Marine construction of vessels and offshore vessels are a costly undertaking. The architecture of the construction of new vessel will typically involve guarantees by both parties as both yard and buyer weather a substantial amount of risk as the vessel’s construction progresses from fabrication works, keel laying to final delivery to the buyer. In a shipbuilding contract (“SBC”) the buyer makes progress or milestone payments to the yard, effectively funding the construction of the vessel. With tens of millions of dollars paid upfront as instalments by the buyer, the refund guarantee is typically the most important document in marine/offshore construction, ensuring a buyer has the security of a guarantee for a refund upon the occurrence of specified events such as the yard’s insolvency, delays to completion of the vessel or the delivery of a defective vessel.
The refund guarantee is the cornerstone of a SBC: it is a unique document as it is inextricably linked to the rights and obligations of the SBC but yet designed to operate as an independent source of capital, triggered with as little as a written demand by the buyer stating it is entitled to payment under SBC. The entitlement to trigger a refund guarantee is often the subject of litigation bringing into sharp focus two common themes; (a) whether the guarantee is a co-extensive surety which generally requires proving liability of the yard before the guarantor has to pay; and (b) whether the buyer is entitled to a refund particularly if both yard and the buyer have each attempted to terminate the SBC.
Refund guarantees – “on demand” or contracts of surety?
The classification of a refund guarantee as a surety contract or an on-demand guarantee is critical and can make all the difference in monetizing payment, since an on-demand guarantee means that contentious issues between buyer and yard are not particularly relevant when seeking payment from the guarantor. An on-demand guarantee gives the buyer a more convenient route of securing refund of its monies but as such can also be subject to abusive calls. A somewhat unhappy compromise and practice of Chinese banks issuing refund guarantees is a hybrid guarantee that suspends the obligation to pay after a claim is made if arbitration is commenced by the yard within a certain time period. Such clauses often give rise to confusion over the classification of whether the refund guarantee is meant to operate as a surety contract, contingent on establishing liability of the yard or as an on-demand guarantee; this question arose in Shanghai Shipyard Co Ltd v Reignwood International Investment (Group) Co Ltd  EWCA Civ 1147 (“Shanghai Shipyard”) which concerned a dispute over whether a vessel was in a deliverable condition and if the final instalment sum for a vessel had become due and payable. The final instalment sum had been secured by way of a payment guarantee, and the yard accordingly demanded payment from the guarantor. To avoid making immediate payment arbitration proceedings were commenced against the shipyard. The guarantee in question provided, at clause 4, that if the buyer defaults in making payment of the final instalment for fifteen days, the guarantor shall make payment on the yard’s “first written demand”. However, clause 4 also provided that in the event a dispute between the shipyard and buyer was submitted to arbitration, the guarantor would be entitled to withhold payment until an arbitration award had been published. In apparent conflict with clause 4, clause 7(a) provided that the guarantor’s obligations to make payment are to be unaffected by any disputes under the shipbuilding contract.
The English High Court held that, in light of clause 4, the guarantor was entitled to refuse payment until arbitration proceedings between the buyer and shipyard had been fully resolved. However, the High Court’s decision was ultimately reversed on appeal, with the Court holding that the refund guarantee in question operated as a hybrid guarantee. In essence:
- The first portion of Clause 4 of the guarantee acted as an on-demand payment obligation, where the yard is entitled to immediate payment on issuance of a first written demand to the guarantor.
- In order for the guarantor to be entitled to defer payment (on the terms of the guarantee in question), there must have been both a dispute and the commencement of arbitration prior to a valid demand being made.
In a sense, such hybrid guarantees creates different milestones between liability and payment. Shanghai Shipyard emphasizes the importance of clear and unambiguous wording, and for parties not to sacrifice clarity in an attempt to compromise on whether a guarantee should operate as an on-demand or a surety guarantee at the time the guarantee is negotiated.
RGs: Static Document operating in a Dynamic Construction process.
The construction process is a dynamic one where delays are not uncommon and parties may seek to agree an extension to the delivery date. But some refund guarantees have fixed calendar expiry dates pegged to the expected delivery dates initially stated in the construction contracts. While delivery dates can be mutually extended, this may leave a misalignment with the refund guarantee, where the right to call on the guarantee (for example, an extended delayed delivery) arises only after the refund guarantee has expired. To ensure the buyer retains its rights under a refund guarantee, it may be prudent that the validity period of the guarantee is pegged to a payment milestone rather than a fixed calendar date.
Termination of SBCs & Refunds
Termination is often a pre-cursor for a buyer claiming on a refund guarantee but what happens if both the yard and the buyer have attempted to terminate the SBC? In Havila Kystruten A.S v Abarca Companhia De Sugoros S.A.  EWHC 3196 (Comm) (“Havila v Abarca”) the yard had entered into two SBCs with Havila Kystruten AS (“Havila”) for the design and build of two coastal passenger vessels for a price of EUR 108 million per vessel. The Yard purported to terminate the SBCs on the basis that Havila had failed to provide a “written committed statement” of its financing for the vessels. Havila rejected these grounds and proceeded to terminate the SBCs itself, on account of among other things the Yard’s delay and inability to complete the vessels, the Yard’s repudiatory breach of the SBCs and the Yard’s application for judicial dissolution. Havila then sought to call on repayment guarantees provided by Abarca to recover instalments it had paid to the Yard.
The Court held that the Yard was not entitled to terminate the SBC. Havila had procured a commitment letter to the Yard for financing the vessels, and this satisfied the requirement for Havila to provide a “written committed statement” to the yard. Having rejected the yard’s termination, the Court considered the buyer’s termination which included a contractual right arising if the vessel will be delayed by the “drop dead” date – which was satisfied by the yard’s own conduct in stopping work and purporting to terminate. In addition, the yard having commenced dissolution proceedings also meant the buyer was contractually entitled to terminate. These events gave the buyer the right to seek its reliance loss (i.e., the refunds) from the yard and as such from the guarantor. While termination and refunds are often linked, a crucial aspect of termination that isn’t stated expressly in contracts arises from the common law concept of repudiatory breach and in particular, anticipatory repudiatory breach – where a party seeks to terminate before the time for performance. Putting the wrong foot forward may result in wrongful termination, giving the advantage to the other party to terminate and may have consequences on the guarantee cover.