Letter of Indemnity

A letter of indemnity (LOI) is a written undertaking in which one party promises to compensate another for any loss, liability or cost it suffers as a result of doing something at the first party's request. In international shipping, the term usually refers to the indemnity a cargo receiver gives a carrier so that the carrier will deliver goods without the receiver presenting the original bill of lading. Because the carrier risks delivering the cargo to the wrong person, it asks for an indemnity to shift that risk to the party making the request, often backed by a bank.

Letters of indemnity are also used in banking and corporate administration, for example when a customer asks a bank to issue a replacement for a lost share certificate or cheque, or to act on instructions that lack the usual formalities.

A negotiable bill of lading is a document of title: whoever lawfully holds the original is entitled to the goods. A carrier that releases cargo to someone without the original can be liable to the real holder, for example a bank that financed the purchase under a letter of credit and holds the documents as security. Yet ships often reach port before the documents have passed through the banking chain, especially on short voyages or when cargo is sold several times while at sea. Waiting would leave the vessel idle and incur demurrage, so the receiver offers an LOI instead.

The receiver, often a trader or buyer, sends the shipowner or charterer a letter asking it to deliver the cargo to a named party at a named port without production of the original bill of lading. In return, the receiver promises to:

• indemnify the carrier, its agents and servants against all liability, loss and expense arising from the delivery;
• provide funds to defend any legal proceedings brought against the carrier;
• provide security, such as bail, if the vessel is arrested by a party claiming the cargo; and
• deliver the original bill of lading to the carrier as soon as it is obtained.

The International Group of P&I Clubs, which insures most of the world's ocean-going tonnage, publishes standard wordings for such indemnities. These are widely used because delivery without production of the original bill is normally excluded from a shipowner's protection and indemnity cover, leaving the LOI as its main protection.

A receiver's own promise is only as good as its balance sheet. Carriers often require the LOI to be countersigned by a bank, which turns it into a form of bank guarantee. The bank, in turn, will usually ask the receiver for collateral or a counter-indemnity and will seek to obtain the original bills when they arrive. The bank's exposure may be open-ended unless the wording caps it at an amount, such as a percentage of the cargo value, and sets an expiry date.

• Change of discharge port. A charterer may ask the owner to discharge at a port different from that named in the bill of lading.
• Switch bills. A trader may ask for a new set of bills with different details, such as a different shipper or port of loading, often to protect commercial confidentiality.
• Clean bills. A shipper may ask the carrier to issue a clean bill of lading without noting visible damage or shortage, in return for an indemnity.

Using a sea waybill or an electronic bill of lading can reduce the need for LOIs, because a waybill is not presented for delivery and an electronic bill can be transferred instantly.

An indemnity given to induce a carrier to issue a document that misrepresents the cargo can be unenforceable. In the English case Brown Jenkinson & Co Ltd v Percy Dalton (London) Ltd (1957), the Court of Appeal held that an indemnity given in exchange for a clean bill of lading, when the carrier knew the goods were damaged, could not be enforced because the arrangement was designed to deceive buyers and banks relying on the bill. The same principle makes clean bills issued against an LOI a red flag in trade finance.

Letters of indemnity are also a channel for fraud and sanctions evasion. Cargo released against an LOI may be diverted, sold twice, or delivered to a sanctioned party while the documents describe another destination. Banks treat LOI requests as part of trade-payment compliance and trade authenticity verification, checking vessel movements, the commercial invoice and the parties against sanctions lists, including the SDN List.

An indemnity creates a primary obligation to make good a loss, whereas a guarantee is generally a secondary promise to answer for another person's default. In practice the two overlap, and a bank-countersigned LOI functions much like a demand guarantee. The commercial background to these instruments is described in the entry on trade finance, and the allocation of transport risk between buyer and seller in the entry on Incoterms.