UK: Letters Of Indemnity Against Discharge Without Bills Of Lading – Seeking To Minimise The Trader's Risk

Last Updated: 9 August 2011
Article by Stuart Shepherd

It is common practice for traders, usually when they are the sellers of the goods and the charterers of a vessel, to instruct the carrier to discharge cargoes without production of the original bills of lading and to agree to indemnify the carrier against the consequences of doing so. This is done by providing a Letter of Indemnity ("LOI"). Sometimes, LOIs appear to be given by traders without a full appreciation of the risks involved or consideration as to how those risks might be minimised. In this Bulletin, we identify the risks involved in the use of LOIs from the trader's perspective and look at what steps might be taken to minimise those risks.

In what circumstances are LOIs used?

The bill of lading is of course the "key to the warehouse" and the carrier's obligation, under a negotiable bill, is to give delivery to the holder of the bill of lading and only the holder. No carrier in his right mind should give delivery of cargo without production of the bill of lading – unless he has an LOI from a party he believes is reliable. This is because if he delivers the cargo without production of the bills of lading, he may face a claim for the value of the cargo from the holder of the bills of lading (including possible future holders of the bills of lading) if the person to whom he gives delivery of the cargo is not one and the same. However, most carriers will agree (either at the time of entering into the charter or thereafter) to give delivery of cargo without bills of lading if they are provided with an LOI in the standard P&I Club form.

The bill of lading's progress through the payment chain is often slower than the vessel's progress to the discharge port and in those circumstances, if discharge had to wait for the bill of lading to catch up, large demurrage claims would arise.Therefore, in order to avoid demurrage liabilities, traders often instruct the carrier to discharge the cargo without bills of lading in return for an LOI. The risks of doing this are limited so long as the trader issuing the LOI is justifiability confident that (a) he will be paid for the cargo (if he is the seller) and (b) there will be no call under the LOI. Unfortunately, on occasions, confidence that payment will be made and that there will be no call under the LOI proves to be misplaced. We will discuss that further below.

Terms of the LOI

The vast majority of LOIs are issued in the standard wording recommended by shipowners' P&I Clubs. The key features of such wording are that the party giving the indemnity will:

  1. indemnify the indemnified party (usually the shipowner), their servants and agents and hold all of them harmless in respect of any liability, loss, damage or expense of whatsoever nature which they may sustain by reason of delivering the cargo in accordance with the request to do so;
  2. provide sufficient funds to defend any claim brought in connection with the delivery of cargo without bills of lading and
  3. provide security in respect of any third party claims brought against the indemnified party, their servants and agents for delivery without bills of lading should the vessel or any vessel or property in the same or associated ownership, management or control be arrested or threatened with arrest.

Therefore, if a third party comes along claiming to be the holder of the bill of lading following delivery of the cargo, and makes a claim against the carrier backed up with a threat to arrest his vessel, the trader who has issued an LOI will

  1. have to arrange security of that claim;
  2. be liable to indemnify the carrier in respect of that claim if the carrier is successful and
  3. have to provide the carrier with the funds to defend the claim. Since the third party's claim will almost invariably be for the full value of the cargo, the sums involved can be very significant indeed.

However, whilst the trader in such circumstances will have to pay the claim and finance the defence of the claim, he will have to rely upon the carrier to properly defend the claim in circumstances where he, the carrier, has no financial interest in the outcome of it - that financial interest of course now being with the trader who has issued the LOI. This is because the P & I Club standard form LOI wording does not give the party issuing the LOI any right to take over the handling of third party claims against the carrier, even after he has posted security in respect of that claim.

There is also no limit on the number of times which the indemnifying party is required to provide security. So if there are competing claims between different parties claiming to be the lawful holders of the bills of lading, it is quite possible that the trader issuing the LOI will have to provide security more than once. This can therefore prove to be an expensive business.

Risks to be assessed when issuing an LOI

The first, and obvious, risk of instructing a carrier to discharge cargo without bills of lading is that it renders the bills of lading valueless in the hands of the trader issuing the LOI in the sense that it is no longer gives him effective title to the goods. This is because if he were subsequently to bring a claim, as holder of the bills of lading, against the carrier for wrongful delivery of the cargo, that claim will boomerang back at him under the LOI – he would have to indemnify the carrier against his own claim. So any trader who issues an LOI should, before doing so, be sure that he is going to be paid. In our experience, the "security" of a letter of credit often provides traders with what they believe to be the requisite degree of comfort in this respect. However, we have seen cases where a seller, having issued an LOI, has been unable to obtain a payment under the letter of credit due to an unrectifiable discrepancy in the documents that must be presented under the letter of credit. In that situation, the "unsecured" seller will be left chasing his buyer for payment.

The second risk of issuing an LOI is the risk of that LOI being called upon. That can happen in circumstances where the bills of lading do not make their way through the chain to the receiver to whom delivery of the cargo has been facilitated by the LOI. We have seen this happen on a number of occasions where the bank, who has paid the seller under the letter of credit, does not have financial cover from its customer and thus retains the bills of lading. The bank then knocks on the carrier's door, holding the bills of lading, and asks for delivery of the cargo. The carrier will then inevitably make a call under the LOI which will result in the seller, who has issued the LOI, having, in effect, to pay back the value of the cargo delivered – which might be even greater than the price he has received for the cargo in the first place. Furthermore, in those circumstances, the seller may have no remedy at all against the buyer. The seller has, after all, been paid for the cargo under the letter of credit. His loss will result from having entered into a separate contract (the LOI) with a third party to facilitate the early discharge of the cargo from the ship to minimise his demurrage exposure and not from any contractual failure by the buyer. It is possible, depending on the facts of the case, that if the ultimate receiver had requested the seller to arrange discharge without bills of lading, that some form of implied indemnity may arise entitling the seller to an indemnity from the buyer. However, this is far from certain and is no sure route to recovery for the seller in such circumstances. And once again, such a claim would be unsecured.

Seeking to avoid the pitfalls of the use of LOIs

Bills of lading have been described as the "life blood of trade". Whilst LOIs do not quite justify the same epitaph, they are an instrument commonly deployed in international trade to remove bottlenecks in the supply chain. It would, therefore, be uncommercial to suggest that LOIs should be avoided at all costs. However, careful scrutiny of a trader's security for payment and of the risk of the bills of lading not making it through the financial/contractual chain to the receiver should be conducted before any LOI is issued.

As to the terms of LOIs issued, lawyers often say, quite rightly, that it is all in the wording and that anticipated pitfalls can be dealt with through careful drafting. However, unless you are able to negotiate a different wording at the time of chartering a vessel (which of itself would be difficult), carriers tend religiously to demand LOIs in the wording recommended by their P&I Club when asked to deliver without bills of lading and such wordings are of course very carrier-friendly. There is therefore little, if any, scope for seeking to negotiate on that wording by, for example, seeking the addition of a provision entitling the indemnifying party to take over the defence of any claim which is subject to the indemnity in the LOI.

However, one area where there is scope to reduce risk through drafting is in the wording of the sale contract or at the point of issuing the LOI at the request of a buyer. As we have said above, there may well be no right of recourse against a buyer in the event that the carrier makes a call under an LOI. Such a route can, however, be created by a provision in the sale contract providing for an indemnity in circumstances where the buyer asks the seller to issue an LOI to the carrier to hasten discharge. Alternatively, such an indemnity could be sought and obtained at the time that a buyer asks for the seller to issue an LOI to the carrier – that is, by getting a back-to-back LOI from the buyer in suitable terms – ideally counter-signed by a bank.

Conclusion

LOIs against delivery without bills of lading have been used for decades and are here to stay. However, there are very real risks in their use and it is important to have a full appreciation of those risks. Whilst the terms of LOIs are virtually non-negotiable, there are steps which can be taken to significantly improve a seller's position with a buyer in the event that LOIs are deployed, so that if calls are subsequently made on the LOI given to the carrier, there is a route of recovery as against the buyer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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