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GTR Asia | Legal Notes

Financing the

DLA Piper’s James Willcock looks at the use of bills of lading and letters of indemnity in the oil trade.

Despite the ubiquity of financing against bills of lading and letters of indemnity (LOIs) in the trade

finance market, misconceptions persist in respect of the rights and obligations of the various participants involved in the sale and purchase of oil. Typically, a letter of credit will be payable upon presentation of either the relevant bills of ladings or against an LOI in lieu of shipping documents. For a financing bank in particular, it is

essential to recognise the distinction between the proprietary rights afforded to it when financing against bills of lading, coupled with a pledge, as opposed to the mere contractual rights it has when financing against LOIs.

What is a bill of lading?Most importantly, a bill of lading is a document of title. Understanding the meaning of that epithet as it is used in respect of bills of lading is a prerequisite to any analysis of the nature of a financing bank’s rights in respect of a bill transferred to it. Intuitively, the word title seems to imply that the party to which a bill has been transferred has a proprietary interest in the oil represented by the bill; this may not necessarily the case. As Professor Roy Goode explains in Goode on Commercial Law, “the focus on title is…misleading, for the transfer of title is an aspect of the relationship between seller and buyer, whereas the bill of lading concerns the relationship between holder and carrier”. The transfer of a bill of lading will operate to transfer the transferor’s property in the oil, if the transfer was made with that intention, but no property is transferred in the absence of such intention. This has given rise to the mantra: “Whether or not the transfer of a bill of lading

James Willcock is a solicitor in the

finance and projects department at

DLA Piper in Hong Kong, specialising in

structured trade and commodity finance

oil trade

transfers the property in goods is always a question of fact.”

The rights of a financing bankIf the transfer is by way of pledge, the bank will have a “special property” in the oil represented by the bill, while the “general property” will remain unaffected by the transfer of the bill. What does this mean? In practical terms, the special property to which the pledge gives rise, permits the bank to sell the oil upon default of the applicant notwithstanding that it does not have general property in it. As the bill of lading constitutes an acknowledgement by the carrier that the oil will be held for whoever is the current holder of the bill of lading, the holder is treated as having constructive possession of the oil. Transfer of the bill of lading to the bank perfects the pledge and, as we have seen, upon default of the applicant, gives the bank the right of sale. Again, as Goode summarises: “The bill of lading should…be seen as a control document by which constructive possession is passed rather than as a document by which title is passed.” There is, however, a notable exception to the rule that possession of the bills of lading is essential to the continuing validity of the pledge. The bank is treated as remaining in possession of the bills of

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Legal Notes | GTR Asia

“A clear understanding of this difference in approach can avoid unnecessarily pouring oil onto troubled water.”

lading, and therefore retains its rights as pledgee if the bills of lading are released to the applicant under a trust receipt for the limited purpose of selling the oil and repaying the bank. Any proceeds of sale arising from the sale of the oil are held on trust by the applicant for the bank.

If, on the other hand, the financing bank is unsecured, its rights as a transferee of the bill of lading are principally contractual, as by virtue of the Carriage of Goods by Sea Act 1992, the lawful holder of a bill of lading has transferred to it all rights of suit under the contract of carriage. As lawful holder of the bill of lading, the bank is entitled to delivery of the oil from the carrier upon presentation of the bill. If the carrier delivers the oil otherwise than against presentation of the bill, he will be liable to the bank. In addition to its contractual rights against the carrier, the bank may be able to argue that it benefits from a banker’s lien over the oil, which arises by operation of law rather than the intention of the parties. If established, it would give the bank the right to retain the goods until the amounts outstanding under the letter of credit are repaid. The bank may also be able to sell any uncollected oil as bailee. It is clearly preferable, however, to have the certainty afforded by a pledge rather than relying upon rights arising by operation of law.

What is an LOI?Where cargos routinely arrive ahead of documents, as is typically the case in the oil trade, letters of credit commonly permit the presentation of LOIs in lieu of bills of lading. In an LOI, the seller undertakes to the buyer that it will indemnify the buyer for any loss it may

suffer as a result of it being subsequently unable to provide the bills of lading to the buyer and/or its financing bank. The same procedure is followed in respect of each subsequent sale and purchase of the cargo until the arrival of the ship at the port of destination.

Obtaining the oil How does the ultimate purchaser obtain the oil without the bills of lading? As previously noted, a carrier who releases the oil otherwise than against presentation of the bills of lading does so at his peril as he will be liable to the lawful holder of the bill of lading. Given the reluctance of the carrier to release the oil, how does the ultimate purchaser of the cargo obtain the oil without presentation of a bill of lading? This is where the second type of letter of indemnity comes in. The ultimate purchaser of the oil indemnifies the carrier against any loss it may suffer as a result of releasing the oil to the purchaser without provision of the bills of lading. If a third party subsequently presents the bill of lading to the carrier for oil which it has already released, it will likely call on its indemnity against the ultimate

purchaser. The ultimate purchaser will, in turn, claim on its LOI against the entity which sold the oil to it and so on up the chain of sellers and purchasers.

Charting safe passageWhere oil cargos routinely arrive ahead of documents, the necessity of presenting bills of lading to obtain the oil is commercially cumbersome and impractical. There can be little doubt that the use of LOIs provides a neat solution to the speed of the modern oil trade. Financiers should, however, remain cognisant that the risks of financing against LOIs contrast markedly to financing against bills of lading, particularly where the financing bank is secured by a pledge over the bills. As one might expect, if the bank is providing unsecured financing against bills of lading or financing against LOIs its principal recourse is to the balance sheet of the applicant and/or the carrier. If, however, the bank is secured, possession of the bill of lading presented to it under the letter of credit will give it constructive

possession of the underlying oil and the power to sell the oil on

default of the applicant. A clear understanding of this

difference in approach can avoid unnecessarily pouring oil onto

troubled waters. GTR