Is the salvage industry in terminal decline? LOF v Commercial Contracts Written by Martin Hall In May this year I gave a presentation at the Clyde's Marine Conference in Singapore titled "Is the Salvage Industry in Terminal Decline?" (as reported in Lloyd's List). 1 In July, Lloyd's List published a further article headed "Who Killed LOF?"2 Following this theme, in September at the IUMI conference in Tokyo, David Lawrence, the Lloyd's Controller of Agency (responsible for the administration of LOF), stated "While not necessarily at the peak of fitness, LOF still does have a pulse." 3 David Lawrence highlighted the number of LOFs agreed during the year to date, which was 45 (now around 50). However, crucially, he also pointed out that there has been a rise in side agreements to cap the salvage awards (so called "hybrid" LOFs), which he thought represented "more than 50%" of cases. As Jeremy Russell QC (the current LOF Appeal Arbitrator) said at a conference in March this year, as reported in Tradewinds, "People look for ways to avoid LOF contract with a cap or wreck-removal contract or a towing contract." So, why is that? One major perception is that LOF has simply become too expensive. Salvage Award Data To test this assumption, I have analysed whether there has been a general increase in the level of awards over the last seven years and have sought to identify trends in salvage awards under LOF to see where the reality lies. Lloyd's Salvage Arbitration Branch publishes statistics for LOF usage on their website going back to 1990, and the website is updated to cover more recent years. In considering these statistics we have to take into account that these figures are based on awards; a good proportion of cases settle – around 70% on average. 1 Lloyd's List Maritime Intelligence 26 May 2017 2 Lloyd's List Maritime Intelligence 05 Jul 2017 3 Lloyd's List Daily Briefing 20 Sept 2017 LOF CASES 0 20 40 60 80 100 120 140 160 180 200 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 LOF v COMMERCIAL CONTRACTS To make this easier I have extrapolated the statistics into separate graphs: . The first thing that will be noticed is that since 1990 the trend in terms of new LOFs has shown a marked decline. So why the drop in the number of LOF cases? The most obvious reason is simply a lack of casualties. Safety at sea has improved over the years, also compounded by periods of reduced trade. However, there is also increasing pressure from the insurance market to steer away from LOF where possible. TOTAL VALUE (MILLION) $0.0 $100.0 $200.0 $300.0 $400.0 $500.0 $600.0 $700.0 $800.0 $900.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 LOF v COMMERCIAL CONTRACTS This graph shows the peak in total salved values in recent years before the shipping recession. It also shows much higher values in the early 1990’s. However, it has to be remembered that there were more LOFs then and more awards. Apart from a low start to the 1990s this starkly demonstrates the extraordinary years of 2007 and 2009 both of which it has to be said were followed by sharp drops in levels of awards. None more so than in 2010, which coincided with the impact following the economic downturn in 2008. Whilst values recovered in 2011, the overall trend is very erratic. The award figures for 2007 and 2009 show that 6 or 7 “mega” awards dominated the figures (including "APL PANAMA" and "OCEAN CROWN", the 2 biggest awards ever). One factor that clearly had an impact on the level of salvage awards in recent years was the enormous increase in vessel values leading up to September 2008. We also saw a substantial increase in bunker prices and inflated charter rates for, for example, bulk carriers. In addition, salvage tugs and supply vessels were earning well over US$100,000 per day in pure commercial work. How times have changed! LOF v COMMERCIAL CONTRACTS PERCENTAGE OF AWARDS TO VALUES 0 10 20 30 40 50 60 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 This graph, showing the levels of award expressed as a percentage of salved values, probably gives us the best indication of whether awards have in fact increased over the whole 26 years and not just looking at 2007 and 2009 in isolation. Obviously, the much higher the fund the more likely the award will be more generous. Likewise, the higher the expenditure and greater cost of investment in salvage equipment involved in rendering salvage services, the greater the award. Of course, recent adverse developments in the market have had an impact: the boom times are over, vessel values have dropped considerably (although picking up again) and commercial rates for towage operations and the offshore supply industry have significantly dropped with many tugs and supply vessels laid up. Such market conditions will inevitably see awards reducing as a whole. Having said that, whilst there are substantial peaks and troughs, generally the trend is upwards over the whole period in terms of awards expressed as a percentage of values. It is important to stress that whilst the salvors may be getting a greater percentage of salved values, this does not necessarily mean they are getting more money. The International Salvage Union (ISU) latest statistics demonstrate a substantial reduction in income, not only from LOF but overall. They also show, interestingly, an increase in recent years in non-LOF salvage work even though the revenue for such work is also down. ISU figures show total revenue for the salvage industry last year of US$380 million, compared with US$717 million in 2015, a drop of nearly 50%. So what are the reasons for the increasing trend in awards as a percentage of values? Possible reasons may include:- 1. Larger investment in salvage equipment 2. Bigger and more complex salvage cases 3. More dangerous cargoes 4. More difficult/dangerous environmental considerations 5. More third party interference 6. More stringent conditions imposed 7. Greater potential liabilities to salvors (civil and criminal). 8. Less LOF cases. 9. Increased operating costs. 10. Reduced salved values. Although values and awards declined sharply in 2010, the one thing that has not gone down is operating costs, apart from bunker prices. This, of course, puts more pressure on the salvage industry. Such is the state of the salvage industry, particularly for those with salvage tugs on station, that companies are quoting unusually low rates for towage jobs, as well as variations of, or alternatives to, LOF. So, ironically, market conditions have had the effect that the insurance industry was striving for when it was concerned in recent years that salvage awards had increased. However, a further effect is that with awards inevitably coming down due to market forces, but with operating costs generally not having reduced, we have already seen, and will continue to see, less salvage tugs on station. What is clear is that unless and until anyone comes up with a better solution, and with governments applying austerity measures, LOF remains the primary means to maintain the salvage industry. Ultimately, the insurance market subsidises the salvage industry and, as a result, as that subsidy reduces in monetary terms due to, for example, less LOFs combined with reduced values, the greater the pressure on arbitrators to increase the percentage of awards to values. As Jeremy Russell and David Lawrence have both alluded to, more LOFs are being entered into with caps, or commercial terms. This is a sign of things to come. Why is this – apart from the perception that LOF is more expensive? Insurers are more sophisticated, some with in-house expertise. 1. Insurers are more assertive in their approach to the types of salvage contracts to be used. 2. P&I Clubs, with the use of SCOPIC, are more involved in salvage. 3. There are more experts available – brokers, consultant salvage masters (who have left salvage companies and now joined or formed their own consultancy firms), aside from lawyers. 4. Communications are easier and quicker. 5. Market forces - salvors are more desperate given lack of work. 6. Cut-throat competition – what I have previously described as a "race to the bottom". 7. Drive towards pre-arranged commercial contracts or tariff rates. LOF v Commercial Contracts So what are the pros and cons of entering into a clean LOF rather than some sort of hybrid version that reflects more commercial terms or capped salvage awards, or indeed a pure commercial salvage type of contract such as Towhire, Towcon, Wreckhire or Wreckfixed? Why LOF? Pros: ·No cure – no pay. ·Quick to agree – no need to hesitate in emergency. ·Approved (in principle) by the insurance industry. ·Salvors take over funding. ·Salvor's responsibility – best endeavours. Higher standard. ·Pro-rata ship/cargo/bunkers. ·Well established system of determining the level of award by experienced arbitrators. ·Well established group of practitioners – over 70% of cases settle. ·FCAP regime to reduce legal costs. ·Designed to sustain a viable salvage industry – subsidised by the insurance industry. Cons: ·Thought to be too expensive. ·Ultimate award unknown – problems of reserving (although security). ·Too salvor biased – although matter of public policy. Why commercial contracts? Pros: ·Owners/insurers have more say over operation and cost - more control. ·Takes advantage of cut-throat competition to reduce cost. ·Owners/insurers can choose the salvor – maybe by tendering. ·Pre-existing contracts/tariff rates may be used. ·Bimco towage/wreck removal forms industry approved – but not "hybrid" LOFs. Cons: ·No ultimate cap on costs, potentially never ending. ·Due care – lower standard than best endeavours. ·Fixed price contracts – not fixed price! ·Not limited by value. ·Not no cure – no pay. ·Knock for knock regime – salvors not responsible for loss/damage to ship. ·Time required to enter contract – not for emergencies. ·Delay can have unintended consequences. ·Termination issues. ·Pre-existing contracts/tariffs – can be an issue if the "preferred" salvor not near the casualty or doesn’t have suitable equipment etc. ·Is the right salvor in the right place? ·Funding – insurers not normally able or willing to fund in advance the costs (issues with co-insurers, cargo etc). ·Owners have to pay in first instance. Hybrid LOFs Capped LOFs are becoming more common on the basis that the insurance industry can keep the benefits of LOF but also keep the cost down to a capped award figure. Salvors are being forced to use them more due to intense competition. But care needs to be taken – such a capped LOF could prejudice P&I Club cover. The P&I industry has already issued warnings about this. The reason for P&I concern is that where the SCOPIC clause is invoked and the SCOPIC claim exceeds the ultimate salvage award, then the Club will be liable for the difference between the salvage award and the SCOPIC claim. If the salvage award has been capped, this may result in increased SCOPIC exposure for the P&I Club. Caution should also be exercised in relation to side agreements that may seek to cap or regulate the amount of the Article 13 salvage award against all or some parties to the LOF: ·Collateral agreements are not necessarily binding on cargo/bunkers, particularly if not deemed to be reasonable and/or there is no urgency – owners' authority to bind cargo or any other party to the LOF is governed by Article 6 of the Salvage Convention 1989. ·If the side agreement is designed only to benefit one party to the LOF and not any other party, it could be in breach of Clause L of LOF, which voids any LOF signed under any form of inducement, and/or ·Could be deemed fraudulent, particularly if not disclosed to the other parties. Conclusion There is no doubt that LOF remains the best all-purpose salvage contract around – particularly in emergencies. We do not want to go back to the days when we saw casualties and environmental disasters similar to "Amoco Cadiz" in 1978 that occurred over haggling about contracts. LOF will not therefore disappear, but the trend towards hybrid LOFs or commercial salvage terms is likely to increase, due to pressure from the insurance industry and also salvors' desperate attempts to secure business. Despite the range of difficulties that it faces, the salvage industry does retain one significant advantage; the insurance industry is not really in a position or indeed willing (except in rare cases) to (A) arrange salvage operations in their own name, (B) fund salvage operations or (C) take the risk. Also, the insurance industry has to be careful that they do not negotiate terms that could lead to potential civil or criminal liability to be imposed on the insurers themselves, for example in the event of loss of life or pollution. However, the salvage industry (in particular the ISU) needs to move with the times and to meet the challenges presented by market conditions and the insurance industry. In particular they could help to develop a standardised hybrid or more commercial tariff-based LOF, to run side by side with the 'clean' LOF, and which can be used for the less urgent cases to cap or control costs. Such a hybrid LOF - that may, for example, incorporate a success bonus - has the potential to address the concerns and issues currently surrounding the negotiation of commercial contracts. It could establish a level playing field, more transparency and enable salvors to avoid excessive focus simply on tariff rates. Certainly such a standard form of hybrid LOF could result in lower returns for salvors on the less urgent salvage cases, but that is happening now anyway. It should, however, mean higher returns, with contractual benefits for all sides, on cases for which LOF is currently felt to be less suitable. A standardised version 2 of LOF for the less urgent cases, based more on commercial terms or capped awards, could mean that LOF would once again become the salvage contract of first choice in the vast majority of cases – the only choice to be made by the parties being whether it will be LOF1 or LOF2 that is more suitable. Martin Hall Head of Marine Casualty Clyde & Co LLP E: Martin.Hall@clydeco.com © Clyde & Co 2017. All rights reserved.