As the number of shipyards in distress, and cancelled contracts, increase in the current difficult market, the risks associated with shipbuilding projects is on the rise. Even where the builder is still solvent and the buyer still wants the ship, the pressure on both sides is forcing them to take harder positons and amplifying the costs of managing these kinds of projects.

In this article, we cover a number of issues that give rise to difficulties in shipbuilding projects, many of which find themselves in the spotlight in the present environment. We also consider some practical points which may assist the parties involved.

Whilst contract terms vary, the issues discussed below are broadly applicable to all newbuilding contracts. That said, we refer to the most widely used form of newbuilding contract, the Shipbuilders’ Association of Japan form (the SAJ). This form, or modified versions of it, are widely used in Asia where the majority of commercial ships are built. Comments made in this article as to matters of law and interpretation are confined to English law and practice as at the date hereof.

Common disputes: Liquidated Damages; Force Majeure days and ready for delivery

The SAJ, like most building contracts for large-scale projects, will entitle the buyer of a ship to an agreed amount of damages, often referred to as “liquidated damages”, for each day that the ship is delayed from an agreed date (e.g. 30 days after the contractual delivery date). These liquidated damages will often be the driver of disputes, as they put a monetary value on lost time, albeit often subject to an overall cap.

Whilst liquidated damages may be the underlying reason for a dispute, one of the most common areas of shipbuilding disputes is in the attribution of responsibility for delay (i.e. which days of delay are for the buyer’s account and which are for the builder).

When considering such delay cases, proper construction of the force majeure clause is frequently a key element. Generally, force majeure days will not count towards the buyer’s liquidated damages, but will count towards the required time limit before the buyer has a right to cancel the contract for excessive delay.

As the SAJ, in common with most commercial shipbuilding contracts, does not promise interim performance of construction milestones, the focus of the parties (in terms of both liquidated damages and cancellation under the terms of the contract) must be on the contractually agreed delivery date. Prudent parties will wish to scrutinise, as it arises, the scope of any event which may allow deviation from that date, or which may contribute towards an early cancellation.

The question of whether the ship is technically ready for delivery is relevant to the delay cases discussed above (as this is when the clock stops for the accrual of liquidated damages), but it is also often important where the buyer seeks to cancel a shipbuilding contract for excessive delay. If disagreement over whether the ship is ready for delivery or not persists for long enough, the cancellation date will eventually arise, at which point the buyer must make an election as to whether to cancel the contract or take delivery of the ship.

If the buyer elects to cancel the contract for technical reasons, and it is later decided that the buyer did not, in fact, have the right to do so, the builder may then have the right to cancel the contract, leaving the buyer unable to call on its refund guarantee. This can make it a high-stakes gamble for both sides.

Understanding the importance of the Refund Guarantee

As title to the ship usually remains with the shipyard until delivery, virtually all buyers require the builder to procure a refund guarantee (there may be several) from an acceptable bank, to secure the return of their pre-delivery instalments (where the buyer is validly able to exercise its right to cancel the contract). Where the builder is encountering financial difficulties, the buyer will be especially keen to ensure its refund guarantee remains in place – and the refund guarantee may prove to be its sole realistic prospect of recovery.

As you might expect, the refund guarantee and the underlying shipbuilding contract are intended to be linked in most key respects. Notwithstanding this, one critical concept to understand is that the refund guarantee should be an independent obligation of the refund guarantor and entirely separate from the underlying shipbuilding contract. This is of course intentional, as the purpose of the refund guarantee is to provide the buyer with security from a source that is independent of the builder. However, this creates a risk that the refund guarantee may sometimes not operate as expected when changes are made to the underlying shipbuilding contract.

One such example is where a project is delayed, and the parties have agreed an extension to the contractual “Delivery Date” (often made in exchange for a discount to the purchase price of the ship). This is common practice and there may be a number of these agreements, for relatively short extensions, toward the end of a newbuilding project. However, serious problems can arise in cases where the refund guarantee has a fixed expiry date (as is the case with virtually all refund guarantees issued by Chinese banks). This is because the date on which the buyer’s right to cancel the contract, is linked to the Delivery Date (being, usually, between 180 and 210 days after the Delivery Date). Where there have been extensions of the Delivery Date, the buyer runs the risk that its right to cancel the contract may be triggered only after the date on which the refund guarantee expires. Whilst this is an easy issue to avoid if the parties are careful with amendments, it can catch out even experienced buyers.

Another consequence of the refund guarantor’s independence is that amendments to the shipbuilding contract, for example to the timing and amounts of instalments, can cause uncertainty. Due to protections afforded to guarantors under English law, such amendments may, absent consent from the refund guarantor, discharge the refund guarantor from its obligations under the refund guarantee (or give it an argument that it has been so discharged). Ultimately, the degree of amendments and the answer will depend on the interpretation of what has been agreed in the refund guarantee itself. In order to avoid argument, the buyer should, where practically possible, seek the consent of the refund guarantor whenever the underlying contract is to be varied.

An important caveat to the general link between the shipbuilding contract and refund guarantee is as follows. In circumstances where the builder has either fallen far behind the construction programme or failed to start work at all, the buyer may wish to treat the builder’s conduct as a repudiation of the contract and elect to terminate the contract on this basis. The risk to the buyer in doing so, is that its claim for damages is not secured by the refund guarantee. Whilst the wording of some refund guarantees will be sufficiently wide as to cover a claim for damages, it is unusual for a refund guarantee to cover damages. Most refund guarantors will respond only to a demand for repayment of instalments of the contract price, usually (but not always) with interest. Faced with prolonged delay and continuing inactivity on the part of the builder, a buyer will be advised to persevere with the shipbuilding contract, await the contractual cancellation date to exercise its cancellation right and make timely demand under the refund guarantee.

As is seen from the points discussed above, there are a number of risks that can arise throughout the construction process, especially when commercial circumstances require changes to be made. Managing risk effectively in shipbuilding projects requires not only supervision of the technical construction of the ship, but also an ongoing consideration of the implications of changing contractual terms.