Refund Guarantees and Shipbuilding Contracts
By Roger Heward[Republished on June 13, 2012 with the kind consent of the author.]
Rainy Sky SA v Kookmin Bank
In June 2010, we issued a briefing in respect of the decision of the Court of Appeal in the Kookmin Bank case - a dispute as to the enforceability of refund guarantees issued by Kookmin Bank, in Korea, in connection with a shipbuilding contract entered into between Rainy Sky SA as Buyers and Jinse Shipbuilding of Korea, as Builders. By that time, the case had attracted considerable attention, first, because the Court of Appeal (by a 2-1 majority) had reversed the decision of the Judge at first instance and, secondly, because it was thought by some commentators to have adverse implications as to the general enforceability of refund guarantees issued by Korean financial institutions (a view which we did not share). The Buyers’ appeal to the Supreme Court was heard recently by a panel of five Justices, who have unanimously reversed the decision of the Court of Appeal and have restored the original order of the Judge at first instance. Given the importance of refund guarantees to our ship finance and shipowning clients, we are issuing this summary of the Supreme Court judgment and its general significance.
The refund guarantee
The building contract obviously provides the context within which the refund guarantee was issued, but the latter is a separate contract entered into between different parties. The problem in the present case arose from the somewhat ambiguous drafting of the refund guarantee coupled with the fact that the terms of the guarantee did not correlate clearly with the provisions of the building contract. Paragraph 2 (para 2) of the guarantee recited that: “Pursuant to the terms of the Contract, you are entitled upon your rejection of the Vessel -, your termination, cancellation or rescission of the Contract or upon Total Loss of the Vessel, to repayment of the pre-delivery instalments ...â€
Para 3 provided that:
“In circumstances of your agreement to make the pre-delivery instalments under the Contract .. we undertake to pay to you ... all such sums due to you under the Contract ...â€
In a nutshell, the question was whether the undertaking to pay “all such sums†(in para 3) referred back to the specific repayment rights set out in para 2, (all of which arose only upon termination of the building contract), or whether those words were a reference to “the pre-delivery instalments†mentioned in para 3. In the latter case, the undertaking imposed a broad liability upon the Bank to refund instalments whenever the same became repayable by the Builders, irrespective of whether or not the building contract continued in existence.
The building contract
The building contract provided that, in a variety of circumstances, the Buyers would be entitled to repayment of pre-delivery instalments - namely, upon termination, cancellation or rescission of the building contract, or if the vessel became a total loss during construction. The Buyers were, for example, entitled to terminate the building contract if there was delay on the part of the Builders (ie, if the vessel was not delivered by the cancellation date). Also, if the Builders entered into any kind of insolvency procedure, the Buyers were entitled (but not obliged) to demand immediate repayment of their instalments, but insolvency of the Builders did not give rise to any right to cancel on the part of the Buyers. The Builders, in such circumstances, had an option - either to cancel the contract, or to complete and deliver the vessel. If the Builders elected to complete the vessel, the Buyers would be liable to pay the entire price at delivery (assuming that the Builders had refunded all instalments following the insolvency event).
The Builders become insolvent
In January 2009, the Builders entered a formal debt work-out procedure under Korean law (known as corporate rehabilitation or “rehabâ€). The rehab was not a liquidation - the procedure entails the appointment by the court of a trustee, whose initial task is to establish whether the debtor can be re-structured and carry on trading pursuant to a rehab plan (which will also fix the proportion of debt recovery to be paid to unsecured creditors). The Buyers reacted to the rehab by demanding immediate repayment of their instalments. The Builders failed to pay and the Buyers then made a demand on the Bank under the refund guarantee.
We understand that the rehab subsequently failed; the rehab order was revoked by the Korean Court and the Builders entered into liquidation. The Builders ceased shipbuilding operations, although they apparently continued with other types of business, whilst under the control of the liquidator.
Supreme Court judgment
Against that background, the Supreme Court considered what was the preferred interpretation of the refund guarantee. The most persuasive argument presented by the Bank was that the reference in para 3 of the guarantee to “all such sums†must have been a reference back to the sums which were itemised in para 2 as being potentially refundable, otherwise para 2 served no purpose at all and might as well have been omitted entirely from the text. That argument had been regarded as decisive by the Court of Appeal. The Buyers’ main argument was that it made no commercial sense to interpret the refund guarantee in such a way that it did not apply to the Builders’ obligation to refund instalments, on demand, following an insolvency event:
“In the absence of paragraph [2] there would be no doubt that the reference to “such sums†was a reference to the “pre-delivery instalments†at the beginning of paragraph [3]. That makes perfect sense because one would naturally expect the parties to agree (and the Buyers’ financiers to insist) that, in the event, for example, of the insolvency of the Builders, the Buyers should have security for the repayment of the pre-delivery instalments which they had paid.â€
The Supreme Court also quoted, with approval, an extract from the dissenting judgment in the Court of Appeal:
“On the happening of an [insolvency] event the Buyer was entitled to a refund of its advance payments “immediatelyâ€. .... . If the Builder did not proceed with the construction of the vessel, as would be extremely likely if it was insolvent, the Buyer could terminate for delay .... but .... only after 90 days plus 14 days notice. Only then could it call on the Bond [refund guarantee]. I cannot see how any Buyer (or its financiers) could possibly be satisfied with this as a remedy in the situation where the Builder was insolvent, or nearly so.â€
These views as to what was a commercially sensible result were taken into account by the Supreme Court in choosing which of the two possible interpretations of the refund guarantee to prefer, with the result that the Justices held unanimously that the Bank was liable to pay.
Shipyard insolvency
Pre-delivery finance is widely regarded as being more risky than ship mortgage finance. In the context of pre-delivery finance, a primary concern of the lender is to have (usually by virtue of an assignment from the buyer) the benefit of a reliable refund guarantee.
Building contracts invariably contain provisions entitling buyers to terminate the building contract and to recover the instalments paid, in certain circumstances. If a building contract is validly terminated or rescinded, the refund guarantee will invariably secure that repayment obligation (however, it is most unusual for a refund guarantor to undertake any liability in circumstances where the building contract has not been terminated).
In our experience, however, shipyard insolvency is in most cases (especially those involving Asian shipyards) not an event which entitles a buyer to terminate the building contract. (Indeed, in Kookmin Bank, the Builders’ insolvency did not give the Buyers the right to terminate). Commercially, there are two main reasons why building contracts are drawn up in this way. First, shipyard insolvency is not uncommon and there are different kinds of “insolvencyâ€. In many cases, an “insolvency†takes the form of an administration, or “rehabâ€, in which the insolvency officer takes over control of the yard and, ideally, performs existing contracts (which will often be regarded as valuable assets of the shipyard), and delivers the newbuildings on time and within the required specifications to the various buyers. (In Kookmin Bank the rehab subsequently failed, but that does not affect the principle). Secondly, a buyer does not need a right to terminate upon insolvency of the builder, because the buyer will always have a right to terminate if the vessel is not delivered by the cancelling date. If the rehab or administration is successful, the vessel will be delivered in good time and the buyer will be no worse off by reason of the insolvency. But, if the insolvency officer fails to procure the delivery of the vessel in accordance with the building contract, the buyer will be entitled to terminate the contract when the cancelling date arrives and, thereafter, make a full recovery under the refund guarantee.
The Supreme Court took the view that, commercially, neither buyers nor their financiers would be satisfied with having to wait until the cancelling date before becoming entitled to claim under the refund guarantee. But, if there is a delay in the performance of the building contract, or if construction of the vessel is inept and the buyer eventually becomes entitled to reject the vessel, the buyer or financier becomes entitled to claim under the refund guarantee only after the cancelling date. In our view, there is no significant distinction to be drawn among these various risks - delay; failure to meet the specification; and insolvency of the builder. Provided that there is a creditworthy refund guarantee and provided that the guarantee extends to accrued interest, we do not regard a delay of 104 days in accrual of the right to make demand under a refund guarantee as significant.
Conclusions
* the outcome of the dispute depended upon its precise facts and upon the Supreme Court’s interpretation of the ambiguous drafting of the refund guarantee;
* in order to resolve an undoubted ambiguity in the drafting of the refund guarantee, the Supreme Court was influenced by its view of what was a commercially sensible outcome, although opinions as to what is “commercially sensible†may differ;
* in accepting the interpretation which it regarded as more commercially sensible, the Supreme Court attributed no contractual meaning or effect to para 2 of the refund guarantee;
* in the context of a Korean or Chinese shipbuilding contract, it would not have been surprising if the parties had indeed intended that the refund guarantor would not become liable until the cancelling date arrived;
* there is no substitute for careful and accurate drafting of legal documents: if the documents are ambiguous, the parties must submit to the outcome of legal proceedings;
* the judgment created no new law: well-established principles of contractual interpretation were applied, although the Supreme Court emphasised that the courts are entitled to apply a purposive interpretation in circumstances where the contract is ambiguous; and
* Kookmin Bank has no significance which is adverse either to the Korean shipbuilding market, or to the reliability of Korean refund guarantors.
About the Author
Roger Heward is a dispute resolution lawyer based in London. He specialises in maritime, trade and energy disputes.
Roger was the resident partner of our associated Piraeus office for four years, during which time he was heavily involved in English law disputes arising in the Greek shipping market. Roger has a particular interest in commercial and marine litigation, ship mortgage enforcement, and banking and insolvency litigation.
Roger is a member of the Baltic Exchange. He is a contributor to the Maritime Law Handbook (Kluwer), of which he is formerly the editor.
Contact Info
Telephone: +44 (0)20 7444 2568 | Fax: +44 20 7283 6500 | Email:roger.heward@nortonrose.com