BG: Letters of Indemnity in International Trade – Misdelivery, fictitious BLs & missing cargo

Bills of lading (“BLs”) are the wheels on which international trade moves. With its primary function as a title document, a BL serves as the trigger for both payment and discharge of cargo across the world. But, as paper documents that can only operate as originals, BLs have trouble keeping up with the pace of modern international trade where cargo is bought, sold, on sold or even repurchased in a matter of days. With cargo arriving at discharge ports well before BLs, traders have long relied on letters of indemnity (“LOIs”) in lieu of BLs. The use of LOIs is widespread but they present a risk as they decouple the movement of the cargo from the movement of its corresponding BL – a recipe for litigation long after the cargo is discharged. With high profile misdelivery claims increasing in the past few months, we explain the risks of using LOIs and the future of the use of LOIs in international trade.

Discharge LOIs

The starting point is that a shipowner can only release cargo upon presentation of an original set of BLs – it cannot release the cargo to anyone else, not even the cargo owner if it fails to present the BLs. To avoid incurring substantial demurrage costs, a seller, whose cargo has arrived at the discharge port before the BLs, would typically issue a Discharge LOI to the shipowner, effectively indemnifying the shipowner against any claim that may arise from releasing the cargo without presentation of the BLs. For most part, a seller’s Discharge LOI to the shipowner is replicated in a “back to back” LOI from the buyer to the seller. Buyers and sellers with established trading histories between them typically view Discharge LOI risks as minimal as the BLs should only be in the possession of either buyer or seller. Discharge LOIs however are not and cannot serve the same function as BLs – the key difference is that only BLs give rights of possession of the cargo to their holder. Modern trade finance involves not just buyers and sellers, but a vital third party, banks, who may seek possession of the cargo.

A bank that receives BLs it has financed, even after the cargo has been discharged, has a right to demand delivery of the cargo from the ship, failing which the shipowner would be liable for misdelivery. The shipowner in turn will seek to trigger its indemnity under the Discharge LOI with the seller, who may then look for indemnity under its own LOI with the buyer, if there is one.

For the seller, this reintroduces a credit risk on the buyer even in situations where the seller has sought to avoid that very risk by obtaining a letter of credit. A buyer, unable to pay its bank is likely to be in poor position to answer a seller’s demand for an indemnity. Having sold and received payment for a cargo, a seller might be blindsided by a misdelivery claim arriving through the back door of its Discharge LOI.

BLs can confuse the concept of title. Title in the context of BLs means right to possession of the cargo from the shipowner. It does not mean a right to ownership – which is normally determined by the sales contract. If the right to possession from the shipowner is determined by the possession of a document such as a bill of lading, then that document is a document of title.

“Spent” BLs?

Shipowners have time and again tried resisting banks’ misdelivery claims by challenging the banks’ title to sue. There is a common misconception that BLs became spent after the cargo has been discharged against LOI. The argument in essence is that in circumstances where cargo is discharged before a bank obtained the BLs, the BLs are “spent”, or in other words, incapable of passing lawful title to the bank. The argument has resoundingly been rejected by Singapore courts. The recent decision of The You Yue 902[2020] 3 SLR 573 confirms that a bill of lading is only considered “spent” if cargo is discharged to the person entitled to it. Discharge against an LOI does not qualify. BLs therefore are not spent if cargo is discharged against a Discharge LOI. In any event, a bank receiving BLs after cargo has been discharged is likely to retain its right of suit because the bank’s rights as holder of the BLs are likely to be created pursuant to its facility agreement used to finance the transaction and such financing arrangements will invariably precede the sales contract and the discharge of the cargo. A bank lawfully holding on to BLs therefore retains good title to sue a shipowner for misdelivery.

Discharge LOIs decouple title to the cargo vested in the holder of the original BLs from the physical movement of the cargo. It is a common feature of double financing claims that banks are left with BLs while the cargo has long disappeared. This triggers a misdelivery claim that creates a domino effect under LOI arrangements, ultimately falling on the seller if the buyer is insolvent. The only credible way of mitigating a misdelivery exposure is to obtain the consent of the holder of the BLs, i.e., the financing banks to discharge the cargo against an LOI, a proposal that a bank is unlikely to find attractive.

Payment LOIs

A completely separate LOI mechanism is prevalent in the oil trade, where LOIs are used in lieu of BLs for payment under a letter of credit. Such Payment LOIs typically warrant the seller’s good title to the cargo as well as the surrender of the original BLs when they become available. Payment LOIs complicate the risk matrix further because at the time of payment, the BL is neither in the hands of the seller, the buyer nor the bank paying under the letter of credit. When there are gaps in the trail of the BL, double financing flourishes – either the same BL has been used to monetize the trade a second time or a fictitious BL may be in operation undetected. A Payment LOI can counterintuitively unravel the security of an LC payment as failure to provide good title to the bank will create liability for the seller under the LOI where BLs are not provided to the bank or fictitious BLs are provided.

The practice of Payment LOIs has been significant scrutinised in recent collapses of oil traders and appears a probable area of reform by banks faced with cumbersome exercises of proving double financing and fictitious trades before embarking on challenging recoveries typically against insolvent parties. Payment LOIs face an uncertain future in the current climate of international trade and it is likely that banks would only finance on BLs that can verified and authenticated. It remains an open question as to how BL verification can be done transparently to boost confidence in trade finance.


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