Briefing

Letters of indemnity, electronic bills of lading and the future of misdelivery risk

Letters of indemnity (LOIs) are, and will remain for some time, a key part of international trade. However, the environment in which they operate is shifting on two fronts simultaneously: judicially, through increasing scrutiny of the causation of loss following misdelivery; and structurally, through the adoption of electronic bills of lading (eBLs) that could gradually erode the documentary opacity on which the LOI’s commercial necessity is based.

This article examines the risk framework governing LOIs under English law and considers the implications of the shift to eBLs for carriers, charterers and trade financiers.

Background: why are LOIs needed?

Bills of lading are the cornerstone document in the world of shipping and commodities. They famously serve a triple function as (i) a receipt for the goods shipped; (ii) evidence of the contract of carriage; and (iii) a document of title. It is in this last capacity that they assume their greatest commercial significance, as physical possession of them typically entitles the lawful holder to demand delivery of the corresponding goods.

Speed is essential in international trade: goods often arrive at the discharge port before the corresponding original bills of lading (OBLs) have made their way through the trading and/or banking chain. This gap is the structural problem that letters of indemnity (LOIs) have long been used to solve.

However, the growing adoption of eBLs is increasing the speed at which documents move through the trading chain and, crucially, how carriers identify the lawful holder at the point of discharge. Whilst in a paper-based system, that holder can be difficult to identify, under the eBL system, that uncertainty could evaporate, as the lawful holder could be identified in real time. As such, the commercial logic that sustains the LOI in its traditional form may not survive the transition away from paper-based trading.

Who bears the risk?

An LOI is an enforceable contract under English law, provided it is properly executed and free from defects that may invalidate it, such as fraud. It is, in essence, a contractual promise given by the party requesting discharge of the goods without OBLs (typically a charterer or cargo receiver) to indemnify the carrier (and/or their contractual counterparty if part of a contract chain) of those goods against claims that may later arise if it emerges that the lawful holder of the OBLs is someone other than the party to whom the goods have been delivered.

However, even a valid and well-drafted LOI is only as strong as the party behind it. If the issuer is insolvent or refuses to respond when called upon to do so, a LOI will be of little value to the holder.

LOIs typically operate in a chain, with charterers issuing an LOI upwards to owners while receiving a back-to-back LOI on similar terms from a downstream party. Each LOI in that chain is a standalone contract, meaning that charterers’ obligation to indemnify owners (and/or their upstream contractual counterparty) is entirely independent of whether their own, downstream LOI responds. If the counterparty behind that downstream LOI cannot pay, charterers may be left facing the claim themselves without recourse.

The Singapore case of Re Projector SA¹ is illustrative: here, a vessel was jointly arrested by two related banks holding OBLs after they had paid for goods under a letter of credit (LC), had not been reimbursed, and later found that the underlying goods had been discharged without presentation of the OBLs – leaving both banks without security for the LC sum paid. Charterers had received an LOI, pursuant to which the issuer was obliged to provide sufficient security to either prevent arrest or secure the release of the vessel. However, after the vessel was arrested, the LOI issuer was in serious financial difficulty and unable to respond. In the interim, costs mounted. Ultimately, charterers had no option but to provide a bank guarantee for the release of the vessel themselves, whilst the LOI issuer went into liquidation.

This is also a good example of the exposure faced by commodity trade financiers. Banks routinely take OBLs as security under LCs for financing the trade of goods but have little or no control over how or when those goods are discharged. If a payment default occurs and the bank looks to enforce its security, it may find that the goods have already been delivered against an LOI issued by another party in the chain – potentially leaving the OBLs it holds with little immediate practical value.

The Rules of the International Group of P&I Clubs generally exclude cover for liabilities arising from delivery without presentation of OBLs, known as misdelivery claims. In other words, accepting an LOI will usually prejudice P&I cover. Whilst the Clubs offer standard LOI template wording to help their members manage drafting risk, the use of such wording does not vary this position. As such, where possible, owners and charterers should require LOIs to be countersigned by a reputable bank as primary obligor or backed by a demand guarantee. In practice, however, this may be difficult and costly to obtain.

Challenging LOIs: drafting, causation and the consent defence

Drafting

Even where an LOI is in principle enforceable, a preliminary question arises – was delivery effected in accordance with its terms? The answer turns on effective drafting.

In The Songa Winds², back-to-back LOIs issued up a charterparty chain to head owners provided for discharge to the named receiver “or… such party as you believe to be or to represent… or to be acting on behalf of” that receiver. Head owners discharged to a third party, the notify party on the OBLs, and later faced a misdelivery claim from the bank financing the trade. There was an issue as to whether discharge to the notify party fell within the scope of the discharge request in the LOI. The English Court held that head owners’ actions fell within the terms of the LOI as the third party was a representative of the receiver and, accordingly, the undertakings set out in the LOI were engaged. However, it should be noted that, had the LOIs been drafted more narrowly, providing solely for discharge to the named receiver, head owners’ position would have been significantly weaker. In the earlier case of The Bremen Max³, where delivery of the goods was not made to the specific party named in the LOI, the English Court therefore found that LOI indemnity was not triggered.

Parties accepting LOIs should therefore press for the broadest possible wording, covering delivery to the named party or any person representing or acting on behalf of that party, and should be alert to any mismatch between the party named in the LOI and the original consignee in the OBLs.

Causation

The more significant battleground in recent years has been causation – accepting that misdelivery occurred but questioning whether it caused the financier’s loss. Carriers have increasingly argued that even if they discharged the goods without the OBLs, the financier would have consented to discharge in any event and therefore would have suffered the same loss.

In Unicredit Bank AG v Euronav NV (“The Sienna”)⁴, this argument succeeded. The English Court of Appeal upheld a finding that on the available evidence, the bank was aware of the delivery of the goods without presentation of the OBLs and would have permitted discharge without production of the OBL if asked. The causation defence was therefore established on the facts.

The Singapore Court returned to this point in The Maersk Katalin⁵, applying English law, in the context of the 2020 Hin Leong collapse. Here, the bank brought a claim against owners in respect of goods that had been discharged under an LOI provided by receivers, and on-sold to Hin Leong. The bank financed Hin Leong’s subsequent purchase of the goods under a LC and, following Hin Leong’s insolvency, brought a claim under the OBLs against owners for misdelivery. Owners accepted that they had misdelivered the goods but argued, following The Sienna, that the bank would have consented to the discharge in any event and therefore the misdelivery had not caused its loss.

The Court disagreed. It started from the “baseline inference” that banks take security for a reason and will not relinquish it without sufficient commercial justification. Owners bore the evidential burden of demonstrating that the bank would have consented to discharge without the OBLs if asked, and were unable to meet that burden, effectively asking the Court to assess the bank’s likely response in a vacuum.

The Court also dismissed owners’ argument that the bank’s issuance of the LC after discharge had already taken place could be treated as implied consent to the discharge of the goods without OBLs, as the Court was not convinced that the bank knew at the time the goods had already been delivered (although it noted that persons with greater operational experience of international sales might have drawn that inference). This decision was also upheld on appeal⁶.

Whilst the bank in The Maersk Katalin ultimately succeeded in its claim, the trajectory of these cases makes clear that misdelivery claims are becoming increasingly complex and fact-intensive.

The impact of the transition to eBLs

The growing adoption of eBLs could ultimately materially reshape the LOI landscape and the misdelivery risk that sits behind it⁷. However, that change is likely to take some time.

Under the current paper-based system, a carrier discharges against an indemnity because it cannot easily verify who holds the OBL at any given moment. That uncertainty is the gap that the LOI is designed to bridge. Many eBL platforms have the capability to remove that opacity entirely. Carriers, financiers and other interested parties could know, in real time, who the lawful holder of the eBL is and, potentially, the whereabouts of the underlying cargo. A bank that has taken an eBL as security could be identifiable as the lawful holder at the point of discharge, without any need for the carrier to speculate. Where a paper OBL might be in transit, held by a bank, or delayed, an eBL is present in the system. Accordingly, the practical necessity for LOIs would diminish and with it, the volume of misdelivery claims.

However, whilst that capability exists, it is not yet being used to its full extent. This is for a number of reasons:

The industry is in no rush to adopt this change; it is comfortable with the current, more familiar system.
Transparency could create commercial sensitivity, for example if all the parties in a contractual chain are visible to each other.
Transparency could also create sanctions liability for carriers in relation to parties further up/down the chain.
The current emphasis is on ensuring functional equivalence between eBLs and paper bills of lading, rather than exploring the scope for different functionality.

In addition, there is scope for new complications if the current approach is changed. A carrier presented with a discharge request could be able to identify whether a bank is in fact the lawful eBL holder and seek its consent before proceeding. If the bank refuses, for example because it intends to hold the cargo as security following a counterparty default, the carrier would face a dilemma – it cannot discharge without the holder’s authorisation and risk a misdelivery claim, but it cannot discharge the vessel whilst still waiting for that authorisation at the discharge port. The financier, on its part, would face mounting exposure to claims for demurrage and storage costs. It would also need to be careful not to consent to discharge given the trajectory of the case law discussed above. Neither outcome is commercially attractive.

The consequence would be a new form of pressure on banks. A bank holding a paper OBL is invisible to the carrier at the point of discharge; a bank holding an eBL might not be. The transparency that eBLs offer therefore cuts both ways – it would give the bank a visible and enforceable position, but it would also place the bank in the firing line if it exercises that position in a way that creates deadlock. Banks may therefore find that their security over the cargo by virtue of being an eBL holder places them under commercial pressure to consent to discharge (with resistance to that pressure coming at real commercial cost) but risking the worth of the eBLs they hold as security by agreeing to the discharge of the goods to cargo receivers.

There is also a contractual dimension to navigate. Many standard-form charterparties currently impose an express obligation on the carrier to deliver without OBLs against LOIs. As eBLs become more prevalent, owners and charterers will need to reconcile that obligation with the changed documentary environment, and we are likely to see amendment to those contractual provisions, whether through market practice, standard form revision or bespoke negotiation.

Practical steps for managing risk

In view of the risk landscape described above, the following practical steps should be followed when accepting LOIs. These steps remain relevant in the current paper-based system and, during the period of transition to eBLs, will assume added importance as the consent and liability framework evolves:

Counterparty due diligence – perform thorough financial checks on counterparties before accepting an LOI. As eBL adoption increases, verify whether a relevant eBL platform records a bank or financier as the eBL holder.
Drafting – use the International Group P&I Club template as a baseline. Ensure the LOI is broadly drafted to cover delivery to multiple classes of parties and claims from any party asserting a right to the goods. Narrow drafting creates gaps.
Back-to-back indemnities – ensure that LOIs received and LOIs issued in turn are on materially back-to-back terms, so that liability can be passed along the indemnity chain without gaps.
Layered recourse – seek LOIs from more than one party where possible. Consider including an express indemnity clause in sub-charterparties for discharge against LOIs⁸, having the LOI counter-signed by a bank and/or, where the lawful OBL or eBL holder can be identified, obtaining their express written consent to discharge before it takes place (therefore creating a robust causation defence to any misdelivery claim at the outset).

Conclusion

Until the time comes that LOIs are no longer needed, the appropriate response is not to avoid them (in many trades they still remain the only practical option to discharge the goods without delay), but to structure them carefully – engage in rigorous counterparty due diligence, ensure that they are broadly worded, and obtain back-to-back indemnities and layered protection wherever possible.

That said, as eBLs gain popularity, it would be prudent to revisit contract provisions that currently mandate delivery against LOIs, considering whether this language adequately addresses consent dynamics in the eBL environment and, if you are a financier, how your position may be affected if your consent to discharge is sought and withheld.

If you would like to discuss any of the issues raised in this article, please do not hesitate to get in touch. We regularly advise shipping and commodities stakeholders on misdelivery risk, LOI structuring and the management of trade finance disputes.

Footnotes