Structuring Shipbuilding Contract [Part 2]

(A follow-up from Part I and what does it take to negotiate a shipbuilding contract)

Introduction
The major milestone in a typical shipbuilding process are contract award, design, drawings, detailed engineering, equipment procurement, material requisition, keel laying, fabrication, equipment installation, launching, test, commissioning, delivery and warranty. Key participants during the whole process will include: the seller (shipyard), buyer, classification society, regulatory authorities, consultant engineers, equipment suppliers, subcontractors, shipping agents, banks and insurers.

The Shipbuilding Contract
Shipbuilding contract governed by English law (and jurisdictions that treat English decisions as authoritative or persuasive) are essential agreement for the construction and sale of a ship by description, (and more specifically a sale of future rather than existing goods) [1].

Primary obligation of Shipbuilders
The primary obligation of the shipbuilders or seller is to construct and deliver a vessel that complies with the contract specifications (i.e. description, dimensions, characteristics, performance requirements, classification and regulatory rules). Depending on the gravity and magnitude, non-compliance with specifications may be construed as breach of contract. Buyer’s remedy would include rejection of the vessel, remedial work and/or damages or specific performance (Though for practical reason, the courts are reluctant to order specific performance where parties are located in different jurisdictions).

Implied Terms
Apart from the expressed terms, implied terms in the Sale of Goods Act [unless expressly excluded] govern issues on description, quality and purpose. If applicable, the test of whether the vessel had complied implicitly with its contract specification is an objective one, from the point of view of a reasonable Buyer and the burden of proof is on the Seller to show that the breach is so slight that it would be unreasonable for the Seller to reject the vessel [2]. In practice though, issues of conformity are mitigated or addressed by remedial work to correct shortcomings identified during the on-going inspection, tests and trials.

Classification and Regulatory Requirements
Besides providing independent technical expertise, Classification Societies (class) is a key player in any shipbuilding project. They develop technical standards, i.e. rules, for the construction of ships, approve designs against their standard, conduct surveys during the construction of a vessel and issue a certificate to say that the vessel meets the requirements of their standard on delivery. They prescribe regulations requiring periodical surveys to indicate that the vessel still meets the required standard. *ABS, BV, CCS, DNV, GL, LR, NK, RINA, RS and IRS (abbreviation for classification societies).

Delays in drawing/plans approval by class and changes in class or regulatory rules are inevitably risk to seller and buyer in terms of impact on the construction schedule [3] and costs. Apart from a variation order, this item should be the subject of detailed discussion. An equitable solution for seller would be an adjustment for cost and time impact where delays not due to shortcomings on their part and where class rules and regulation are changed after the date of the contract.

Design Responsibility
One major issue during contract negotiation is often the allocation of design responsibility. Where the shipbuilding contract is silent on design responsibility, cases has shown that seller inevitably assumes full responsibility [4].For proto-type design developed by buyer or their designers, prudent seller should resist request for total assumption of full design responsibility and instead negotiate for loose alliance and close cooperation arrangement, demarcating responsibility in the early stage of the design development. Allowance should also provide for timely transmittal of information, data and clarification relating to the basic design (prototype or otherwise) from buyer.

Price and Payment Terms
The primary obligation of the buyer is to pay the contract price when due and take delivery of the vessel tendered in conformity with the contract. Failure to pay the contract price in a timely manner will give rise to a claim for debt or damages. In addition, most shipbuilding will provide for payment of interest accruing from the due date till date of actual payment and a right to suspend (after expiry of grace period) further performance of the contract for a limited period, followed by termination if non-payment persist.

The contract price is usually fixed on a lump sum basis, subject to adjustment for variation orders. Payment structure would commonly be fixed lump sum, milestone payment, subject to adjustment for delay delivery, variation orders and price escalation. In the absence of any price escalation clause, any attempt by the seller to increase the price unilaterally may be dismissed for lack of consideration or economic duress, save for special circumstances where buyer benefited [5].

Depending on bargaining position, an ideal payment schedule for seller would be receiving the bulk during contract award, keel laying, fabrication and erection of steel hull, leaving 10% for launching and delivery.

Where the buyer (non-ship or one-ship special purpose company) has no substantial asset, seller should insist on appropriate security to address payment risk. This can be procured by buyer through documentary credit, payment guarantee or parent company’s guarantee.

Extras and variations will inevitably have an impact on the project schedule and seller’s cash flow. It is normal to subject request for variation orders to seller’s other work commitment and slot availability. A suggested payment schedule for mitigating cost impact of variations could be structuring payment terms at 50% upon signing of variation orders and balance upon completion of the extras. Rates could be agreed at time and material basis, plus a mark-up percentage. [To avoid uncertainty, a breakdown of the items included in the contract price should be extended to Buyer (example manuals or drawings, spares, tools, expenses during launching or sea-trials, telephone bills, office space, amenities, additional service and training etc)]

Bank Guarantee
To address buyer’s concern about credit and performance risk, buyer will insist on bank refund bond or guarantee from seller. Issues for negotiations will relate to the quantum and the event that would trigger a call on the guarantee. There are essentially two types; a conditional and an on demand bond. A conditional bond requires a failure on the part of the seller to perform certain condition in the shipbuilding contract (usually subject to an arbitration award or final court order), whereas an on demand bond can be activate simply by a demand made on the bank without proof or conditions. Seller would inevitably offer a ‘conditional’ performance bond to safeguard itself against unjustifiable call. This poses certain element of risk and uncertainty for buyer in terms of the need to prove the default and being drag through judicial process.

The preferred form for buyer (and in practice, some banks and bond issuers) will usually be an on-demand guarantee. However this poses severe risk implication for seller in the hands of trigger happy buyer who may resort to unfair or unjustifiable call [6]. One possible way of preempting such act will be through an interlocutory injunction to prevent the bank or bond issuers from releasing payment. However the courts are generally reluctant to grant such an injunction unless the bank knew that the request for payment was made fraudulently or on forged papers. They describe it as similar to a letter of credit. An interlocutory injunction is a discretionary remedy, which can be obtained unilaterally in case of urgency by way of an ex-parte application for a court order to restrain the bank or bond issuers from releasing payment on the guarantee, until the case is heard. Claimant will need to show that there is a serious issue to be tried on their claim, damages will not be an adequate remedy and the balance of convenience favors restraint [7].

It should be noted that modification to the terms of the shipbuilding contract may advertently nullify bonds and guarantees already issued. Caution will dictate that the following documents should be obtained; either a copy of the bank’s authorized signatory or a resolution authorizing the issuance of the guarantee.

Liquidated Damages, Assignment, Warranty, and Force Majeure: click on the subject to see previous articles.

Governing Laws
It is not enough to simply state that the parties agree to submit to the jurisdiction of the English Courts. If English Courts should be the forum, then the parties will need to expressly spell out the exclusivity [8]. In the case of Sabah Shipyard (Pakistan) Ltd v The Islamic Republic of Pakistan, the Court of Appeal held that unless such clauses are carefully drafted to grant exclusivity in a given jurisdiction, the court would not infer that such exclusivity existed. In practice, preliminary issues prior to issue of a writ of summons [9] would concern effective service of the writ on the defendant and submitting to the jurisdiction of the English courts. A suggested solution would be inclusion of agreement in the governing law clause that the parties shall irrevocably submit to the jurisdiction of the Courts in England. As for service of writ, appointment of an agent in the UK to accept service would be a practical choice where English law governs the contract.

Lastly, where parties are from different jurisdictions, the paramount consideration for governing laws and judicial forum should be the enforceability of the judgment.

Footnotes

[1]Hyundai Heavy Industries v Papadopoulos [1980] 2 Lloyd’s Rep. 1 and Stocznia Gdanska S.A. v Latvian Shipping Co [1998] Lloyd’s Rep. 609
[2] Section 15A Sale of Goods Act (inserted by SSGA 1994): In a contract of sale, where the buyer does not deal as a consumer, if the seller’s breach of a term implied by ss13, 14 or 15 is so slight that it would be unreasonable for the buyer to reject the goods, then the breach is to be treated as a breach of warranty. N/B: The Act also distinguished between a condition and a warranty. A breach of condition entitles the party not at fault to treat the contract as repudiated whereas a breach of warranty only give rise to a right to damages, but not a right to reject the goods and treat the contract as repudiated.
[3] Construction schedule – most shipbuilding contract will have a separate attachment, sometimes called the Planned Program, illustrating the activities, construction sequent, and dates for each stage of construction.
[4] A.M Gillespie & Co v James Howden and Co (1885); Amoco Cadiz [1984] 2 Lloyd’s Rep 304; Aktiebolaget Gotaverken v Westminster Corporation of Monrovia [1971] 2 Lloyd’s Rep. 505 ; compare with Dixen Kerly Ltd v Robinson (1965) 2 Lloyd’s Rep 404
[5] Williams v Roffrey Bros & Nichols [1991] 1QB CA, Anangel Atlas Compania Naviera v Isika Heavy Industries Co Ltd (No.2), North Ocean Shipping Co Ltd v Hyundai Construction Co Ltd (The Atlantic Baron) [1979] QB 705, 1 Lloyd’s Rep 89.
[6]Edward Owen Engineering Ltd v Barclays Bank International Ltd & Umma Bank (1978) Q.B. 159 C.A.
[7] American Cyanamid v Ethicon [1975] AC 396, House of Lords
[8] Sabah Shipyard (Pakistan) Ltd v The Islamic Republic of Pakistan [2002] EWCA Civ 1643 where the clause : “Each party hereby consents to the jurisdiction of the Courts of England for any action filed by the other Party under this Agreement to resolve any dispute between the Parties and maybe enforced in England’, was held by the Court Appeal not to confer an exclusive jurisdiction on the English Court which would make it a breach of contract for parties to bring legal proceedings in the Courts other than the English Courts
[9] Writ of Summons – an official court document issued by a commercial court, setting out the claim against the Defendant, and containing instructions that defendant must adhered to.

© 2007 David Seah