Irrespective of how the construction of a vessel is financed, the shipyard and its financiers will require that the buyer pays a percentage of the contract price before delivery. This pre-payment may be lost to the buyer if proper security is not put in place. The provision of refund guarantees is the most common way in which this is achieved, but progressive title transfer may in some cases be an alternative method for securing the buyer’s position.
The question of how to finance the construction of a vessel is one of the most important commercial questions that the ship buyer and shipyard face when they enter into a shipbuilding contract. Normally the financing of a vessel is divided between the yard and the buyer. How this is shared depends on a number of circumstances, such as:
- the market situation;
- the parties’ evaluation and appetite for risk; and
- the financing capabilities of each of the parties.
A pre-payment of part of the contract price is usually required from the buyer.
Risk of failure to perform
The parties must plan for the possibility that the other party may be unable to perform its obligations. The shipyard must ensure that the buyer is able to meet its payment obligations, be that during construction or on delivery. In order to gain such certainty, the yard may request a guarantee from a bank or more commonly the buyer’s parent company, for the performance of the buyer’s payment obligations. The yard may also be sufficiently content if it is provided with a binding commitment from the buyer’s lenders. However, even where the yard has not obtained such a security, in any event it will have the hull produced and the materials purchased and could then decide to sell these on to another buyer or use them for other projects.
The buyer is in a different position. Any pre-payments made by the buyer must be individually secured in order to have a reasonable expectation of recovering them in case of the shipyard’s default or bankruptcy. If this is not the case, the buyer would be left with an unsecured claim against the yard and may end up on a long line of unsecured creditors.
Delivery on completion and refund guarantees
In standard shipbuilding contracts (eg, Ship2000 and Newbuildcon) the shipyard’s obligation to repay the pre-payments is secured by refund guarantees issued by banks, financial institutions or insurance companies. Thus, if the construction contract is cancelled or the yard becomes bankrupt, the buyer can call on the guarantees and get its money back. This is a simple system that significantly improves the buyer’s position in case of the cancellation of a contract or the bankruptcy of the yard.
However, depending on the level of pre-payments from the buyer and the level of risk in the project, the provision of such guarantees may be costly for the shipyard and therefore the buyer. Further, this approach means that the ownership of the hull and materials during construction remains with the yard. The yard will in most cases pledge the hull and materials in favour of the yard’s lenders as security for the yard’s construction financing. This means that the hull and materials will be out of reach for the buyer in case the yard goes bankrupt. The buyer will be unable to take possession of the unfinished vessel for completion elsewhere except if he or she purchases it from the bankruptcy estate or the secured creditors, which can prove costly and may be complicated by other possible buyers.
Progressive title transfer
An alternative solution is where the parties agree that the title to the vessel under construction and the parts and materials purchased are transferred to the buyer during construction. If properly implemented, this system means that the hull and relevant materials are out of reach of the bankruptcy estate and the shipyard’s other creditors in case of bankruptcy. The buyer therefore controls the hull and may finish the construction or sell the hull to other parties. Costs involved with refund guarantees may be taken out of the construction budget and contract price and there is no need to lock in capital to secure the refund guarantees.
Where this solution is adopted, it is essential that it is correctly implemented and the fact that implementation may be more complicated when compared to a refund guarantee structure is recognised.
First and foremost, the rights of the buyer need to be sufficiently secured. The buyer’s ownership may need to be registered. Further, such registration may not cover all materials belonging to the vessel and the buyer may need to obtain a floating charge or pledge over the yard’s machinery and plant to ensure that materials and parts belong to him or her. Materials may have been partly paid for but not delivered to the yard and the buyer may therefore also need a right to step into the yard’s subcontracts. Rights and access to other materials (eg, drawings) should also be ensured.
The buyer and shipyard must also constantly and thoroughly monitor and value the progress of the project to ensure that there is a balance between the level of pre-payment made and the value of the parts produced and owned by the buyer, which may be difficult in practice. Planning, engineering and purchases at the beginning of the project are not normally linked to a corresponding part that has been constructed.
Delivery on completion coupled with refund guarantees is regarded to be the default solution in most standard shipbuilding contracts as it is a simple, widely understood and fairly balanced solution. However, there may be reasons to deviate and elect for progressive title transfer where this can be tailor-made to suit the demands of a particular project.