Arbitrating disputes under shipbuilding contracts

Introduction

The shipbuilding industry, like many other sectors, has benefitted in recent years from innovation and new technologies. More disruption is on the horizon given the pressures on the sector to improve efficiencies and limit its impact on the environment. This innovation means that buyers and shipbuilders are entering into shipbuilding contracts for a new generation of ships, with new and complex design elements. This inevitably increases the risk of technical disputes arising. 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 arbitral proceedings, and pursuing them quickly, can be crucial, particularly in respect of predelivery disputes and those under Chinese refund guarantees.

Pre-delivery disputes

One of the main concerns for a buyer who comes across a technical defect during the construction of a vessel is the risk that the builder will not accept that there is a defect and insist on delivery. If the buyer refuses to accept delivery on the basis of the defect, it risks being in repudiatory breach of contract. The consequences for a buyer in those circumstances are draconian. The builder can opt to terminate the shipbuilding contract and keep the installments already paid. The builder frequently can then sell the vessel either at an auction or by private sale to a third party with the buyer to receive only what remains (if anything) after the builder deducts from the installments 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’s rejection was valid, it will have a claim in damages against the shipbuilder, but damages are often restricted to repayment of installments 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.

The risk to the buyer is generally lower where the technical issue becomes apparent at an early stage, as the dispute is generally more easily settled and issues remedied prior to delivery. In many cases, however, the defect does not become apparent until a much later stage, often at the time of the sea trial. At that point, the risk increases that the builder will dispute that there is a technical issue and terminate the vessel sale contract on grounds of repudiation if the buyer insists on delaying acceptance until the defect is remedied. These disputes can come to a head quickly in a rising market, as the builder will usually be unwilling to delay a decision on whether or not to terminate for a protracted period of time. The builder can also be pressed to make a swift decision on termination by its obligations to deliver other orders and lack of capacity in the shipyard. 

The buyer will, however, have a substantial advantage if the shipbuilding contract contains an arbitration clause providing for expedited arbitration proceedings for pre-delivery disputes. In those circumstances, the buyer can refer the matter to arbitration seeking an urgent 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 to make the requested rectifications. There is also benefit to the builder in agreeing to an expedited procedure for pre-delivery arbitrations since it will also benefit from having certainty at a much earlier stage as to how the defect will be treated. Typical expedited arbitration 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 award.

Chinese refund guarantees

Care over the timing for bringing arbitral proceedings also must be taken when looking to recover under a refund guarantee, particularly if it has been issued by a Chinese bank. 

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, despite installments being paid by the buyer 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 to secure the return of pre-delivery installments in circumstances where the buyer is entitled to exercise its right to cancel the contract. If the builder is encountering financial difficulties, the buyer will be especially keen to ensure its refund guarantee remains in place – the refund guarantee may prove to be its sole realistic prospect of recovery.

Timing is not such a big issue in relation to refund guarantees from Korean or Japanese banks, however refund guarantees from Chinese banks can be tricky as often their expiry date is a short period after the date the contract was cancelled – commonly one month but sometimes substantially shorter, amounting to just a few days after the cancellation date. But time will be stopped if arbitral proceedings are commenced, pending resolution of the dispute over payment. This means that, to preserve the buyer’s position, it is very important for buyers to instruct lawyers at an early stage and ensure that arbitral proceedings are commenced as soon as possible after the cancellation date.

Timing risks can also arise where changes have been agreed to the underlying shipbuilding contract, such as extending the contractual delivery date. It is common practice to agree extensions, often in exchange for a discount to the purchase price of the ship, and there may be a number of agreements for relatively short extensions over the life of the project. Given that the refund guarantee and shipbuilding contract are intended to be linked in most key respects, it is easy to forge t that they are discrete obligations; the guarantee is an obligation between guarantor and buyer, separate to the shipbuilding contract between builder and buyer. This is intentional, as its purpose is to provide the buyer with security from an independent source. But where changes are made to the shipbuilding contract, it creates a risk that the guarantee may no longer operate as expected.

Extending the project delivery date can result in particularly serious problems where the guarantee has a fixed expiry date (as do 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, so an extension may mean the buyer’s right to cancel is triggered only after the expiry date of the refund guarantee. The buyer will have lost critical security. Whilst this is an easy issue to avoid if the parties are careful with amendments, it can catch out even experienced buyers.

Conclusion

These are a few examples of the importance of arbitration proceedings in shipbuilding disputes, and where the timing of strategic steps (particularly how and when to commence arbitration) can make a huge difference to the balance of power between the parties. Indeed, such tactics can make or break a case. Buyers should keep these timing issues in mind, particularly where they are entering into shipbuilding contracts for the 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.