Oil & Gas: Contractual protections in scrapping decommissioned assets 

International

Every year hundreds of vessels and oil rigs are sold to shipbreaking yards in South Asia, which include some of the busiest breaking yards in the world (more than 70% of ships sold for scrap end their lives in the region). The scrap thus obtained fuels a voracious domestic requirement for steel.

The current pressures on the oil and gas market may incentivise asset owners to decommission and scrap those assets earlier than they may otherwise have done. Oil and gas companies and other vessel owners choosing to scrap their vessel may choose to sell it to a scrapping contractor, who shall take ownership of the vessel for the purposes of heading a decommissioning, recycling and scrapping supply chain. 

For scrapping contractors (and, indirectly, the owners of vessels), the employment of a South Asian yard can be a cheaper alternative to shipbreaking than elsewhere in the world (particularly in Europe). 

However, this industry has been the subject of criticism owing to the impact it has on the health and wellbeing of its workers and the environment. See, for example, the recent BBC Article – “Breaking Bad”: https://www.bbc.co.uk/news/extra/ao726ind7u/shipbreaking.

For this reason, many oil and gas companies and other vessel owners will be concerned about what happens to their vessels, once they have been sold to a scrapping contractor, despite the economic advantages of using certain yards.  The prime concern in this regard will be for a loss of reputation and the very real economic disadvantages this can entail.

This article provides a brief summary of the forms of contractual protections a vessel owner could seek to include in its arrangements with the scrapping contractor. 

Contract Structure and Core Obligations

As the primary purpose of the arrangements between the vessel owner and the contractor is to transfer the obligation to decommission, recycle and/or scrap the vessel, the two key requirements to enable this are:

  1. a sale of the vessel to the contractor – selling to a contractor can assist in the avoidance of certain environmental and other obligations, which generally follow ownership in the vessel; and
  2. an obligation to scrap the vessel in accordance with a detailed scope of work (requiring the use of certain yards) – this obligation could be within the contract of sale or in a separate services agreement.

In the below, the vessel owner shall be referred to as the “Seller” and the scrapping contractor as the “Contractor”.

Restrictive Covenant

There should be a clear restriction on the Contractor’s use of the vessel after the sale.  The restriction should prevent: (i) the commercial use of the vessel; (ii) the abandonment of the vessel; and/or (iii) the use of certain yards.

Injunction

In theory, the best form of protection would be an injunction from a court in the jurisdiction in which the vessel is located, which would ‘promote’ the restrictive covenant to be an obligation towards the relevant court.  Such a remedy would be the usual starting point for the enforcement of a restrictive covenant. 

However, this remedy would only be of practical benefit if the vessel was still within the relevant waters and/or in a jurisdiction that would recognise and support the injunction from the court. The problem is that, in the event of a breach of covenant, there would be a strong risk of the vessel being removed to a location where the court injunction might not be recognised or enforced.

Arbitral Award with Court Support

It would be beneficial for the contract to contain an arbitration clause, with arbitration based in London. The New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards can be used to enforce London arbitral awards in a broader range of jurisdictions than those which would recognise and enforce a court judgment.

The arbitration clause should also expressly be backed up with a right for the Seller to issue court proceedings for urgent injunctive relief.

Rescuing the Vessel

Should it transpire that the vessel is being used in breach of the contract (e.g. commercial use, abandonment or the use of a prohibited yard) the contract could provide for a right of the Seller to ‘rescue’ the vessel. 

This may be achieved by one of (or potentially a combination of) the following:

  1. a reversion of title to the vessel;
  2. a right to take a charter and/or loan of the vessel for the purposes of scrapping/recycling it; or
  3. the right to appoint a different decommissioning contractor to scrap/recycle the vessel on the Contractor’s behalf, with an obligation on the Contractor to do all such things as to facilitate such work, including the transfer of title in the vessel to the new contractor.

The tax and regulatory implications of pursuing any of the above would have to be assessed on a case by case basis, but in any event the Seller should seek to place all costs relating to such title transfer, charter/loan and/or decommissioning contractor upon the Contractor, by way of an indemnity, as the costs arose as a result of the Contractor’s breach.

The problem of ‘equity’s darling’

One of the key problems with any of these protections is that they will likely prove to be unavailable if the vessel has already been on-sold by the Contractor to a third party, where that third party had no notice of the relevant restrictions (i.e. the bona fide purchaser for value without notice – known as “Equity’s Darling”).

If the third party did have notice, and failed to scrap/recycle the vessel in accordance with the contract, the Seller would arguably have a tortious right against the third party for an injunction or damages for knowing interference with the Seller’s rights under the contract. However, such claims are not straightforward and might involve complex jurisdictional arguments.

To mitigate this risk, the Seller could seek to:

  1. require the transfer of the vessel to be possible only with a novation of the contract; and/or
  2. impose an obligation on the Contractor to inform any third party purchaser of the vessel that its use is restricted by the contract, preferably by way of a contractual term and representation automatically repeated at sale.The Seller could also consider imposing an obligation on the Contractor to buy the vessel back from the third party, so as to bring the vessel back under the Contractor’s obligations under the contract.

Damages

Although damages are the normal ‘go to’ for a breach of contract, in this scenario it is arguably a much less useful remedy.  Damages would be difficult to claim because the Seller would have to establish a loss from the breach of contract and, as the Seller no longer owns the vessel, it is not obvious how a failure to decommission, recycle or scrap the vessel could cause the Seller any loss – save as to reputation.  In any event, with regards to a loss of reputation, ‘prevention is better than cure’.

An attempt could be made to agree liquidated damages for a breach, but – assuming this became a sole and exclusive financial remedy – the value of liquidated damages may be far too low (especially for reputational loss).  Such liquidated damages may also prejudice an injunction claim (as an injunction will only be awarded if damages are not an adequate remedy).

The damages could be ‘promoted’ to be payable on an indemnity basis (and expressly stated to be without prejudice to any claim for injunctive relief), but, again, unless loss can be proven, damages may be hard to obtain.

Creditworthiness of Contractor / Parent Company Guarantee

As with any contract, the creditworthiness of the Contractor should be assessed and financial and/or performance security obtained in the event the counterparty lacks the resources or ability to fulfil the obligations.

As such, the Contractor should be under an obligation in the contract to obtain a parent company guarantee in favour of the Seller from a guarantor of sufficient financial strength to satisfy the Seller that damages, indemnities and/or the costs of rescuing the vessel can be recovered for breach of the contract, and indeed for the obligation to decommissioning, recycle and scrap the vessel to actually be performed.

In the event that the vessel is sold, if not otherwise, the Contractor’s parent should become a primarily obligor – meaning that it can be sued prior to the underlying obligor being found liable.

Summary

There are a range of potential contractual protections which could be employed by a Seller in its arrangements with the Contractor.  As it cannot be determined in advance which of the remedies may be the most useful, a Seller could perhaps consider attempting to include all of them in order to provide a ready arsenal, should the Contractor breach the contract.

The reputational losses that can stem from an oil and gas company or shipping firm whose former vessel has been disposed of in certain yards (perhaps still replete with corporate logos), can be significant, especially in light of the high number of personal injury and environmental incidents that are known to happen at these yards.   

Such potential exposure should require a careful consideration by vessel owners about what contractual regimes they can employ to protect their position.