SHIP BUILDING CONTRACTS

 Published in Mariner Life  September 2002; Fisherman Life October 2002; Reprinted Mariner Life March and April 2006

As noted by Edward Horsey Q.C. (a retired lawyer), “[s]hipbuilding contracts are like chameleons, when the shipbuilder changes the colour of the ink he uses to keep his books of account, the clauses and terms of a shipbuilding contract also are likely to change.” When shipyards are busy (and they are using black ink) they can insist on terms they believe are necessary for their well being.  However, in times when they are idle (and they are using red ink), they find these provisions to be not as important as getting the work. 

This article reviews the terms commonly found in shipbuilding contracts from the perspective of both ship builders and purchasers.   Although the word “ship” is used primarily in this article, most of the commentary is equally applicable to contracts to build yachts and fishing vessels.

METHOD OF PAYMENT

Contractual terms regarding the method of payment can vary widely depending upon the cost of the ship being built and the negotiating strength of the parties.  From the perspective of the purchaser, a lump sum payment upon delivery and completion of sea trials is the most advantageous.  This allows the purchaser to continue to earn interest on his money while the vessel is being built and more importantly ensures that he has sufficient funds on hand to complete the construction of the ship if the shipbuilder fails to do so.  Conversely, from the shipbuilder’s perspective, it is desirable to have funds paid in advance so as to avoid having to borrow funds to pay for materials and labour.  In practice, the compromise that is often made is an agreement on a number of progress payments to be made when certain milestones have been passed.  These milestones could include: the laying of the keel, completion of the hull, installation of engines, tanks and generators, installation of the superstructure, completion of interior finishing, completion of sea trials, and expiry of a trouble free period since delivery.  It is important when negotiating such a schedule to try to have it accurately reflect the work performed to date.  Since it almost always costs more to have a second yard finish a job started by another, a purchaser with negotiation leverage will normally try to hold back a reserve to cover at least part of the extra cost of having a different yard finish the job should this become necessary. In order to avoid disputes, it is also useful to give some person, such as a marine surveyor or naval architect, authority to make a binding determination of whether or not a milestone has been achieved.

An approach sometimes used as an alternative to defined milestones, is for regular payments to be made based upon the percentage to which the vessel has been completed at the date of the payment.  As in the case of the milestone method, in order to avoid disputes it is also useful to give some designated person the authority to make a binding determination as to the percentage the vessel has been completed. 

TITLE AND SECURITY

Contractual terms regarding title and security can vary depending upon whether or not the ship is being built for export.  In contracts for the construction of ships to be used within British Columbia, there are normally provisions that provide for title to pass to the purchaser as construction proceeds and the ship is paid for.  These clauses also attempt to pass title to equipment purchased for the ship before it has even been incorporated into the ship.  Given the relatively large number of insolvencies that have occurred in the British Columbia shipyards in recent years, these provisions are very important for the protection of the purchaser. 

These provisions, however, can cause problems if a ship is being built for export outside the province and/or country.  Often through careful planning, both provincial and federal sales tax can be avoided by structuring the sale so as to qualify for the export exemptions provided by the applicable tax laws.  By transferring title prior to delivery and prior to the vessel leaving the province there is a serious risk of losing one or more of these tax exemptions.  Accordingly, this risk is often avoided by providing the purchaser an alternative (and less secure) source of security by way of a builder’s mortgage.  This is done by leaving title in the name of the shipbuilder and having him record the vessel under construction with the Ship’s Registry.  The builder will then give the purchaser a builder’s mortgage to be registered against the recorded vessel. 

In order to register one’s title after the sale has completed, it is necessary for the shipbuilder to provide the purchaser with a builder’s certificate naming the purchaser as the first owner of the ship. If a yacht is being exported to the U.S.A. (commercial ships cannot be exported to the U.S.A.), a U.S. Coast Guard form of builder’s certificate is required. At this point any builder’s mortgages or other encumbrances will also have to be discharged.  It is also common to get an invoice for the ship and all its related equipment marked, “paid”. 

PLANS AND SPECIFICATIONS

Most shipbuilding contracts have specifications and drawings attached as schedules.  The purchaser should review these schedules with great care, as they contain most of the details of the ship to be built.  If the purchaser does not have expertise in ship construction, he should retain a naval architect or marine surveyor to assist him in reviewing the specifications and drawings.  Since not all the details of construction can be included in the drawings and specifications, it is also common to have a general provision requiring the builder to build the ship “in accordance with good ship building practise”.  In addition, there are often provisions requiring the ship to be built so as to conform to any applicable standards for the ship in question such as those of Transport Canada – Marine Safety or the requirements of any applicable classification societies. 

WARRANTIES AND LIMITATION OF LIABILITY

Negotiations over warranties can be quite difficult, as ship builders are generally reluctant to expose themselves to unlimited liability for their product.

One issue of particular difficulty that arises when a ship is designed by a shipbuilder is the question of whether or not that builder will warrant his design with respect to matters such as speed, fuel consumption, length, hold capacity, or tonnage.  Since breach of a warranty normally only entitles the injured party to damages, this can be problematic if a particular design characteristic is of great importance to a purchaser.  In some sophisticated contracts, damages are agreed to ahead of time on a sliding scale depending on the degree of deviation from the specifications.

Most shipbuilders give a warranty against faulty workmanship and material for a specified period of time.  One area of contention in such warranties is the question of who should bear the cost of travel if the ship breaks down at a distant location.  Most contracts require the ship to be delivered to the shipbuilder’s yard at the purchaser’s cost, although many also contain a provision whereby the builder can, at his option, grant an allowance to the purchaser of funds to complete the repairs elsewhere.  Since the cost of repairs is often quite high at remote locations, these provisions are not always satisfactory to the purchaser.

Most shipbuilding contracts also contain a clause excluding liability for any consequential damage suffered by the purchase such as damages for loss of use of the vessel. From the perspective of the shipbuilder (and his insurers), this is a very important provision.

Another area where shipbuilders often limit their liability is with respect to equipment manufactured by others, unless the failure of that equipment was caused by improper installation by the builder.  Usually shipbuilders will agree to attempt to do whatever is necessary to give the purchaser the benefit of any warranty provided by a manufacturer.  In some cases the manufacturer will allow its warranty to flow through to the purchaser and in other cases, the warranty must be assigned by the builder or enforced by the builder for the benefit of the purchaser.  In the case of a builder having to actually enforce a warranty for the benefit of a purchaser, the contract should provide who will pay the expenses of such activities.  For expensive items, the question of transferability of warranties should be reviewed ahead of time with the manufacturer before a commitment is made to purchase the item.

EXTRAS AND CHANGE ORDERS

One of the most common sources of disputes between shipbuilders and purchasers is the determination of whether or not an item is an extra or part of a fixed price contract.  In this situation, the best way to resolve the problem is for the purchaser and builder to have an agreement to continue with the work and sort out the dispute at a later time by either arbitration or litigation.  If the shipyard does not have such an agreement and the purchaser refuses to make such an agreement at the time the dispute arises, the shipyard may lose its right to later claim the item was an extra, even if it does the work under protest.  Furthermore, if the shipyard refuses to perform the work without an agreement to treat it as an extra, it runs the risk of a substantial damage award for non performance being awarded against it, if it turns out it was wrong in treating the work as an extra.  Accordingly, from a shipyard’s perspective, it is important to have a clause in its contract which allows disputes over whether or not an item is an extra, to be resolved by way of arbitration after completion of the project.

Assuming, that the parties have agreed that the requested work is an extra, an important issue is the question of whether or not the purchaser should be given the right to make any alterations at all from the original contract during the course of construction.  From the perspective of the shipyard, it would be desirable to be able to refuse to make any alterations.  This would give it extra bargaining power when setting a price for the alterations and prevent conflicts with other jobs that may have been taken on by the shipyard.   However, most ship building contracts do allow alterations at the request of the purchaser.  Some building contracts provide that the shipbuilder does not have to perform alterations unless the alterations are reasonable and within the capacity of the ship builder, and an extension of time is given for completion.  The ship builder may also require an alteration of the payment schedule so as to allow for early payment for extras.

Assuming a shipyard has agreed to provide extras, another difficult issue is the determination of a fair price for the extras.  A common method of resolving this issue is to include a requirement that the price be determined by arbitration if the parties fail to reach an agreement. If delay were not of concern, it would be advantageous to the purchaser to arbitrate the price prior to commencement of the work so as to maintain the option of not proceeding if the price is too high.  However, even though arbitration is faster than litigation, it is often not practical to delay completion of a project until the completion of an arbitration hearing.  Since arbitration can be costly, this type of provision creates some incentive for the parties to reach an acceptable price by way of agreement.

For contracts providing that extras are to be paid for on a “cost plus” basis, it is useful to stipulate whether this includes any cost for items such as overhead and fringe benefits and what the mark up will be on materials.

As an aside, if it is necessary to litigate or arbitrate the value of an extra, good time records are very important.  Detailed time records should be kept for each worker that allow the shipyard to identify and quantify work done on extras.   Similarly, records should clearly show what materials were used on extras.   A slightly more difficult problem is the quantification of any labour or material saved as a result of the extra.  It is best to document these savings as closely as possible while they are still fresh in everyone’s minds.  

One potential trap for the unwary shipyard is the question of whether or not surveyors, marine architects and engineers acting for the purchaser are properly authorized to order extras.  In the absence of such authority, it is likely that the purchaser will not have to pay for the extra work, although the shipyard may have an action for breach of warranty of authority against the person who ordered the work.  Accordingly, from the perspective of the shipbuilder, it is best to include a term in the shipbuilding contract which specifies exactly who is authorized to order and approve extras.  If such a term is not in the contract, a separate written authorization from the purchaser should always be obtained.

COMPLETION DATES

Given the difficulty of obtaining materials and other supplies on a timely basis as well as the general reluctance of shipyards to turn away any work (whether they have time to do it or not), completion dates can be a problem. 

If it is important for a purchaser to have a ship completed by a certain date, it is best to include a liquidated damages clause in the contract specifying the per diem penalty for late delivery.  In exchange for a clause of this nature, shipyards will sometimes require a bonus for early delivery.  At the very least, a shipyard will require a “force majeure” clause spelling out the circumstances outside its control that will excuse it for failing to meet the completion date.  Although shipyards are initially often reluctant to allow for a liquidated damage clause, these clauses can sometimes be to their benefit by limiting the damages far below the actual loss suffered by a customer as a result of a late delivery.  Sometimes, shipbuilders are also able to negotiate an overall cap on damages payable pursuant to such a clause.

  Although shipyards are generally very reluctant to allow a purchaser to terminate a contract for late delivery, they will often agree to a provision allowing for the purchaser to take possession of the vessel (after reasonable notice of its intention to do so) and have it completed by another shipyard. Such provisions will also usually reserve the right of the purchaser to make a claim against the original ship builder for the extra costs associated with having the ship completed by another yard. 

INSURANCE

It is important to make sure the ship is adequately insured for the benefit of both the shipyard and the purchaser.  Normally shipyards carry a builder’s risk policy that covers all ships under construction or repair in its yard.  Some, but not all, of these policies include coverage to newly constructed ships during sea trials.  Since the scope of these policies can vary quite widely from shipyard to shipyard, it is best to have the shipyard review any proposed provisions regarding insurance coverage with its broker prior to entering into any contract.  Otherwise, it may find itself unable to obtain the type of coverage it contractually bound itself to provide.

TAXES

Unless a purchaser qualifies for some exemption, both provincial and federal sales tax is payable upon the purchase of a new ship.  Accordingly, unless a tax exemption is being claimed, the shipbuilding contract should normally specify that tax is payable.  The most common exemptions to one or more of these taxes are for: ships built for export, ships purchased by commercial fishermen, ships delivered to Native Indians on a reserve, and self propelled ships in excess of 500 gross tons.  The requirements to qualify for these exemptions are complicated and change from time to time. Unfortunately, an opinion from a lawyer specializing in tax matters can be very expensive and is often qualified.  Although government officials will give advice on requirements for such exemptions, their advice is not generally binding on the Crown unless it is in the form of an advance ruling that can take a number of weeks to obtain. As a result of this uncertainty, in cases where purchasers are claiming the benefit of an exemption, many shipbuilding contracts contain indemnity provisions requiring the purchaser to indemnify the builder in the event that the purchaser does not qualify for the tax exemption and the builder is called upon to pay the tax. 

As is the case with many commercial agreements, the negotiating of a shipbuilding contract is an attempt to avoid future disputes by trying to anticipate as many problems as possible in advance and decide ahead of time how those problems will be resolved or avoided.  To a large extent, many of the contractual provisions involve allocation of risk between the purchaser and the builder.  The extent to which a builder is prepared to accept risk will depend on a number of factors, including the availability of other work and the profit which he anticipates making on the contract. Similarly, a purchaser may be prepared to accept more risk if the purchase price is lower than that offered by competing yards.  Hopefully this article will help the respective parties to avoid disputes by helping them to evaluate the risk they are assuming when they are entering into a shipbuilding contract and negotiate for provisions commensurate with the amount of risk they are prepared to accept and the amount of security they are prepared to pay for.

Brad Caldwell is a Vancouver based lawyer and former fisherman and tow boat worker whose practice is primarily devoted maritime and insurance matters.