* Overcapacity causes widespread delivery defaults by Chinese shipyards
* Customers invoke refund clauses, but shipyards file injunctions
* Defaults exposing banks' overseas operations to retaliation
* Regulators discourage smaller banks from refund guarantee business
* Highlights conflict between industrial policy and financial reform
By Pete Sweeney
SHANGHAI, April 7 (Reuters) - 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 in 2013, according to data from Clarksons Research, a UK-based shipping intelligence firm. Although that was an improvement from 36 percent a year earlier, it was well behind rival South Korea, where shipyards routinely delivered ahead of schedule the same year.
That means Chinese banks may be on the hook to pay large sums to buyers if the yards can't come through per contract, with little hope of recouping the cash from the yards. China is the world's biggest shipbuilder, with $37 billion in new orders received last year alone. Buyers pay as much as 80 percent of the purchase price upfront.
Chinese bankers rushed to finance shipbuilding after the 2008 global financial crisis as Beijing pushed easy credit and tax incentives to lift the industry and sustain industrial employment levels in the face of collapsing exports.
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 submitted injunctions against banks in Chinese courts to prevent them from paying out.
"China's ambitions to take over 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 upfront to cover material and labour costs. Buyers normally obtain a refund guarantee from a bank to assure 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 these guarantees are 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."
He and other bankers interviewed for this article all spoke on condition of anonymity because of the legal sensitivities of the issue.
Minsheng Bank did not respond to a request for comment.
In one case, UK court records show that in November 2012, subsidiaries of German ship owner First Class Ship Invest GmbH took China Construction Bank Corp to court in London to enforce payment of more than $10 million under a refund guarantee after Zhejiang Zhenghe Shipbuilding Co Ltd allegedly failed to deliver on an order.
CCB lawyers argued that an injunction served on it by Zhejiang Zhenghe in China would open up the bank to fines and the responsible banker could be arrested in China were it to pay out, but the judge rejected the argument.
None of the parties in the suit responded to requests for comment from Reuters.
Reuters was unable to find a single public example of a Chinese bank successfully fighting off a refund guarantee claimant in an overseas court; 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 has 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 China's supreme court planned to issue guidance to lower courts on the handling of injunction applications.
Most customer suits are settled in arbitration and domestic court records are usually not published, so there is little hard data on the number or value of contracts under dispute.
But loan officers at China Export Import Bank, Bank of Communications, Bank of China and Shanghai Pudong Development Bank told Reuters that they had seen refund claims rising rapidly in 2012 and 2013.
The problem was widespread enough for the China Behavior Law Association Training Cooperative Center, an organisation registered with the Ministry of Civil Affairs, to hold a three-day conference for Chinese banks last July on the risks of refund guarantees.
On the other side, the Shanghai Shipbrokers' Association published advice for shipyards on how to keep banks from paying out refund guarantees on its website, saying Chinese banks should be more cooperative.
Shanghai Pudong Development Bank said it largely disbanded its shipping finance team in 2012, due to the sudden rise in refund guarantee claims and worsening market conditions.
An executive at another Chinese municipal bank told Reuters his company was interested in getting into the refund guarantee business "but we've been warned by regulators to be careful."
Jonathan Silver, shipping finance partner at Howse Williams Bowers, said banks have been taking steps to reduce their exposure, including asking shipyards to put up the partially built vessel as collateral for the guarantee.
But lawyers also said that the Chinese shipyards are not always to blame, nor are their injunctions always frivolous.
Ismail of Dongfang Shipyard said his experience at the yard showed many foreign investors had exploited the weakness of Chinese shipyards - and inexperience of Chinese banks - to drive very hard bargains vis a vis refund guarantees.
Some buyers would gamble that prices would rise by the time the ship was completed and they could sell for an immediate profit. If prices didn't rise, they would reject the ship and cash in the guarantee.
In one instance, he said Dongfang had an agreement to deliver two or three ships that were behind schedule but 90 percent completed. The buyers pulled the plug and sought a refund, even though Dongfang was willing to renegotiate and sell the ship at a lower price, he said.
Clarkson Research data shows that the Chinese shipbuilding industry won $37 billion in new ship orders in 2013, up 92 percent year-on-year.
But this rising tide is not lifting all boats: Chinese state media reported that 80 percent of new ship orders went to just 20 yards. Investors are concerned that the debt-sodden Chinese shipping industry is set for a wave of defaults if Beijing doesn't bail it out.
China Rongsheng, the country's largest private shipyard, reported a $1.4 billion loss for 2013 and and some customers are worried about Rongsheng's $4.6 billion worth outstanding orders.
Greek ship operator Dryships Inc has already put down a $11.56 million downpayment, 8.5 percent of the total cost, toward four cargo ships scheduled to be delivered in 2014, but Dryships executives said they aren't sure Rongsheng has even started cutting steel.
"We don't want to make any more payments to Rongsheng," Dryships CFO Ziad Nakhleh told Reuters in February. "Things are getting worse not better."
Rongsheng said in an emailed statement to Reuters that thanks to recent refinancing, it is optimistic it can make delivery, but would not otherwise comment on other refund guarantee cases.
Regardless, Dryships executives also said they expect Bank of China, the guarantor, to refund their money plus 8 percent interest if Rongsheng fails.
Bank of China did not respond to a request for comment.
By paying up, Chinese banks can reassure foreign customers doing business in China, protect their overseas assets and preserve their reputations. And the amounts, while large, are manageable, said Silver of Howse Williams Bowers.
"If there is any collection of banks anywhere in the world able to disperse those sums of money... it's going to be Chinese banks." (Additional reporting by the Shanghai Newsroom, Fayen Wong, and Keith Wallis in SINGAPORE; Editing by Emily Kaiser)