Insecure Securities: why guarantees should be handled with care
Mark Jones
This article by Mark Jones first appeared in Lloyd's List on 29 June 2011.
Guarantees of one sort or another are a common device in the shipping world. That is not surprising given the prevalent use of so-called one-ship companies and other entities with few fixed assets within the industry. Thus a ship owner may want the comfort of a parent company guarantee to back the performance of a charterer with no fixed or long term assets. A buyer of new tonnage will almost certainly want the security of a refund guarantee issued by a trusted bank in case the yard defaults and is unable or unwilling to pay back the substantial price instalments already paid by the buyer. Even if a ship owner or buyer is willing to take the risk of proceeding unsecured, it is most unlikely that their financiers would be willing to do so. The potential risk arising from a defaulting counterparty can be huge, and recent history is littered with examples of that risk proving to be fatal to players in the industry who either had no security at all or believed themselves to be secured only to find that their supposed guarantees were worthless.
This article looks at some of the pitfalls that can occur, and considers first the refund guarantees commonly issued in the shipbuilding context, before then considering the more informal guarantees often provided in the charterparty context.
The purchase of a new vessel is likely to be the largest single investment that a ship owner makes. The combination of high stakes and the relatively long lead time before those stakes can come to fruition exposes a buyer to what are among the most significant financial risks in the shipping industry. As a result, the refund guarantee issued by the yard’s bank has been described as the cornerstone of a shipbuilding project.
One would hope that an international bank with a reputation to protect and looking to increase its standing in the shipping industry would be reluctant to take technical points on a refund guarantee.
However, such a hope may well be naïve when one remembers that a bank’s exposure under a refund guarantee may well be significant and, by definition, arise where the bank will have little chance of later recouping its money from its client, the defaulting yard.
What follows highlights four potential pitfalls relating to refund guarantees, and what can be done to avoid them.
First, always check when the refund guarantee expires. That may sound obvious, but it is astonishing how often it seems that the expiry date of the refund guarantee is fixed for a date that does not allow sufficient margin for one or more valid postponements of the buyer’s responsibilities under the shipbuilding contract.
Second, check that the refund guarantee is actually valid. Issues of local law such as the scope of the authority of the actual signatory and local regulatory processes can still throw a spanner in the works.
Third, consider carefully what the refund guarantee covers. Usually, the refund guarantee covers only the obligation to provide a refund of the instalments paid and will not extend wider so as to cover a claim for damages for breach of contract. This means that it is very important for a buyer to wait until it is certain of its rights to cancel and claim a refund using the mechanism set out in the shipbuilding contract, rather than jump the gun by relying on some wider right to terminate arising out of the general law of contract.
Finally, check to see if the refund guarantee may have been discharged by alterations made to the shipbuilding contract during the project. English law takes a very strict approach to the effect on a guarantee of a material alteration to the secured contract.
A guarantee will usually be discharged by such a variation: often referred to as the rule in Holme v Brunskill [1878] 3 QB 495. The rule is ancient and has been strongly criticized by various commentators. But a rule it remains – now far too established for challenge, and regularly applied by the modern Courts.
To those unfamiliar with the English law on guarantees, the strictness of this rule can come as a deeply unpleasant surprise. A detailed explanation of the rule is beyond the scope of this article; suffice to say that even an apparently trivial variation that seems to benefit the yard (such as the granting of an extension of time by the buyer) can trigger the effect of the rule – even though such a variation might make default by the yard less, rather than more, likely.
There are a number of ways of avoiding the impact of the rule. In the writer’s opinion, the only realistic way of avoiding the effect of the rule after the refund guarantee has been issued and accepted is to ensure that the refund bank consents to any variations agreed, which effectively means that the refund bank should be involved and sign off whenever any variations are negotiated and agreed between the parties. In real life, however, achieving this is likely to be ridiculously cumbersome and impractical. Better by far to avoid the problem in the first place.
One way of avoiding the rule is to settle only for a guarantee payable on demand: that is to say, a guarantee that imposes a stand-alone liability on the refund bank to pay without question usually on provision of certain documentation. Under English law, such an instrument is not seen to be as intertwined with the underlying shipbuilding contract, does not create a surety relationship in its strictest legal sense, and so does not fall within the scope of rules such as that in Holme v Brunskill. It is not always easy to determine whether any given refund guarantee is a ‘demand guarantee’ or a guarantee in the wider sense, as shown by various modern cases on the issue: Gold Coast Ltd v Caja de Ahorros [2002] 1 Lloyds Rep 617, Marubeni Hong Kong & South China Ltd v MongoliaRainy Sky v Kookmin Bank [2005] 2 Lloyds Rep 231, and [2009] All ER (D) 78).
Of course, the existence of several reported cases should not be taken as an indication that a ‘demand’ guarantee is the norm in shipbuilding projects; on the contrary, in this writer’s experience, they are the exception. In practice, the best (and indeed normal) way to avoid the problem is to ensure that the refund guarantee includes an express provision providing that it will not be discharged by any variation of the underlying shipbuilding contract. Such clauses are common place, and yet appear to have been overlooked in a surprising number of cases. The recent Court of Appeal case of Associated British Ports v Ferryways NV
[2009] EWCA Civ 189 provides a stark warning as to the consequences of a failure to include such a clause. The parties in that case agreed to give one party more time to perform some of its contractual obligations without obtaining the guarantor’s consent (or even informing the guarantor), and as a result the performance guarantee involved was rendered unenforceable.
Guarantees given to secure a charterer’s performance can, of course, be in the form of a separate document signed by the guarantor. But the manner and speed with which charterparties are frequently negotiated has given rise to a more informal practice by which the guarantee in question is recorded in brief terms in the charterparty itself or even merely in the exchange of emails leading to a recap. As a general rule, English law does not impose requirements of form on commercial contracts. Guarantees, however, are an exception to the rule. To be effective, a guarantee must be recorded in writing and signed by or on behalf of the guarantor: see section 4 of the Statute of Frauds 1667.
The English Courts have recently shown a willingness to move with the times in their assessment of the ways in which the requirements of that 17th Century Act can be met. In Golden Ocean Group Ltd v Salgaocar Mining Industries PVT Ltd [2011] EWHC 56 (Comm), the Commercial Court recently ruled that it was at least well arguable that a guarantee could be recorded within an exchange of emails, and had already ruled that the deliberate (but not the automated) insertion of a name at the end of an email could amount to a signature: see N Mehta v J Pereira Fernandes SA [2006] EWHC 813 (Ch). On the whole, these rulings are to be welcomed as they free up commercial parties to give effect to their agreements without the burden of archaic formal requirements. Informality, however, inevitably brings with it the risk of uncertainty, and uncertainty makes lawyers nervous.
One example of the uncertainty that can and does arise from such informality stems from the very brief wordings often used when a parent company guarantee is recorded in the body of the charterparty itself. It is not uncommon for a charterparty to be negotiated and agreed between an owner and a parent or group holding company X, even though the eventual charterer is intended to be a single-purpose vehicle Y backed by a guarantee from that parent or group holding company X. The resulting charterparty is drawn up to describe the charterer as “X or nominee whose performance is hereby guaranteed by X” or similar. There is no doubt in principle that the guarantee can be contained in the body of the charterparty itself, so long as the requirements of the Statute of Frauds are met: see Stellar Shipping v Hudson Shipping Lines [2010] EWHC 2985. Problems can, however, easily arise where inadequate care is taken over the wording used.
Consider a description of the charterer as “X or guaranteed nominee”. That could arguably be read as enabling X to nominate a different charterer Y, so long as X also gave a separate guarantee covering Y’s performance, or it could arguably be read as itself providing the necessary guarantee by X if and when X nominates Y to take its place as the charterer. It is that kind of uncertainty that can prove disastrous to a ship owner when something goes seriously wrong under the charterparty at a later date.
On top of that, it should not be forgotten that such an informal charterparty guarantee is also subject to the usual rules applicable to guarantees in general, including the potentially ruinous rule in Holme v Brunskill.
So what are the lessons to be learned? There should be no need for lawyers to be involved in the great majority of commercial agreements made in the shipping industry. But it seems to this writer that extra care is required when it comes to guarantees. Guarantees come with their own set of idiosyncratic legal rules, both as to form and as to substance. While a litigation lawyer will naturally see more of the guarantees that prove problematic than those that operate as planned, it still amazes this lawyer just how many guarantees do prove problematic as a result of entirely avoidable defects.
Asking a lawyer to check the wording and form of a proposed guarantee requires little time and expense, and yet could well avoid the making of a disastrous error. Think on this: if you feel that the degree of your contractual exposure is such as to warrant the provision of security by your counterparty in the form of a guarantee, then surely it also warrants the relatively minor time and expense required to ensure that security will actually be effective in the event that the project, whatever it might be, turns sour?