Practical Takeaways for Commodity Traders – Risks Involved in Issuing Letters of Indemnity

It is common practice for commodity traders who have chartered vessels to instruct the shipowner to discharge cargoes without production of the original bills of lading and to agree to indemnify the shipowner against the consequences of doing so. This is done by providing a Letter of Indemnity (“LOI“). It is often the case that LOIs are given by traders without a full appreciation of the risks involved or consideration as to how those risks might be minimised. These issues have recently been brought into the spotlight because of the collapse of major oil trading entities including Hin Leong Trading (Pte) Ltd and Hontop Energy (Singapore). In this article, 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.

When are LOIs used?

The bill of lading is commonly known as the “key to the warehouse“. This is because the carrier’s paramount obligation under a negotiable bill of lading is to only deliver the cargo on production of the original bill of lading. If the carrier delivers the cargo without production of the bills of lading, he may potentially 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). Having said that, for the sake of commercial expediency, most carriers will agree (either at the time of entering into the charter or after) to give delivery of cargo without bills of lading if they are provided with an LOI in the standard P&I Club form. This is because the bill of lading’s progress through the sale chain, especially where banks are involved, is often slower than the vessel’s progress to the discharge port. In such circumstances, large demurrage claims would arise if discharge had to wait for the bill of lading to catch up. 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 reasonably 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 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 the shipowners’ P&I Clubs. The key features of such wording are that the party giving the indemnity will:

1. indemnify the shipowner in respect of any third party claim they may face by reason of delivering the cargo in accordance with the request (i.e. without production of the original bills of lading);
2. provide security in respect of any third party claims brought against the shipowner 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; and
3. provide sufficient funds to defend any claim brought in connection with the delivery of cargo without bills of lading.

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 need to:

1. arrange security of that claim;
2. provide the carrier with the funds to defend the claim;
3. in the event that the carrier does not succeed in defending the claim, indemnify the carrier in respect of that claim. In this regard, it bears mentioning that the third party’s claim will almost invariably be for the full value of the cargo.

In circumstances where a trader puts up security and is also funding the defence of the claim from the third party, he will still have to rely upon the carrier to properly defend the claim in circumstances where the carrier no longer has any financial interest in the outcome of it. 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 for example, where there are multiple bills of lading issued for a single shipment of cargo and 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.

Risks to be assessed when issuing an LOI

The obvious risk of instructing a carrier to discharge cargo without bills of lading is that it renders the bills of lading worthless in the hands of the trader issuing the LOI. This is because if the trader were to subsequently bring a claim, as holder of the bills of lading, against the carrier for wrongful delivery of the cargo, that claim will rebound back at him under the LOI – the trader would have to indemnify the carrier against his own claim. Any trader who issues an LOI should, before doing so, be sure that he is going to be paid. In this regard, the fact that payment it to be received under a letter of credit often provides traders with what they believe to be a certain degree of comfort. 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 a 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 other 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 sale 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, is not paid by 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. 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.

Seeking to avoid the pitfalls when using LOIs

LOIs 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. LOIs have been used for decades and are here to stay. However, a careful scrutiny of a trader’s security for payment and of the risk of the bills of lading not making it through the sale chain to the end receiver should be conducted before any LOI is issued.

As to the terms of LOIs issued, unless a trader is 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.

Having said that, one area where there is scope to reduce risk through drafting is in the wording of the sale contract. 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. Alternatively, this can be done by getting a back-to-back LOI from the buyer in suitable terms and ideally counter-signed by a bank. While obtaining a back-to-back indemnity from the buyer may mitigate the risk, this will ultimately depend on the financial state of the buyers at the time that the seller calls on the LOI. In cases where the buyer has become insolvent, it will not assist the CFR seller to have a back-to-back LOI. The only way for a trader to completely eliminate against such risk would be to sell on FOB terms and buy on CFR terms and also to decline providing any back-to-back LOIs when requested to do so. This will mean that the trader is completely out of the arrangements for the shipment of the cargo.

This article is authored by Shipping Partner Prakaash Silvam and Associate Tan Yu Hang. Do not hesitate to contact them should  you have any enquiries pertaining to maritime related matters.