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Letters of Indemnity – a necessary evil?

Letters of Indemnity – a necessary evil | BDM Blog | BDM Law

Let’s start with the obvious question – what exactly is the Letter of Indemnity (LOI) and why is it important?

Very simply, it is a contract which states that a party (in many cases the vessel charterer) will indemnify the other (usually the ship owner) for the consequences of releasing goods without the production of an original bill of lading.

LOIs are important because, more often than not, an original bill of lading is a document of title. The physical original bill enables its lawful holder to take possession of the goods. If the carrier releases the goods without an original bill (for example as per a request from the charterer) then they will be in breach of the bill of lading contract if the party receiving delivery is not legally entitled to the original bill.

The LOI protects the ship owner or carrier against this risk. In effect, if someone pops up with an original bill of lading and demands compensation, then the ship owner/carrier can bring a claim against the party that issued the LOI and/or demand that the party issuing the LOI puts up security for that claim and deals with it.

To give a very simple example, A is an oil producer in Saudi Arabia. A sells oil to B perhaps under a long term contract. A may arrange the carriage (we call that a C&F sale) or B may send a ship to collect the oil (we call that an FOB sale). B however may sell the oil to C who sells to D and so on. In some cases, the oil could be traded many times.

The party taking delivery (let’s call them D in this case) needs to prove that it has title to the cargo, but the financing structure is such that the original bill may be pledged to a financing bank under a Letter of Credit. In essence, a Letter of Credit requires delivery of original bills of lading to trigger payment and the paying bank will not usually pay the seller unless it can be sure that the keys to the cargo (the original bills) have been delivered to it.

The problem is that the original bills may not be available at the delivery port. In the above example, they may be with the buyers’ correspondent bank in Saudi or they may be in transit to the bank that opened the Letter of Credit. It is increasingly rare for original bills to be available when the ship arrives at the discharge port.

The LOI is vital because it facilitates the prompt discharge of the cargo. Ship owners need to keep their ships moving. Trade would grind to a halt if ships were held up waiting for original bills to arrive.

There is however a problem. Sometimes things go wrong. In most cases, the problem arises in connection with the financing. Perhaps one of the traders in the chain takes a risk relying on the creditworthiness of their counterparty. If that counterparty fails to pay (not uncommon in these uncertain economic times) then the cargo may end up being released to a buyer who has either not paid or who has paid a trader who has failed to pass the payment on to the original seller.

In practice, claims under LOIs usually involve some underlying financial problem e.g. the insolvency of one of the parties in the chain. The problem however is faced not by the defaulting trader but the innocent ship owner. That is because it is very easy for a party holding an original bill to get security for their mis-delivery claim. All they need do is arrest the ship owners’ vessel.

That is exactly what happened this week in Singapore where ING bank arrested two tankers, the Navig8 Ametrine and Vosco’s Dai Minh. This will probably trigger claims under LOIs which in turn may lead to litigation in the Courts. One only has to look at what happened earlier this year when Cido’s Miracle Hope was arrested in Singapore. That led to claims under LOIs in Singapore and London involving Trafigura, Clearlake and Petrobras.

The ship owners’ burden is all the more heavy where the LOI issuer fails to put up satisfactory security for the underlying claim. The ship owners’ P&I insurance does not normally cover claims under LOIs so the ship owner is often left with a major problem. In many cases, cash strapped ship owners are simply unable to post security of millions of dollars to cover the mis-delivery of an expensive oil cargo. That forces them into Court to seek redress by way of mandatory injunctions to force the LOI issuer to honour its obligations.

To sum up, LOIs are regarded as a necessary evil by ship owners. The industry requires ship owners to accept the risks as the obligation to deliver against an LOI is often written into the charterparty. However, there are ways for ship owners to reduce the risk. The most obvious one is to insist at the contract stage that the LOI will be countersigned by a bank or a financial institution. If that can’t be done, then the credit risk of the charterer (and its parent if standing as guarantor) needs to come into play. These considerations may not prevent litigation but they may give the ship owner some solace in knowing that the LOI which they agree to accept in exchange for taking on a potentially huge uninsured risk is worth something.

LOIs are of course tied up with the shipping industry’s reliance on paper based original bills. If paper based bills can be replaced, for example by using blockchain technology, then we may see the need for LOIs diminish. There is a lot of work going on in this area but the legal framework is still embryonic. It seems likely however that this will change as we move into an increasingly digital world.

Over the years we have handled dozens of claims under LOIs and we routinely advise ship owners on their charter arrangements where the LOI risk is in play.

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