Based on many years of experience in shipbuilding, conversion and repair contracts, acting for shipyards and buyers worldwide in both contentious and non-contentious matters, CJC Director Chris Kidd offers guidance on preparing for the issues that will rise out of current market trends.
I am often asked what causes the most frequent problems in shipbuilding projects. Of course, it is not always possible to predict, and it varies from time to time as the market changes but it is possible to identify some common themes from the cases I have handled.
The present market
The shipping market itself is volatile in the short term, with longer term boom and bust cycles which vary from sector to sector. Over the last 20+ years we have seen the boom of the early 2000s followed by the bust starting in 2008 and a further one, particularly involving offshore construction, following the oil price crash in 2014-2016.
We now are in a sellers’ market with contracted newbuiding tonnage and prices increasing and long order books approaching three years. This is not surprising when the number of yards has reduced, capacity is substantially more consolidated, fleets are aging and need replacing (with lower carbon emitting vessels powered by new fuel technologies), and there is a strong demand for LNG and container vessels.
This is all going to affect how contracts are negotiated and managed.
Market impact on shipbuilding contracts
When the shipbuilding market fell in 2008 and again in 2015 some buyers tried to renegotiate instalments and exercise rights of termination or even repudiate contracts but as we move into a hardening sellers’ market buyers will be more likely to want to take delivery of the ship . They are less likely to want to ditch the contract and risk delay, loss of earnings and higher prices to find a replacement. On the other hand, a builder might, as some did before the market fall in 2008, feel it is in its commercial interest to get out of the contract if it can sell the vessel to another buyer at a better price, particularly if its costs of production are being impacted by general inflationary pressures in the supply chain.
A buyer will therefore need to ensure that a seller is locked into the contract from the outset by ensuring it promptly complies with any conditions precedent relating to, for example, guarantees and board approvals. Care will also need to be taken to ensure option agreements are not unenforceable agreements to agree and in negotiating provisions relating to the yard’s provisions of refund guarantees to ensure it can’t hide behind a failure to provide them as a reason to say the contract has not become effective.
Buyers will also need to ensure that they do not get lured into unrealistic delivery dates. Whilst a contractual right to terminate for excessive delay and a refund of the instalments may provide the buyer with some protection it may well prefer not to terminate in a rising market. In this case it will be important to negotiate adequate delay liquidated damages provisions to ensure the vessel is delivered promptly and the buyer is adequately compensated for delays.
We are also likely to see the yard trying to make delay in delivery by subcontractors or suppliers a force majeure event which entitles it to claim that it is permissible delay and claim an extension of time for delivery. We can expect buyers will want to resist such attempts.
In rising markets there is an increased risk of construction defects arising out of the builder being overstretched or cutting corners to meet the delivery date. The clauses relating to quality control e.g. the choice of and yard’s responsibility for subcontractors, inspecting the work, attendance at tests and trials will therefore be important. So will those relating to the yard’s obligations to remedy defects prior to delivery and under the warranty provisions in respect of defects discovered after delivery.
We can also expect yards may try to recover unexpected additional costs arising from inflated prices in the supply chain by claiming additional time and costs for variations. The variation order regime and procedure will need to be carefully negotiated and, just as important, operated properly during the project to avoid costly and lengthy disputes.
Capacity constraints may well lead to delays which will lead the yards to ask for price increases or acceleration costs which will need to be resisted. We may also see the return of attempts by yards to negotiate price escalation clauses to protect themselves against rising costs in their supply chain.
To guard against the risk of the yard repudiating the contract to sell at a higher price to another buyer it will be important to ensure that the yard is not able to limit its liability just to repayment of predelivery instalments plus interest, as it will often try to do, or to a fixed sum. It is also important for buyers to remember that a refund guarantee is usually limited to securing repayment of instalments and does not usually cover claims for damages for other losses that might arise if a yard is in repudiatory breach of contract . The usual wordings would need to be amended if guarantees are to cover claims for damages.
In the past rising markets resulted in speculative orders. It is obviously riskier for the yard if the customer places the order on a speculative basis without any existing contract for the operation of the vessel or even with the intention of re-selling the ship on the assumption that the market will rise. If the customer cannot find employment for the ship or the market does not rise as the buyer hopes, there is an increased risk of problems from the buyer further down the line including possible reluctance even to take delivery. The contract terms will be important to try to limit the buyer’s room for manoeuvre.
New markets and technologies
Builders and buyers often have problems when moving into markets that are not familiar to them, for example the offshore market or the cruise ship market. Much the same applies where new or evolving technologies are involved. Many yards have lost large amounts of money because of this learning process, and it has produced substantial disputes.
All will be aware of the recent technological challenges arising out of the decarbonisation of shipping and shipbuilding. Specification of newbuildings have changed to enable owners to reduce carbon emissions, increase the efficiency of vessels and comply with changes in international legislation using new fuels, and even sails. This brings together two fertile areas for generating disputes: design risks and changes in regulations.
Design issues can affect a project in different ways. They can cause problems from the early stage if the yard experiences delays in the design and engineering but, as is often the case, construction starts before the design and engineering is sufficiently developed stage. This is often a recipe for delay, disruption and cost overruns with the result that a vessel is delivered late and over budget. Disputes often follow.
It is therefore a good idea for a buyer to mitigate this risk by checking what experience the yard has with a new technology. Where it is has little or no experience the buyer is best advised to ensure the contract contains approval and inspection rights during the design process to identify problems and ensure that the project schedule provides enough time for the yard to carry out the necessary design and engineering before construction starts.
It is also important to carefully consider the allocation of design risk. Once again, the yards obligations to remedy defects prior to delivery, the warranty provisions and the process for modifications during construction are important, particularly where modifications arise from a change in regulation or evolution of the design. Contracts which share the design risk between the builder and buyer, or require vessels to be fit for purpose, can give rise to significant disputes, particularly if the contract wording is unclear. Buyers and builders will need to consider whether, in the various circumstances that may arise, the builder is obliged to make a modification even if it means resolving the time and cost consequences at a later stage.
A shipbuilding contract will usually contain provision for the payment of liquidated damages for failing to comply with defined performance criteria and if these exceed a defined limit, a right to rescind the contract.. We can expect that buyers will look to require new liquidated damages clauses relating to the vessel’s performance, and additional rights to reject the vessel or terminate the contract if the vessel does not comply. These may however be of limited benefit to a buyer, and it will have to rely more heavily on proactive project management by using the supervision rights contained in it to identify and correct failures to comply with the vessel’s description and specification..
Where parts of the vessel’s performance will not be tested until after delivery (which is the case, for example, with boil off gas on LNG carriers) buyers will want to negotiate provisions to protect themselves if a vessel fails to perform in accordance with its specification, particularly where a defect may be latent as a result of the new technology or design.
There are likely to be an increased number of warranty claims when vessels are delivered incorporating new technologies (where the design responsibility may have been shared with the buyer). Particular attention will need to be focussed on the extent to which builders can limit their liability to remedying the defects and exclude liability for loss of earnings, profits etc.
Negotiating in a rising market
In highlighting the above risks and the ways that they might be managed it is fully appreciated that in a sellers’ market a buyer may find it difficult to negotiate provisions to protect itself and we may find that yards will adopt a take it or leave it approach to their standard contracts. Buyers may well have to make the most of those contracts by ensuring they operate them during the project to help manage the risks.
Unfortunately, it is all too often the case that a project team is only given the specification to get on with the project. The main terms are put in a drawer or on a shelf. Everything goes well and then an issue arises. There are lots of discussions. Attempts are made to resolve things amicably, but they fail. Late in the process someone asks, “what does the contract say?”. Usually, this is a lawyer. There are blank looks. Someone remembers where they put it – on a shelf or in a draw. All of this is a waste of all that time and money spent negotiating the contract in the first place. If parties are in this position the chances are they will have missed some tricks and could well have weakened their position by not implementing the contract. The party that has used the contract is likely to be in the much stronger position.
Resolving disputes
Most shipbuilding projects reach a successful delivery with any issues being amicably resolved by negotiation, but it might be that disputes nevertheless arise. The approach to dispute management is important and parties often don’t approach things in the right way. Experience shows that successful dispute resolution, where both parties find a solution they can live with, is more likely to be achieved by adopting the following approach:
1. It usually helps to identify the central issues early on.
2. This will make it much easier to have a structured senior management meeting between the parties to explore the possibilities of a negotiated solution.
3. By the time things have reached this stage it is important to have solid factual and expert evidence. If you have this the prospects of reaching a favourable negotiated solution are substantially increased.
4. Taking the position based on vague allegations usually fails.
5. Use project management technics to prepare for the negotiation, and any subsequent arbitration. Set a timetable for the team to prepare, including your lawyers. Maintain close financial control by budgeting. Insist on regular management reports, not just from your team but from your lawyers so that you stay in control.
6. Manage your lawyers in preparing for an arbitration.
7. Finally, choose the right lawyers. Shipbuilding cases are construction cases. It is a specialist area and many maritime lawyers are not familiar with the approach required by the law, the courts and arbitrators, particularly on delay claims. It requires a very particular approach to analysing delay and causation which is different from other areas of law. I have seen may cases where shipping lawyers simply adopt the wrong approach.
For further information, please contact:
Chris Kidd
Director
Chris.Kidd@CJCLaw.com