The Nature of Refund or Payment Guarantees in Shipbuilding Projects

 

In order to manage counter-party risks in shipbuilding contracts, most buyers will require a refund guarantee from the shipbuilder to secure repayment of instalments when the buyer terminates the contract lawfully.   

On the other hand, where the payment terms are heavily end-loaded or where the buyer is a special purpose company without substantial assets, shipbuilders will require a payment guarantee from the buyer. Such guarantees may be issued by banks, financial institutions, insurers and at times, the parent company of the parties. 

Such guarantees could either be traditional or demand guarantees, and this will depend on its language as a whole in its particular commercial context. (Per LJ Popplewell at para 34 in Shanghai Shipyard Co. Ltd V Reignwood International Investment (Group) Company Limited [2021] EWCA Civ 1147).   

A guarantor’s liability under a traditional guarantee is secondary and is dependent upon the liability of the principal debtor. (i.e. an undertaking by the guarantor to be liable for the debt or obligation of another if that other defaults). Such guarantees by way of suretyship are sometimes called “see to it” guarantees, following the dictum of Lord Diplock in Moschi v Lep Air Services Ltd [1973] AC 331, 348; that the nature of the guarantor’s obligation was “to see to it that the debtor performed its own obligation to the creditor”. Per LJ Popplewell at para 22 in Shanghai Shipyard v Reignwood International Investment (Group) Company Limited [2021] EWCA Civ 1147. 

In contrast, a demand guarantee can simply be activated by a demand made on the guarantor and is payable without proof or condition, independent of the underlying shipbuilding contract. Though at times, it may be conditional upon an arbitration award. 

The distinction between traditional and demand guarantees has often led to disputes. In Gold Coast v Caja De Ahorros Del (2001) EWCA Civ 1806, the issue was whether the defendant's bank refund guarantee was payable on demand or after the shipbuilder’s liability has been determined by arbitration. Under the guarantee, the defendant bank had to pay specified amounts on first written demand, subject to receipt of a certificate issued by Lloyd's Bank, stating the instalment amount paid to the shipbuilder, the date of such payment, and that buyer has become entitled to a refund pursuant to the contract and that the shipbuilder has not made such refund. 

The Court of Appeal (CoA) held that the instrument was a first demand guarantee as the obligation, which is expressed to be an “irrevocable and unconditional undertaking", is that the bank “will pay” on a first written demand. Also, the condition of payment only requires a certificate, with no reference to arbitration or any underlying liability under the shipbuilding contract. The instrument also contains its own dispute resolution provision. 

In Wuhan Guoyu Logistics Group Co Ltd and Another v Emporiki Bank of Greece SA [2012] EWCA Civ 1629, the terms of the payment guarantee provide for payment to be made on the shipbuilder’s first written demand, stating that the buyer has been in default of the payment obligation for 20 days. Payment is to be made “immediately” without any request being made to the shipbuilder to take any action against the buyer. Also, the guarantee provided that the bank’s obligations shall not be affected or prejudiced by any dispute between the shipbuilder and the buyer under the shipbuilding contract or by any delay by the shipbuilder in the construction or delivery of the vessel.

 

The CoA found for the shipbuilder on the basis that while the interpretation of a guarantee is dependent on the words used, there is a presumption that, if certain elements are present in the document, the document will be construed in one way or the other. Such elements were propounded in Paget’s Law of Banking 11th edition under the heading “Contract of Suretyship v. Demand Guarantee”, which provides that where an instrument will almost always be construed as a demand guarantee: 

 

“(i) Relates to an underlying transaction between the parties in different jurisdictions. 

(ii) Is issued by a bank.

(iii) Contains an undertaking to pay “on demand” (with or without the words “first” and/or “written”).

(iv) Does not contain clauses excluding or limiting the defences available to a guarantor,

 

According to the appellate court, the words “will almost always be” amount to a presumption which was by then fully justified by the Court of Appeal authorities (see Howe Richardson v Polimex [1978] 1 Lloyd’s Rep 161, Edward Owen v Barclays Bank [1978] QB 159 and Esal (Commodities) Ltd v Oriental Credit Ltd [1985] 2 Lloyd’s Rep 546).

 

Such presumption was subsequently approved by the CoA in Gold Coast Ltd v Caja de Ahorros[2002] 1 Lloyd’s Rep 617 at para 16,  and the document held to be a demand guarantee, despite the absence of the fourth element concerning presumption.

 

In the Wuhan  Guoyu Logistics Group v Emporiki Bank’s case referred to above, there was this postscript:

 

“… if, on the assumption that the Bank is liable to pay and does pay the amount guaranteed, the underlying position turns out to be that the Buyer never was obliged under the ship-building contract to pay the second instalment.  Would the Seller [shipbuilder] hold the amount paid by the Bank on constructive or resulting trust for the Buyer?  That is better considered when finality is reached in the arbitration.”

 

In a subsequent hearing, the CoA held that even though the arbitration tribunal decided that the buyer was not obligated to pay the second instalment at the point in time of the shipbuilder’s demand, the second instalment was due from the bank under the guarantee because the shipbuilder asserted in good faith that the buyer was in default of payment under the shipbuilding contract.

This “rendered payment due under the guarantee, and once due it remained due.”

 

The CoA concluded that the second instalment paid by the bank to the shipbuilder under the guarantee was not held by the shipbuilder on trust for the bank. Also, the CoA considers it inappropriate and declined to express any view on whether the shipbuilder holds the money on trust for the buyer as the buyer was not before the court and “the creation of a trust for the Buyer will be inconsistent with the obligation to account which envisages the payment of the balance due on striking the account as between Seller [shipbuilder] and Buyer”.

 

In Shanghai Shipyard Company Ltd v Reignwood International Investment (Group) Co. Ltd [2020] EWHC 803 (Comm), [2021] EWCA Civ 1147, involving a shipbuilding contract for an offshore drillship, the court had to decide whether a payment guarantee provided by Reignwood to the Shipyard was a surety or ‘see to it” guarantee or a demand guarantee. The terms of the guarantee included, inter alia the following: 

• Under Clauses 1, 3 and 10, Reignwood irrevocably, absolutely and unconditionally guaranteed "as the primary obligor and not merely as the surety" payment of the delivery instalment and interest thereon at a rate of 5% (capped per clause 10 to a maximum of 60 days interest).
• Under Clause 4, if the buyer fails to punctually pay the Final instalment or any interest thereon, and any such default continues for a period of fifteen (15) days, then, upon receipt of the shipyard’s first written demand, Reignwood shall immediately pay to shipyard all unpaid Final instalment, together with the interest. In the event that there is a dispute between the shipyard and the buyer concerning payment of the final instalment and such dispute is submitted to arbitration, then Reignwood is entitled to withhold payment until the publication of an award ordering the buyer to pay the delivery instalment.
• Clause 7 comprised anti-discharge provisions. 

Subsequently, Reignwood novated the contract to Opus Tiger 1 Pte Ltd (“OT1”), a single-purpose company. In due course, OT1 refused to pay the final instalment. They contended that the vessel was not in a deliverable condition because of major and critical defects. The Shipyard demanded payment under the guarantee, but Reignwood refused to pay. The Shipyard then sued Reignwood in commercial court. (Some months later, Reignwood started arbitration against the Shipyard in the name of OT1). In the commercial court, the issues were as follows: 

• Issue (a). Whether the guarantee is a demand guarantee, such that; subject to issue (b) the guarantor’s liability by reason of the demand, whether or not the buyer was liable to pay the final instalment under the terms of the contract; or a “see to it” guarantee or a conditional payment obligation, such that – subject again to the issue (b) the guarantor’s liability arose upon the demand only if the Buyer was liable to pay the final instalment under the terms of the contract.
• Issue (b). The guarantor is entitled to refuse payment under clause 4 pending and subject to the outcome of the arbitration; only if the arbitration has been commenced between those parties as at the date the demand is made; or regardless of when such arbitration is or may be commenced?” 

The commercial court concluded that the guarantee was a “see to it” guarantee, and not a demand guarantee. It held that under clause 4 the guarantor is entitled to refuse payment pending and until the arbitration award. On appeal, the CoA unanimously overruled the commercial court. They stated that the guarantee was a demand guarantee for the following reasons: 

• The words “absolutely and unconditionally” in clauses 1 and 3 would convey to a businessman that the obligations were not conditional on the liability of the Buyer.
• The words in clause 1 “[as primary obligor] and not merely as the surety” clearly indicate that the document is not a surety guarantee.
• The words in clause 4 “upon receipt by us of your first written demand” which triggers the obligation to pay “is the hallmark of a demand guarantee. For “see to it” or surety guarantee, the guarantor will need time to investigate whether there was indeed an underlying liability before making the final instalment payment under the shipbuilding contract.
• Clause 10 which limited the interest payable to 60 days, indicates that prompt payment on demand was required, and “not the lengthy delay which might be contemplated to resolve a dispute about the Buyer’s liability.”

The CoA also concluded that as the demand has been made before the commencement of arbitration proceedings, the Shipyard has an accrued right to payment under the guarantee, which is a right to payment “immediately upon a valid demand”.

The subject of presumption and reliance on precedents was also addressed by the CoA. Reignwood had argued that as it was neither a bank, nor a financial institution akin to a bank, but merely a parent, there is this “presumption about the nature of the guarantee which might lead to a different conclusion to that which would follow if a bank had issued it, by reference to the application of different starting presumptions.” 

The CoA rejected Reignwood’s argument and stated that: 

• It has long been established that payment and refund guarantees may be demand guarantees, and the counterparty risk aspect of such guarantees is that the beneficiary will therefore look to a guarantee from a bank or other financial institution; or a related party, such as a parent company based on the “commercial and financial strength and probity of the guarantor”.
• No preconceptions or assumptions should be made as to the nature of the guarantee based on the identity of the guarantor, as what matters is the wording of the guarantee, “interpreted in accordance with the well-established rules of construction.” Otherwise, this would lead to an uncommercial result.
• Even though Reignwood was a parent company and not a bank, this was not significant because Reignwood clearly exercised a financing function which went beyond that which would normally arise between parent and subsidiary.
• Regarding reliance on decided cases on traditional and demand guarantee, the CoA stated that similarly worded instruments in such cases are only of assistance if the words used in the instrument “taken as a whole are materially identical; and if the contractual context in which they are used is materially identical”. 

In Havila Kystruten v Abarca Companhia [2022] EWHC 3196 (Comm), concerning the termination of two shipbuilding contracts (“SBC”) for the design and build of two coastal passenger vessels, one of the issues before the court was whether the insurance bonds were payable on demand or surety bonds.

 

The insurers submitted that the instruments were not demand bonds for the following reasons: 

• There were no words like “absolutely and unconditionally”, “primary obligor”, “first written demand” and “immediate payment” in the bonds.
• The insurer was not required to pay “upon the buyer’s written demand”.
• The word “Loss” in the bonds “means a situation in which the shipbuilder is obliged to reimburse the buyer the instalments paid.  Therefore, the liability of the insurer to pay under the bond is only triggered if the shipbuilder is liable to repay the buyer.
• The words in bonds requiring the insurer to pay “monetary compensation” to the buyer are inconsistent with a primary obligation to pay and reflective of liability only if the buyer suffers a loss.
• The bonds refer to the buyer “making a claim” under the policy. If the bonds were on-demand guarantees, the language should be making a ‘demand’, instead of a ‘claim”.
• If the buyer makes a claim and the shipbuilder disputes liability to repay the pre-paid sums to the buyer, then the buyer’s only option is to obtain a final and non-appealable decision from the court.
• The bonds do not provide that the obligations of the guarantor remain unaffected by any dispute under the SBC. 

Thus, the buyer’s right to the instalments must be undisputed or judicially determined under the SBC before the insurance bonds respond.

 

However, Mr Justice Henshaw held that the bonds were on-demand bonds. This was because the bonds read as a whole revealed that the insurer’s obligation to pay is not dependent on the buyer establishing any underlying liability on the part of the shipbuilder to the buyer.

 

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