On occasions, a vessel may arrive at a port and be ready to discharge but the original bills of lading in respect of the cargo have not passed through the banking chain to the ultimate receivers, cargo is then discharged against a letter of indemnity (“LOI”) and released to a party who has not paid for the goods, resulting in a claim against the carrier for mis-delivery and, ultimately, a call under the LOI. This scenario is becoming increasingly common in the PRC, particularly in the iron ore trade where banks are looking to enforce their rights in view of the deteriorating financial health of local steel mills and traders. This article highlights the key risks and considers ways in which a party can minimise their potential exposure.

Carriers often come under pressure to deliver cargo without production of the original bills. In light of the potential liabilities, no prudent carrier would agree to delivering cargo without the original bills until they had received an LOI from a party who is financially reliable. Often the carrier will not accept an LOI from the end receiver, who they have had no previous dealings with, and will demand one from its direct contractual counterparty, the charterer. The charterer will in turn want an LOI from the sub-charterer, if there is a charter chain, who may look to its buyer under the cargo sale contract and so on down the chain to the ultimate receiver.

Often the charterer, as shipper the goods, has received payment and, in order to facilitate the discharge of cargo without delay and to avoid a demurrage claim, may issue an LOI without a full appreciation of the risks involved.

There is always a risk of the LOI being called upon. This 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. The bank, which has paid the seller under the letter of credit, may not have received payment from its customer and therefore retains the bills of lading. The bank then demands delivery of the cargo which has already been delivered (to the party named in the LOI, often the bank’s customer). The bank may have a claim against its customer, but the easier target is a claim against the carrier for mis-delivery.  The carrier then inevitably makes a call under the LOI.

Clearly the safest option is for a party to refuse to issue an LOI. However, it not be commercially viable to suggest that LOIs should be avoided at all costs.

If a party is considering providing an LOI, careful scrutiny of the security for payment under the sale contract and of the risk of the bills of lading being stuck in the chain should be conducted first.  If practicable, the internal authority for the issuance of LOIs should be reserved to senior staff in the credit or finance functions of the business as the provision of an LOI re-opens the counterparty risk.

The vast majority of LOIs are issued on the International Group of P&I Clubs standard wording and there is often very little, if any, scope for seeking to negotiate this wording. However, if possible, a party should try to limit its liability under the LOI to be issued with regard to amount and duration.

If a party issues an LOI then it should always obtain an LOI from its charterer/buyer down the chain. The indemnity should be on materially identical terms to the LOI provided (subject to any limits included). Parties should always remember that security is only as sound as the solvency of the party providing it and so the indemnity should be backed by a guarantee from a first class international bank or, at the very least, a parent company of substance.

It is important to consider the enforceability of the indemnity and the appropriate law and jurisdiction clause and whether the LOI would need to be registered.

At ports in the PRC, cargoes are often discharged from vessels to customs controlled warehouses or holding areas pending collection by the cargo owner. Effective control over the cargo is often difficult to monitor following discharge. Bills of lading are often exchanged for delivery orders issued by the carrier's agent which can be used to collect the cargo. If the bills have not arrived, the delivery order is often given to the receiver named in the LOI without due consideration as to whether they are entitled to the delivery order and the cargo released against presentation of it.

In the PRC, it is this lack of physical control of the cargo that is leading to the exposures/losses. Parties should try to insert provisions into its contracts which ensure that delivery orders are only exchanged in return for original bills of lading and find ways of asserting greater control over local agents. Charterers should also instruct the vessel to retain the delivery order until the original bills of lading are presented and insist that the carrier's and receiver's agents are different entities.

Another option which should be explored is increasing the usage of independently owned or leased warehouses or bonded warehouses into which cargo can be discharged. Whether this is viable would largely depend on the facilities at the relevant port and the point at which import duty will become payable.