A choice with consequences – progressive title transfer versus refund guarantees
Irrespective of how the construction of a vessel is financed, the yard and its financiers will require that the buyer prepays a percentage of the contract price prior to delivery. This prepayment may be lost to the buyer if proper security for that prepayment is not put in place. Provision of refund guarantees is the most common way this is achieved, but progressive title transfer may in some cases be an alternative method for securing the buyer’s position.
The question as to how to finance the construction of a vessel is one of the most important commercial questions facing buyer and yard when entering into a shipbuilding contract. Normally the construction finance is divided between the yard and the buyer. How it is shared depends on a number of circumstances, such as the market situation, each of the parties’ evaluation and taste for risk, financing capabilities of each of the parties and so on. A prepayment of part of the contract price is invariable required from the buyer.
Risk of failure to perform by the other party
The parties must plan for the possibility that the other party may be unable to perform its obligations. The yard needs to ensure that the buyer is able to meet its payment obligations, be that during construction, or upon 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 binding commitment from the buyer’s lenders. However, even where the yard has not obtained such security, should the worst happen, the yard at least has in its hands the hull produced and materials purchased. He may then decide to sell to another buyer, or use the hull and materials for other projects.
The position is different for the buyer. Any prepayments made by the buyer must be individually secured for him to have any reasonable expectation of being able to recover these in case of the yard’s default bankruptcy. If not, the buyer is left with an unsecured claim against the yard and may end up in a (long) line of unsecured creditors.
Delivery on completion and refund guarantees – the standard solution
In standard shipbuilding contracts such as SHIP2000 and NEWBUILDCON the yard’s obligation to repay the prepayments 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 cancellation of the contract or bankruptcy of the yard.
However, depending on the level of prepayments from the buyer and the risk in the project, the provision of such guarantees may be costly for the yard, and therefore the buyer. Furthermore 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 of the yard’s bankruptcy. The buyer will not get its hands on the unfinished vessel for completion elsewhere except if he purchases it from the bankruptcy estate and/or the secured creditors. There may be other possible buyers and this situation may prove costly for a buyer in need of the unfinished vessel.
Progressive title transfer – an alternative approach
An alternative solution is where the parties agree that the title to the vessel under construction and the parts and materials purchased, is 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 yard’s other creditors in case the yard goes bankrupt. 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 that it is recognised that implementation may be more complicated compared to a refund guarantee structure.
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 belongs to him. 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. It is also important to ensure rights and access to, for instance, drawings.
Also, the buyer and yard has to constantly and quite thoroughly monitor and value the progress of the project to ensure that there is a balance between the level of prepayments made and the value of the parts produced and owned by the buyer. This may in practice be very difficult. Planning, engineering and purchases at the beginning of the project is normally not linked to a corresponding part that has been constructed.
Delivery upon completion coupled with refund guarantees is the ‘default solution’ in most standard shipbuilding contracts for a reason. It is a simple, known 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.