Addressing Security Requirements in Purchase and Sale Agreements

Tuesday, October 05, 2004

By Brett M. Esber

On July 1, 2004, the new port facility and vessel security requirements contained in the International Ship and Port Facility Security Code ("ISPS Code") became effective.1 The ISPS Code is implemented through Chapter XI-2 of the International Convention for the Safety of Life at Sea ("SOLAS"). Compliance with the ISPS Code is mandatory for the 148 countries that are "Contracting Parties" to SOLAS.The ISPS Code imposes security requirements on port facilities and the owners and operators of vessels subject to Chapter XI of SOLAS. In very general terms, these security requirements involve development, filing and approval of a port facility security plan ("PSP") or ship security plan ("SSP") that satisfies the requirements of the ISPS Code, and operation in accordance with that plan and the general provisions of the ISPS Code.2 Now that the ISPS Code is effective, port facilities located in countries that are party to SOLAS and vessels subject to SOLAS Chapter XI-2 must operate in accordance with their individual PSP or SSP and otherwise comply with the applicable regulations implementing the ISPS Code.

Failure by a port facility or a vessel to comply with the new security requirements could cause delay or even non-performance of commercial transactions involving marine transportation. In response, parties to contracts of sale and purchase involving marine transportation are beginning to insert into their agreements clauses that allocate this risk of non-compliance and the expense associated with potential delays or non-performance resulting from non-compliance with the security regulations.

The purpose of this article is to suggest how these risks and expenses should be allocated between the parties to a contract for the purchase and sale of goods involving marine transportation. This article will also suggest the kinds of clauses that might be inserted into the contract to accomplish this risk/expense allocation.

To allocate the risk and expense of delay or non-performance resulting from non-compliance with security regulations, the contract terms should do the following:

• Identify the party responsible for compliance with the security regulations applicable to the load port facility, the vessel, and the discharge port facility.

• Require that the responsible party produce evidence of compliance as early as possible.

• Obtain from the responsible party a warranty of compliance with the security regulations.

• Provide indemnification for costs, expenses, penalties, fines, etc. arising out of or resulting from breach of the security warranty or covenants (consequential damages should likely be excluded).

• Possibly provide liquidated damages payable by the non-performing party in the event the contract is rescinded for breach of the security warranty or covenants.

Non-compliance with the security regulations at the load port facility, on the vessel, at any interim port facility, and/or at the discharge port facility can cause delay or even prevent performance of the contract. How this risk of non-compliance will (or should) be allocated between the buyer and the seller will likely depend on the applicable terms of sale. Following is a discussion of how the risks might be allocated with respect to three general terms of sale: FOB, CFR and DDU.

FOB Contracts

Under an FOB contract, the buyer must arrange and pay for the vessel. The seller is deemed to have delivered the goods when they pass the ship's rail at the named port of shipment, and payment for the goods is often made at that time. Because in most cases, the seller will nominate the load port and the buyer will nominate the vessel and determine the port of discharge, it follows that the seller should assume the risk of non-compliance with security regulations at the load port and the buyer should assume that risk with respect to the vessel and the port of discharge.

The risk of non-compliance can be allocated through the use of contract warranties and indemnification. Therefore, in an FOB contract, the seller should warrant that the load port facility is compliant, and the buyer should warrant that it will tender a compliant vessel for loading. Compliance by the vessel is important to the seller because a non-compliant vessel may be prohibited from calling the loading port, resulting in an inability of the buyer to perform. The contract should be clear that such an inability by the vessel to call the loading port is not a force majeure event, but is a breach of the contract by buyer for which seller is entitled to damages.

The contract should also require that each party produce evidence of compliance with the security requirements for which it is responsible. In other words, the seller should be required to produce evidence that the load port facility is compliant and the buyer that the vessel is compliant. Evidence of load port facility compliance may include a Statement of Compliance of a Port Facility, a FSP approval letter from the government agency with jurisdiction over the port facility (the U.S. Coast Guard for ports/facilities in the United States), or confirmation from the International Maritime Organization ("IMO") website. Vessel compliance is easily demonstrated by a copy of the vessel's International Ship Security Certificate ("ISSC"). The buyer should have obtained a copy of the ISSC from the vessel owner as part of its vetting procedure prior to chartering the vessel.

In an FOB contract, the buyer should obtain evidence that the load port facility is compliant as soon as possible; preferably, before the contract is signed. A buyer that is very active in a number of different ports around the world can begin to assemble a list of compliant ports, thereby reducing the need to confirm compliance in every future case (although, of course, seller's representation of compliance should remain in the contract). The buyer should avoid chartering a vessel prior to obtaining evidence that the named load port facility is compliant, as there will likely be costs associated with terminating the charter if it is later determined that the vessel cannot call the port because the port facility does not comply with the ISPS Code. Both seller and buyer should agree to indemnify the other for direct costs, penalties, fines, etc. resulting from a breach of its security warranty and covenants. In the case of an FOB contract, it seems that buyer is most at risk as non-compliance of the load port facility might be discovered after the vessel has been chartered or after the cargo has been loaded. In that case, the vessel will almost certainly be delayed, and may be refused entry, to the discharge port assuming that it is located in a country that applies the ISPS Code. The seller's risk is that a non-compliant vessel is refused entry to the load port and is therefore unable to load.

If seller or buyer fails to perform due to a breach of its security representations, the other party might be given a right to rescind the contract and, without prejudice to its right to seek indemnification for costs, etc. arising out of the other party's failure to perform, might be entitled to liquidated damages equal to a portion of the contract purchase price (e.g., 5%).

CFR Contracts

Under a CFR contract, the seller (rather than the buyer) arranges and pays for the marine transportation of the goods to the named port of destination. Like an FOB contract, however, the goods are considered delivered by the seller when they pass the ship's rail at the port of loading. Under the CFR term of sale, the seller must clear the goods for export, but generally is not responsible for clearance of the goods for import.

In this case, the seller should warrant that the load port facility is compliant and that it will provide a compliant vessel. The buyer should warrant that the discharge port facility is compliant. Again, both seller and buyer should be required to provide, in a timely manner, evidence that their respective warranties are accurate. Proof of discharge port facility compliance can take the same form as evidence of load port facility compliance. Each party should agree to indemnify the other for direct costs, penalties, fines, etc. resulting from a breach of its security warranty or covenants.

The buyer has significant exposure under a CFR contract, as the purchase price is often paid at the time the goods are delivered (i.e., when they pass the ship's rail at the port of loading). It is therefore possible that non-compliance of the load port facility or vessel will not discovered until the vessel attempts to call the port of discharge. At that point, the goods are owned by the buyer and the purchase price has been paid. It is therefore important that the buyer obtain evidence of compliance prior to delivery of the cargo and payment of the purchase price. If payment is made by documentary letter of credit, evidence of load port facility and vessel compliance may be included among the documents required to obtain payment under the letter of credit. If credit terms are offered (and assuming the purchase price is not payable until after the cargo would have been discharged), the buyer may be given the right to set off against the purchase price any amounts owing from seller to buyer under the indemnification clause for seller's breach of its security warranty or covenants. That way, if there is a delay in discharging the goods resulting in expense to the buyer, or the goods cannot be discharged due to non-compliance of the load port facility or vessel, the buyer will have a right to set-off its expenses and losses against the purchase price payable to the seller.3 The seller would also be wise to obtain evidence that the discharge facility is compliant prior to loading the cargo on the vessel. It is possible that the vessel may refuse to call a non-compliant port, or may require indemnification from the charterer (in this case, the seller) for fines, losses, etc. resulting from calling a non-compliant port. Any delay or inability to unload the cargo at the discharge port will likely result in a demurrage claim by the vessel or additional freight to discharge the goods at another port. Because the vessel is chartered by the seller, the carrier will look first to the seller for payment of these additional charges.

DDU Contracts

Under a DDU contract, the seller again arranges and pays for the vessel (as under the CFR term). However, the good are not deemed delivered until they are placed at the buyer's disposal (not unloaded) at a named place of destination. The seller is usually not required to clear the goods for import.

In this case, the seller is again clearly responsible for security compliance by the load port facility and vessel. Whether seller or buyer should be responsible for compliance by the discharge port facility will likely depend on which party nominated the discharge port facility. If the buyer has directed the seller to deliver the goods to a discharge port facility selected by the buyer, it seems reasonable to impose upon the buyer the risk that its nominated discharge port facility is non-compliant. If the seller nominates the discharge port facility, then it seems fair that the seller should assume that risk. Evidence of compliance with respect to the load port facility, vessel and discharge port facility can be given in the forms discussed above with each party agreeing to indemnify the other for direct costs, penalties, fines, etc. resulting from a breach of its security warranty and covenants. In comparison to the CFR term of sale, the buyer's risk of security non-compliance under a DDU contract is less, as non-compliance will likely be known before the goods are deemed delivered and the buyer has paid the purchase price. From the seller's perspective, if the buyer is responsible for security compliance by the discharge port facility, seller will have the same risks and exposures that it has under a CFR contract as discussed above. As with the FOB term, if the seller or the buyer is in breach of its security warranty or covenants, the other party might be given a right to rescind the contract and, without prejudice to its right to seek indemnification for costs, etc. arising out of the other party's failure to perform, might be entitled to liquidated damages equal to a portion of the purchase price (e.g., 5%).

Brett M. Esber, currently a partner at Blank Rome LLP, practices in the areas of international and domestic commercial transactions, corporate law and finance. As a member of the firm's Marine Transportation Group, Mr. Esber has specialized expertise and experience handling commercial transactions for companies involved in the shipping industry, such as shipowners and operators, and companies utilizing the shipping industry. He can be contacted at esber@BlankRome.com.

1In the United States, the provisions of the ISPS Code are codified by the Maritime Transportation Security Act of 2002 and its implementing regulations. 2In the United States, the Coast Guard regulations implementing MTSA require that every facility adjacent to navigable waters have a facility security plan ("FSP"). The U.S. equivalent of the ISPS Code's PSP is the Area Maritime Security Transportation Plan, which typically covers more than one port. The ISPS Code has no equivalent to the U.S. FSP. 3In the United States, the USCG will likely delay the discharge of a compliant vessel if the cargo was loaded at a non-compliant foreign port or facility.

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