Shipbuilding Contracts: Pitfalls & Pointers

The energy and offshore oil and gas sectors remain key markets for the growth of the shipbuilding industry. In 2020 the global shipbuilding market was valued at $142.52 billion and is projected to reach $195.48 billion by the end of the decade in 2030. As international commerce picks up following the aftermath of COVID-19, many shipyards find themselves under strain, working relentlessly to keep up with increased demand for newbuild vessels to support container and bulk transportation alongside the various specialized new or retrofitted vessels needed for oil and gas production – rigs, drill ships, FPSO, FSRU and OSVs. Together with increased deployment of green technology, yards are finding their orderbooks at capacity. In this article we discuss common issues that may arise from shipbuilding contracts (“SBCs”) in a market where both manpower and raw materials are facing increased volatility.  

The SBC Architecture: Pre-paid Instalments protected by Refund Guarantees

The SBC is a capital intensive exercise with the buyer paying the yard in advance, millions of dollars pegged to key milestones to secure the materials needed for the construction process. As security for its advance payments, the buyer will obtain a refund guarantee provided on behalf of the yard, in the event it is entitled to a refund of its advances paid under the contract. This is likely to occur in the event of the yard’s failure to meet agreed specifications for the vessel, delays in delivery and/or the yard’s insolvency. The refund guarantee is often an area of dispute – it is a static document that may not always cater for the evolving nature of the SBC. Careful consideration needs to be given to the wording of the refund guarantee and whether it is intended to operate independently of any disputes/variations in the SBC. The trigger for payment under the refund guarantee is vital and can range from a simple demand by the buyer to a reasoned arbitration award in favour of payment in the underlying SBC. What is needed to trigger a refund guarantee alongside events which may occur that necessitate variations or delays to the project, all have a bearing on a critical aspect of the refund guarantee – its expiration date.

Repudiatory Breach: Caution when Renegotiating Price & Time

While the SBC and the refund guarantee provides a regime for the return of instalments, parties should be alive to the possibility of repudiatory conduct under common law. The key difference with a common law termination for repudiatory conduct is that it entitles the innocent party to claim damages e.g., loss of bargain in a rising market, and might expose the wrongdoing party to a larger loss exposure.

Shortage of raw materials caused by market disruptions, increased costs, and manpower disruptions, might result in the yard having to renegotiate terms. In its desperation to demonstrate the impact of such extenuating circumstances, the yard might be tempted to use language to communicate an inability to meet the timeline or complete the project within budget or even to threaten to stop work, until terms are renegotiated. Such attempts (although not expressly barred by the contract terms) must be handled with extreme sensitivity to avoid a situation of a renegotiation attempt being recast as a repudiatory breach or anticipatory breach under common law, entitling the buyer to terminate the SBC. Common law termination is not always clear cut and if done wrongfully, might in itself give the yard the opportunity to seize on that termination attempt as wrongful and exit the SBC to sell the vessel in the market.

Changing circumstances/designs: Variations

Buyers may also contribute to delays by ordering variations to the original vessel’s specifications. It is important for buyers to adhere to the agreed contractual framework for ordering variations to the vessel, as the failure to do so may result in the yard alleging that the buyer is itself in breach of the SBC, such that the yard is entitled to additional time and/or costs for completion. If the buyer insists on a variation without catering for an extension of time, it may run the risk of being disentitled from liquidated damages through the prevention principle (see: section below). In a similar vein, yards must be careful not to commence variation works without a variation order issued by the buyer in accordance with the SBC, as the buyer may dispute the variation and its impact on extension of time/costs.  

Liability Regime: LDs, Warranties, Guarantees but no Damages?

It is essential for all parties to understand the liability regime in respect of the performance of the contract. Delays and performance thresholds are typically backed by liquidated damages. Performance warranties are usually backed by a defects liability period compelling the yard to remedy the contractual defect if applicable, but not taking on any further liability such as loss of profits or business interruptions.  Payments or refunds triggered under the contracts are covered by guarantees, so parties should be alive to what types of damages may not be covered under the SBC.

Delays: Permissible, Excluded & Non-Permissible

Delays to completion may occur for an entire host of reasons, including an over stretched yard with competing deadlines for completion, technical design issues, delays caused by sub-contractors and interfacing issues (for e.g., where equipment modules and the hull is completed by different sub-contractors) and changes in law or classification requirements. SBCs are likely to include detailed provisions on timing of a vessel’s completion and delivery to the buyer, and a ‘drop-dead’ date by which the buyer is able to cancel the contract in the event delivery is delayed. For example, in the Shipbuilders’ Association of Japan standard contract (SAJ form), the buyer may rescind the contract if the yard claims an extension of time (“EOT”) in excess of 210 days.

Delay events are more likely than not given the complexities of a newbuild, but neither the yard nor the buyer will assume all risks associated with delays in a SBC. SBCs typically provide for (i) permissible delays, which allow for the postponement of the delivery date and usually concern events outside of the yard’s control including force majeure events (such as extreme weather, war, pandemics and strikes etc); (ii) other causes of delay including the buyer’s default in payment obligations and failure to supply specified items to the yard (known as ‘excluded delays’ in the SAJ Form); and (iii) non-permissible delays, which concerns delays for which the yard is responsible and for which the buyer may be entitled to levy liquidated damages against the yard.

It is critical for yards to comply strictly with notification procedures in the SBC if it wishes to rely on a delay event to postpone the vessel’s delivery date. The failure to do so will likely result in the yard becoming dis-entitled from relying on a delay event to postpone the vessel’s delivery. Contract management by the yard throughout the construction process is critical. Often, yards are left (i) construing correspondence exchanged with the buyer and meeting minutes in a bid to argue that notice requirements have been satisfied; (ii) alternatively (in some contracts) that notification is not a pre-condition to a yard’s entitlement to an EOT; and (iii) that the buyer has, whether expressly or by conduct, waived strict compliance with notice requirements in the SBC.

Extensions of Time & Liquidated Damages: The Prevention Principle Curveball

The prevention principle can often catch a party off guard and might turn the benefit of an EOT clause on its head. Put simply, the prevention principle denies the buyer a claim for liquidated damages if its own act prevented the yard from completion (e.g., withholding approval of designs or otherwise frustrating the EOT mechanism). In such circumstances, the buyer may lose its rights for liquidated damages and the time for completion under the contract will be replaced by a reasonable time of completion given the buyer’s “culpable conduct”. For this reason, EOT mechanisms need to be carefully considered and followed to cater for a wide spectrum of possible buyer related activities that may impact completion.

Insights

Oil Storage: Considerations for Financiers & Traders
Asset Recovery in Commodities: Know your Tools
International Trade: The Anti-Money Laundering Achilles’ Heel