Arbitrating disputes under shipbuilding contracts – the importance of timing

Introduction

The majority of ships continue to be built in the shipyards of China, Korea and Japan. Where foreign buyers are involved, these contracts are usually subject to English law and, in the event of a dispute, arbitration. From a buyer’s perspective, getting the timing right for starting proceedings and pursuing them quickly can be crucial, particularly for pre-delivery disputes and those under Chinese refund guarantees.

Pre-delivery disputes

One of the main concerns of buyers who come across a technical defect during the construction of a vessel is that if the builder pushes them to accept delivery of the vessel and they refuse to accept it on the basis of a technical issue, they may be in repudiatory breach of contract. The consequences for the buyers in those circumstances are draconian: the builder can opt to terminate the shipbuilding contract and keep the instalments already paid. The builder can frequently then sell the vessel either at an auction or by private sale, with the buyer to receive only what remains (if anything) after the builder deducts from the instalments paid all the costs, interest and any negative difference between the contract price and the sale price. Of course, if the tribunal finds that the buyer’ rejection of the vessel was valid, it will have a claim in damages against the builder, but this is often restricted to repayment of the instalments paid plus interest. This may not fully compensate the buyer in circumstances where the value of the vessel has increased. What the buyer wants, in these circumstances, is delivery of the vessel with the technical issue resolved or a reduction in the sale price.

In some cases, the risk to the buyer of rejecting the vessel when presented for delivery can be avoided because the technical issue becomes apparent at an early stage. In many cases, however, the defect does not become apparent until a much later stage, often at the time of the sea trial. What can the buyer do at that stage to mitigate the risk that the shipyard will cancel if the buyer refuses to accept the vessel until the technical defect is remedied? The problem is that the builder will often dispute that there is a serious technical issue in the first place, and in a rising market it will usually be unwilling to delay a decision on whether or not to terminate for a protracted period of time. The builder’s decision might also be influenced by its obligations to deliver other orders and the lack of capacity in the shipyard to make a decision.

The buyer will have a substantial advantage if the shipbuilding contract has an arbitration clause providing for expedited arbitration proceedings for pre-delivery disputes. In those circumstances, the buyer can ask for a declaration that the builder has to rectify the defect without fear that the contract will be terminated as long as the arbitration is commenced several months before the contractual delivery date. The pressure is then on the builder since it has to decide whether to continue with construction and risk having to re-do work, or give in to the buyer’s demands, making the requested rectifications. There is also benefit to the builder in agreeing to an expedited procedure for pre-delivery arbitrations since it will also have certainty on how the defect will be treated at a much earlier stage. A typical clause would provide for a maximum 12 week window between the appointment of the arbitrators and the hearing. This is a difficult schedule to work to for both the buyer and its lawyers but it can be worth pursuing because of the benefits of an early arbitration ruling.

Timing pitfall of Chinese refund guarantees

Care also must be taken with timing when looking to recover instalments under a refund guarantee, particularly if it has been issued by a Chinese bank. Generally such payment will be suspended if arbitration proceedings are commenced within 28 days of the request for payment. The refund guarantee is an important document in the context of shipbuilding contracts since title to the vessel usually remains with the shipyard until delivery, although instalments are paid at various stages during construction. For this reason, virtually all buyers require the builder to procure one or more refund guarantees from an acceptable bank in order to secure the return of their pre-delivery instalments in circumstances 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 might be expected, 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 fail to operate as expected
when changes are made to the underlying shipbuilding contract.

Timing is not such a big issue in relation to refund guarantees from Korean or Japanese banks but there is an added time pressure where the vessel is being built in China since the refund guarantees have an expiry date which is usually a short period after the cancelling date. Often this period is one month if arbitration proceedings have not been commenced but sometimes the period is substantially shorter, maybe even a few days. This means that there is huge pressure on buyers to instruct lawyers at an early stage to ensure that arbitration proceedings are commenced as soon as possible after the cancelling date to preserve their position. Buyers must also be familiar with the terms of the refund guarantee and prepared to act quickly if necessary.

A further example of an important issue on the running of time 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, over the life of the 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 (for example, for a series of agreed modifications early in the project), 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 ensuring amendments to the expiry date of the refund guarantee, it can catch out even experienced buyers.

These are areas where the timing of strategic steps can significantly impact the balance of power between the parties, and can make or break a case. Buyers should keep these timing issues in mind, particularly where they are entering into shipbuilding contracts for a new generation of ships, with new design elements such as scrubbers or ballast water treatments systems fitted, as new and complex technology inevitably increases the risk of technical disputes arising.