Refund guarantees – avoiding drafting pitfalls

News / / London


Refund guarantees are often described as the cornerstones to shipbuilding projects and the buyer’s main security. Although they do not strictly form part of the shipbuilding contract, a shipbuilding project is unlikely to go ahead at all without one. It is therefore important to understand the different types of guarantee instruments, and the impact each has in practice on the guarantor’s obligations to pay and the buyer’s entitlement to recovery. A well-drafted guarantee provides certainty to the parties and strikes a balance between their respective entitlements and obligations.

Under shipbuilding contracts, the buyer usually agrees to pay out significant pre-delivery instalments of the price to the builder before acquiring title to the ship on delivery. The contract also usually gives the buyer the right to cancel the contract for certain types of builder default (e.g. insolvency, delay, failure to meet defined vessel specifications, etc.).

Without security during the building phase, the buyer will be reluctant to exercise its cancellation rights for such defaults. In order to guarantee that its pre-delivery instalments are refundable, it will often require the builder to obtain an undertaking (i.e. a refund guarantee) from a creditworthy bank or other acceptable guarantor, to refund its pre-delivery instalments with interest if the builder fails to do so in the event of lawful cancellation.

Types of refund guarantee

The two principal types of refund guarantee are:

  1. Conditional, “see-to-it” guarantee; and
  2. Unconditional, “on demand bond”.  

In a “see-to-it” guarantee, the guarantor’s obligation to refund the buyer is secondary to and dependant on the builder’s primary obligation under the shipbuilding contract. It gives rise to a claim for damages rather than a claim in debt. Thus, the bank need not pay until the builder’s liability is agreed, or otherwise determined by an independent court or arbitral tribunal. The bank’s secondary liability is also limited to the extent that the builder fails to pay.

On-demand bonds impose a primary contractual obligation on the bank to pay the full amount specified in the guarantee instrument, unconditionally and on demand regardless of the builder’s liability or any dispute in respect of the underlying shipbuilding contract (except where there are allegations of fraud). A properly drafted demand guarantee is more similar to a letter of credit than a suretyship.

The English courts have, over the years distinguished between these two types. However, the difference between the two is not easy to see and can sometimes be controversial. A guarantee purporting to be an on-demand bond may in fact be a see-to-it guarantee and vice versa. Case law shows that the distinction will ultimately turn on the wording of the document (not the title given), construed in light of the factual matrix surrounding each situation. The Court of Appeal in Wuhan Guoyu Logistics Group Co Ltd & Anor v Emporiki Bank of Greece SA [2012] EWCA Civ 1629 referred to four distinctive factors (known as the Paget’s presumptions) stating that an instrument will almost always be construed as a demand bond if:

  1. It is issued by a financial institution, albeit this is not solely determinative;
  2. It relates to an underlying transaction between the parties in different jurisdictions;
  3. It contains an undertaking to pay “on demand”; and
  4. It does not contain clauses excluding or limiting the defences available to a guarantor.

Postponing payment in demand bonds – Buyer’s perspective

It is often preferable for a buyer for a refund guarantee to be categorised as an unconditional demand bond, and be called upon immediately when the buyer terminates the building contract regardless of any underlying dispute. However, it is not uncommon, in practice, for demand bonds to provide that payment will be delayed pending certain events, in particular the outcome of an arbitration, if proceedings have commenced. Such provisions are usually agreed to protect the bank from paying a buyer where its entitlement to terminate the building contract is disputed.

Deferring payment in this way may, at first glance be perceived to transform an on demand bond into a see-to-it guarantee on commencement of arbitration. However, the recent Court of Appeal case of Shanghai Shipyard Co. Ltd. v Reignwood International Investment (Group) Company Limited clarified that this was not necessarily correct. In this case, the Court confirmed that the wording of the deferral payment clause in the demand bond merely postponed the bank’s primary obligation to pay from presentation of a demand document to presentation of an arbitration award. The Court drew a fine distinction noting that, unlike demand bonds, under a see-to-it guarantee, the guarantor would not lose the right to challenge the tribunal’s conclusion in respect of the builder’s liability. We have reported on this case previously (here) and understand that permission to appeal before the Supreme Court has recently been granted. We will report on developments as they arise.

Postponing payment in demand bonds – Bank’s perspective

Adding a payment deferral clause in the event of arbitration is usually preferred by the guarantor because it strikes a balance between the buyer’s ability to immediately claim under the guarantee and the guarantor’s unconditional obligation to pay. Such clauses should, nevertheless be drafted with care particularly with regard to how they operate if, as is often the case, the guarantee has an agreed fixed expiry date.

For example, we have seen examples recently where a clause which deferred payment “in case of arbitration”, without expressly stipulating when demands had to be made, was capable of effectively retroactively extending the guarantee’s fixed expiry date even when a demand was made and an arbitration was started after the expiry date.

The interpretation of a payment deferral clause will be case specific, so a guarantor can alleviate similar risks by expressly providing for demands to be made and/or arbitration proceedings to start before the expiry date: see for example BIMCO’s standard form of refund guarantee.

Amending the underlying shipbuilding contract – Buyer’s perspective

It is often overlooked, in the case of a see-to-it guarantee, that any material change to the underlying contract without the guarantor’s consent can invalidate the guarantee. This is not the case with on-demand bonds, unless of course its contractual provisions provide otherwise. It is therefore important to be clear what type of guarantee is in place: if it is a see-to-it guarantee, the guarantor’s consent will be needed to any changes to the building contract to ensure that the guarantee still applies.

This includes moving the delivery date, which is common practice, so if in doubt, the buyer should seek the guarantor’s approval for any changes.

Key take away points

The buyer must clearly understand the true nature of its guarantee instruments. Any significant alteration of the underlying contract in the case of a see-to-it guarantee without the bank’s approval can invalidate the guarantee.

Payment extension or deferral clauses also need to clearly allow the bank to determine the guarantee expiry date and set out the precise mechanism for extending it in the event the right to terminate and claim under the guarantee is disputed and has to be arbitrated.

If you have any questions about the content of this article or would like to discuss further, please do not hesitate to reach out.

Chris Kidd

Chris Kidd Head of Shipbuilding and Offshore Construction, Joint Head of Energy & Infrastructure, Partner

Tarek Taha

Tarek Taha Associate

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