such a guarantee for all instalments due under the shipbuilding contract up to and including the delivery instalment. Turning the commercial payment obligations under the shipbuilding contract into on demand guarantee obligations can have material adverse balance sheet consequences and so is not something to agree lightly, and where it is agreed it is beneficial to minimise the extent of the guaranteed obligations. For this reason buyers will typically seek to limit any guarantee to cover only the earlier instalments (not including the first, which is usually aid upon contract effectiveness anyway), on the basis that once the buyer has paid, say, 60% of the price and is holding title to the ship it has little or no real exposure because the value of the ship at any time should exceed the exposure to unpaid work and materials. Certainly, by the time the delivery instalment is due the builder will be holding on to a completed vessel and will generally have received around 80% of the price, and so only needs the value of the completed vessel to be 20% or more of the contract price in order to be fully secured. Alternatively, a shipbuilder may be prepared to accept that a buyer parent may limit its liability by showing that the buyer has committed loan finance available to it and that its credit support liability can therefore be limited to the amount of equity funding required by such financing (and will reduce as such equity is paid in).
Once a ship is delivered to the buyer, rights of redress against the shipyard are typically limited to the builder’s guarantee or warranty provision in the shipbuilding contract. Essentially this will make the builder liable for the repair of all defects discovered during a limited period following delivery (typically 12 months) but at the same time it will limit the builder’s liability so that it does not extend beyond this limited repair obligation. Hence costs and losses associated with having to take the vessel out of service because of the defect or to effect repairs will not be covered. Usually the repair obligation is phrased so as to be limited to repair of the defective item. As a minimum one would expect to expand this so that any damage caused to the vessel by the defective item would also be covered, and it is a good idea to look closely at the extent to which the cost of preparing the vessel for works and for drydocking, if required, will also be covered by the builder. In addition, it is necessary to spend time considering how to handle repairs when it is not economically practicable to return the vessel to the builder’s shipyard for the required repairs. In particular, on what basis can they be performed elsewhere at builder’s cost? And with some shipbuilders one may wish to consider whether they are sufficiently creditworthy to be able to rely on their post-delivery guarantee, or whether that guarantee should itself be backed by financial security such as a bank guarantee.
In any event, where suppliers, such as engine manufacturer or coatings manufacturer, have provided warranties which extend beyond the period of the builder’s warranty a buyer will want to include in the post-delivery warranty that the remaining term of any such warranties are to be assigned to the buyer upon expiry of the shipbuilding contract warranty period.
Finally, many buyers will order vessels on the basis of having a pre-agreed charter in place for a charter term which is to commence upon delivery. Sometimes there will be detailed integration between the charter and the shipbuilding contract, as is often the case with LNG vessels, but generally there will not. In all cases it is important to make sure that the charter commitment is structured in such a way that late delivery, off-spec delivery and non-delivery under the shipbuilding contract do not result in liability under the charter. We often see charterers attempting to claim a pass through of late delivery damages, which rather ignores that the corresponding delay costs are incurred by the owner (in accrued interest costs and lost income) whereas the charterer at least has the off-set of not having to pay the agreed charter hire. Of course, charterer may incur higher costs in chartering alternative tonnage, so there may be a commercial balance to be struck, but if we assume that charterer will not be compensated for non-delivery it may seem odd that it should receive compensation for late delivery.
A pass through of damages for off-spec delivery is also often sought. Whether it should be given will depend upon, first, whether there is a corresponding adjustment of charter performance warranty and, secondly, whether the agreed charter term represents a significant proportion of the vessel’s expected economic life. In general, an owner should set the performance warranties in the charter at a level equal or below the maximum tolerance in the shipbuilding contract, so that it is never required to accept a ship which cannot meet the performance warranties in the charter. If this cannot be agreed, an owner should seek to have the charter performance warranties adjusted to conform to the actual performance of the delivered vessel (and bear in mind that expecting real world performance to match the performance achieved in sea trials is like expecting a car to achieve the manufacturer’s fuel consumption figures). Owners may also wish to negotiate terms with the charterer as regards how off hire is dealt with when caused by matters falling within the builder’s warranty. If the charter is a bareboat charter, this is likely to be at charterer’s risk anyway. With a time charter, depending upon the economic background to the overall arrangement, it may be possible to agree that the charterer will take this economic risk (by agreeing not to put the vessel off hire for issues of this type) or at least will be prepared to compromise by not counting time off hire towards any accruing right of cancellation or similar. These are matters for negotiation with the charterer, rather than the builder, but need to be considered in parallel, not as an afterthought.
Click here for part 1 (Introduction / Specifications and supervision).
Click here for part 2 (Termination / Refund Guarantees).
Your contact persons:
Dr. Stefan Rindfleisch