Default, liability and remedies in shipbuilding in USA

Default, liability and remedies

Do courts consider defective design to fall within the scope of poor workmanship for which the shipbuilder is liable under the warranty clause of the contract?

Builders’ warranty clauses are very specific as to what is and what is not covered and as to the time frame of the warranty. The warranty generally covers all defects and damage due to defective workmanship and materials furnished by the builder or its subcontractors or other fault in construction or installation or builder’s specifications or drawings and almost universally excludes consequential losses. Attempts to expand the builders’ warranty to include any damage caused as a direct and immediate consequence of the defect are extremely difficult to achieve. Since US courts strictly construe warranties (guarantees), the specific terms of the warranty must be negotiated very carefully. This was held to be the case both in New York Marine & General Insurance Co v Gulf Marine Towing, 1993 WL 408374, 2 (ED La 1993) (‘[E]xpress warranties are strictly construed in admiralty law’); and Lexington Insurance Co v Cooke’s Seafood, 835 F 2d 1364, 1366 (11th Cir 1988).

Are there any remedies available to third parties against the shipbuilder for defectiveness?

Absent a specific provision expressly conferring on third parties (expressly identified either as a member of a class or by particular description) certain contractual rights, such third parties will be precluded from enforcing any rights under a shipbuilding contract. See, for instance In re Gulf Oil/Cities Service Tender Offer Litigation, 725 F Supp 712, 733 (SDNY 1989): ‘Although a third party need not be specifically mentioned in the contract before third-party beneficiary status is found, New York law requires that the parties’ intent to benefit a third party must be shown on the face of the agreement [. . .]. Absent such intent, the third party is merely an incidental beneficiary with no right to enforce the contract’.

If the contract contains a liquidated damages clause or a penalty provision for late delivery or not meeting guaranteed performance criteria, must the agreed level of compensation represent a genuine link with the damage suffered? Can courts mitigate liquidated damages or penalties agreed in the contract, and for what reasons?

The liquidated damages provisions in shipbuilding contracts generally specify that the buyer shall not be entitled to claim any damages, whether direct or consequential, in addition to those specified arising out of the failure of the builder to comply with specified requirements of the contract. See question 8.

If the building contract contains a liquidated damages provision, for example, for late delivery, is the buyer then precluded from claiming proven higher damages?

See questions 8 and 26.

Are the parties free to design the force majeure clause of the contract?

The parties are free to negotiate and craft the force majeure clause of the contract, which can vary in its specificity as to events, efforts by the builder to ameliorate or overcome the effects of such events, notice provisions as to the start and finish dates of relevant events and the effect of such events on the delivery of the vessel.

Is certain ‘umbrella’ insurance available in the market covering the builder and all subcontractors of a particular project for the builder’s risks?

Shipbuilding contracts universally require the builder to provide insurance to cover the vessel and such parts as shall be constructed and all materials, engines, machinery, outfit and equipment to be installed in or on the vessel, as well as all of the owner’s supplied equipment within the premises of the shipyard against all risks of loss and damage pre-keel laying and builder’s risk insurance for a total loss of not less than 100 per cent of the contract price. The builder’s risk policies generally include American Institute of Marine Underwriters (Institute) builder’s risk clauses, increased value, Institute strike clauses, Institute war clauses and coverage against hurricanes, windstorms and earthquakes. When the vessel is under way for sea trials or en route to or at the place of delivery, the contract should also require the builder to insure the vessel for protection and indemnity risks and for hull and machinery risks in the same amounts referred to above. Other types of insurance required to be maintained by the builder are workers’ compensation insurance at statutory amounts with Longshoreman and Harbor Workers’ Compensation Act coverage endorsement, employer’s liability insurance and contractor’s equipment and auto liability and comprehensive public liability insurance for negotiated and agreed amounts.

Will courts or arbitration tribunals in your jurisdiction be prepared to set terms if the parties are unable to reach agreement on alteration to key terms of the contract or a modification to the specification?

Some shipbuilding contracts provide that technical disputes that relate solely to the vessel’s classification may be mediated by the chief surveyor of the classification society. Other contracts provide for arbitration according to the Rules of the Society of Maritime Arbitrators or other recognised arbitration bodies. Some contracts provide for arbitration of disputes up to an agreed amount and litigation thereafter or litigation alone. The dispute resolution clause in these contracts is generally driven by the builder based upon its prior experiences with disputes.

Does the buyer’s signature of a protocol of delivery and acceptance, stating that the buyer’s acceptance of the vessel shall be final and binding so far as conformity of the vessel to the contract and specifications is concerned, preclude a subsequent claim for breach of performance warranties or for defects latent at the time of delivery?

A protocol of delivery and acceptance, which states that the vessel is delivered in compliance with the terms and conditions of the contract limits the buyer’s post-delivery rights against the builder to those set forth in the builder’s warranty clause and precludes the buyer from other remedies against the builder. See Stephenson Harwood, Shipping Finance, pp. 281-82 (3rd edition, Euromoney Institutional Investor PLC 2006) (‘For example, the protocol may be worded in such a way that the buyer acknowledges that the vessel is delivered ‘in accordance with’ the vessel’s construction contract and specifications. If the vessel does not ‘accord’ with the MOA the buyer would normally have a right to claim damages from the seller. By executing a protocol of delivery and acceptance such rights may be lost’). The protocol of delivery and acceptance when executed by the builder and the buyer evidences the exact time that all rights, title and risk to the vessel pass from the builder to the buyer.

Can suppliers or subcontractors of the shipbuilder exercise a lien over the vessel or work or equipment ready to be incorporated in the vessel for any unpaid invoices? Is there an implied term or statutory provision that at the time of delivery the vessel shall be free from all liens, charges and encumbrances?

At the time of delivery, the builder is required to certify to the buyer that the vessel is delivered to the buyer free and clear of any liens, claims or other encumbrances upon the buyer’s title thereto and in particular that the vessel is absolutely free from all liabilities of the builder to its subcontractors, employees, crew and of all liabilities arising from the operation of the vessel in trial runs or otherwise, prior to delivery and acceptance. If, notwithstanding the builder’s certification, a supplier or subcontractor has not in fact been paid and subsequently asserts a lien against the vessel after it has been delivered to the buyer, the buyer will have to take appropriate measures to have the lien released and claim against the builder for the amount of the lien and its expenses to have the same released.

Does a reservation of title by a subcontractor or supplier of materials and equipment survive affixing to or incorporation in the vessel under construction?

As indicated in question 5, a US shipbuilding contract is subject to the UCC. Applying the principles of article 9 of the UCC, a perfected reservation of title by a subcontractor or supplier of materials and equipment (goods under the UCC) would survive incorporation into the vessel provided the goods remain an accession. An ‘accession’ is a good that is physically united with other goods to become one good in such a manner that the identity of the original is not lost. Goods only become accessions if the identity of the original good is preserved in spite of the union (UCC section 9-102(a)(1)). Goods that have lost their individual identity are ‘commingled goods’ governed by UCC section 9-336 and are not deemed accessions. ‘A security interest may be created in an accession and continues in collateral that becomes an accession’ (UCC section 9-335(a)). ‘If a security interest is perfected when the collateral becomes an accession, the security interest remains perfected in the collateral’ (UCC section 9-335(b)). Under the ordinary rules, whether the security interest is in the accession only or whether it attaches to the whole depends on whether the good as a whole is within the description of the collateral covered by the security agreement and the UCC Form 1 financing statement. In certain circumstances, where the incorporation of the good into the vessel constitutes ‘commingled goods’, a perfected reservation of title in the good when it was an accession, prior to becoming commingled, could create a security interest that attaches to the product or mass that results when goods become commingled. Therefore, the outcome in each individual scenario is dependent upon the facts of each case as well as the description in both the security agreement and on the UCC Form 1 financing statement.

Assuming title to the vessel under construction vests with the builder, can third-party creditors of the builder obtain a security attachment or enforcement lien over the vessel or equipment to be incorporated in the vessel to secure their claim against the builder?

A security interest can be created in favour of third-party creditors of either the buyer or the builder over both a vessel under construction and related equipment (see question 33 for a discussion of a security interest over equipment and materials to be incorporated into the vessel). While a security interest in favour of builder’s lenders over inventory may extend to a vessel under construction, the enforceability of the security interest may vary depending on state law and the specific facts of each case. For example, in In re Tacoma Boatbuilding Co, 158 BR 19 (SDNY 1993), on the bankruptcy of the builder, the enforcement of a security interest in inventory of the builder over two vessels subject to construction contracts with the same buyer was found to depend on the stage of completion of the vessel at the time the bankruptcy filing. The security interest in the builder’s inventory applied to a vessel while still under construction to defeat a later filed UCC financing statement in favour of the assignee guarantor of the buyer. However, the court held that as construction of the other vessel was completed prior to the bankruptcy filing, it became a good ‘identified’ to the contract within the meaning of UCC 501(1)(b) and title to the vessel had passed to the buyer’s guarantor free and clear of the security interest of the builder’s lender. The court further found that the buyer qualified as a ‘buyer in the ordinary course of business’ under UCC 1-201(9) taking ‘without knowledge that the sale is in violation of the ownership rights or security interest of a third party’. Any right of retention on the part of the builder for non-payment will be resolved pursuant to the terms of the construction contract and financing documentation.

Can a subcontractor’s or manufacturer’s warranty be assigned to the buyer? Does legislation entitle the buyer to make a direct claim under the subcontractor’s or manufacturer’s warranty?

When the builder enters into a subcontract or purchases equipment for the vessel, the builder’s counterparty knows that the work or equipment, as the case may be, will become part of the vessel and the builder generally obtains a warranty from its counterparty, which may exceed the term of the builder’s warranty to the buyer under the shipbuilding contract. In such cases, the builder will be required by the terms of the shipbuilding contract to assign to the buyer all rights and privileges of the builder in such extended warranty; accordingly, the buyer will be able to make a direct claim under such extended warranty after the builder’s warranty period has expired. Prior thereto, during the warranty period specified in the contract, the buyer will pursue its warranty rights under the shipbuilding contract against the builder.

Where a builder defaults in the performance of the contract, is there a legal requirement to put the builder in default by sending an official notice before the buyer’s remedies begin to accrue? What remedies will be open to the buyer?

Where a builder defaults in the performance of the shipbuilding contract, the buyer is relegated to those remedies specified in the contract, which usually includes a requirement for sending an official notice of default to the builder, apart from any provision in the contract that may be adjudged as against public policy; this is unlikely especially if both builder and buyer are represented by counsel in the negotiations.

Are there any remedies available to the shipowner in the event of protracted failure to construct or continue construction by the shipbuilder apart from the contractual provisions?

There are no statutory remedies available to the shipowner in the event of protracted failure to construct or continue construction other than those set forth in the contract. Prudent shipowners will insist on a builder’s default clause that covers a material failure of the builder to prosecute the contract work with such diligence and in such manner as will enable the builder to complete such work substantially in accordance with the vessel’s contract delivery date, except to the extent that such failure is owing to causes excused by events of force majeure or by the buyer’s actions. Without such a clause the shipowner will not be able to call a default and rescind the contract until the delay in delivery is permitted under the late delivery rescission clause.

Would a buyer’s contractual right to terminate for the builder’s insolvency be enforceable in your jurisdiction?

Such termination provisions are commonly known as ipso factor clauses. If the insolvency results in the filing of a bankruptcy petition, either by or against the builder, the answer is no. Once a bankruptcy case has been filed, section 365(e)(1) of the US Bankruptcy Code prohibits modification or termination of an executory contract based solely on the insolvency or financial condition of the debtor. Absent a bankruptcy filing, the buyer may be able to enforce termination rights under the building contract depending on the application of the relevant state contract law. Further, although a bankruptcy filing will generally defeat an insolvency-based termination provision, where an executory contract bars assignment without the other party’s consent, the non-debtor contracting party may be able to seek relief from the automatic stay in bankruptcy to terminate the contract. Depending on the terms of the construction contract, this remedy may be available to the buyer in the event of a builder bankruptcy filing. These facts raise complex questions of law and legal advice should be obtained.

What institution will most commonly be agreed on by the parties to decide disputes?

See question 30. A frequently designated arbitral institution in US shipbuilding contracts is the Society of Maritime Arbitrators in New York, which has many seasoned arbitrators knowledgeable in maritime matters. Otherwise, contracts will provide that disputes are to be arbitrated in accordance with other recognised arbitration associations or litigated in state or federal courts in accordance with the parties’ agreed contract clause.

Would a buyer’s contractual right to take possession of the vessel under construction and continue construction survive the bankruptcy or moratorium of creditors of the builder?

There is not a clear answer to this question. Certain variables must be taken into consideration. A buyer to protect itself in order to survive the bankruptcy or moratorium of creditors of the builder should:

• obtain and perfect an appropriate security interest of all of the builder’s obligations to the buyer under the shipbuilding contract under article 9 of the UCC of the state in which the shipyard is incorporated or organised. This should cover, at a minimum, the goods to be purchased and all materials, component parts and accessories acquired by the builder that are to be incorporated into the vessel and other items related to the construction of the vessel (ie, plans, specifications, relevant contracts with third parties, specialised tooling);
• obtain lien searches against the shipyard to identify any conflicting security interests;
• establish the priority of the buyer’s security interest by securing subordination agreements and consents to the buyer’s priority from the holder of any conflicting security interests - these may be difficult to obtain; and
• apply to require the shipyard or its estate to maintain adequate insurance during the shipbuilding process with the buyer to be named a loan payee under a lender’s loss payable endorsement recognising the buyer’s interest as a secured creditor under its security interest.

A buyer will need to take all of these steps to obtain the best protection possible.

In your jurisdiction, do parties tend to incorporate an ADR clause in shipbuilding contracts?

At present ADR clauses are rarely incorporated in shipbuilding contracts for ocean-going commercial vessels.

Where the buyer defaults in the performance of the contract, what remedies will be available to the builder? What are the consequences of the builder’s cancellation of the contract?

In the event of a buyer default, remedies available to the builder, including but not limited to retention of the vessel and cancellation of the contract, and the consequences of enforcement of such remedies will be governed by the terms of the construction contract as may be limited under the UCC and the US Bankruptcy Code.