Chinese shipyards leave banks holding bag for late projects

Chinese shipbuilders' refusal to pay refunds on late projects creates legal problems for lenders

PUBLISHED : Tuesday, 08 April, 2014, 1:08am
UPDATED : Tuesday, 08 April, 2014, 1:08am

Chinese banks are stuck in a lose-lose legal battle between domestic shipyards and foreign buyers over billions of dollars in refund guarantees that are supposed to be paid out if shipbuilders fail to deliver on time.

One in three ships ordered from Chinese builders was behind schedule last year, according to data from Clarksons Research, a British shipping-intelligence firm. Although that was an improvement from 36 per cent in 2012, it was well behind rival South Korea, where shipyards routinely delivered ahead of schedule.

That means Chinese banks may be on the hook to pay large sums to buyers if the yards cannot meet contract terms, with little hope of recouping the cash from the yards. China is the world's biggest shipbuilder, with US$37 billion in new orders received last year alone. Buyers pay as much as 80 per cent of the purchase price up front.

Chinese bankers rushed to finance shipbuilding after the 2008 global financial crisis, as Beijing pushed easy credit and tax incentives to sustain industrial employment in the face of collapsing exports.

The whole issue of refund guarantees has been a big headache

Fees generated by offering such guarantees looked like easy money until massive oversupply and falling demand started taking a toll on the yards around 2010. Shipyards fell behind schedule and buyers demanded their money back. But behind or not, the builders, keen to keep orders on the books and prepaid money in their pockets, have filed injunctions against banks in Chinese courts to prevent them from paying out.

"China's ambitions to take over from South Korea as the top major shipbuilder meant that all the banks were encouraged to open up their wallets and lend money to the shipbuilders without making thorough due diligence," said AKM Ismail, former finance director for Dongfang Shipyard, the first Chinese shipyard to be listed on London's AIM Stock Exchange in 2011.

Since ships cost millions of dollars and can take years to deliver, a shipbuilder generally asks for part of the purchase price up front to cover material and labour costs. Buyers normally obtain a refund guarantee from a bank to ensure their money is returned if the yard defaults, and the yard pays the bank's fee for the service.

Lawyers say that in many cases, banks did not require shipyards to pledge any specific collateral, partly because such guarantees were like a form of insurance rather than a loan. That leaves banks stuck with the default bill.

If banks obey local court injunctions and hold off from issuing refunds, they risk being taken to court by ship buyers in foreign jurisdictions. But if they pay out under the refund guarantee or seek compensation from the shipyard for the loss, bankers say they risk alienating local governments, which can damage the banks' business interests in the region.

"The whole issue of refund guarantees has been a big headache," said a finance executive at China Minsheng Bank. "On the one hand, we know that our clients, the shipyards, will be saddled with huge debt that they will struggle to repay to us, if they can even pay back at all. But at the same time, our credibility is at risk, so we have to pay them out."

In one case, British court records show that in November 2012, subsidiaries of German ship owner First Class Ship Invest took China Construction Bank to court in London to enforce payment of more than US$10 million under a refund guarantee after Zhejiang Zhenghe Shipbuilding allegedly failed to deliver on an order.

Construction Bank lawyers argued that an injunction served on it by Zhejiang Zhenghe in China would open the bank up to fines and the responsible banker could be arrested in China were it to pay out, but the judge rejected that argument.

Nearly all refund-guarantee contracts stipulate litigation must be conducted in a foreign court.

Jim James, a partner at Norton Rose Fulbright in Hong Kong, said that he had been involved in several cases in which yards repeatedly obtained injunctions from different Chinese courts to drag out the refund process.

James, who has represented buyers, shipyards and banks in different cases, said the problem had become so serious that the Supreme People's Court planned to issue guidance to lower courts on the handling of injunction applications.

Loan officers at China Export Import Bank, Bank of Communications, Bank of China and Shanghai Pudong Development Bank said refund claims had risen rapidly in the past two years.

The Shanghai Shipbrokers' Association has advice for shipyards on how to keep banks from paying out refund guarantees on its website, saying Chinese banks should be more co-operative.