Client Question:

Which Incoterms Rules work best with a letter of credit (L/C)?

Answer:

There is no connection between any form of commercial term and the letter of credit, but you might need to find one.

The Incoterms Rules may be used by sellers and buyers in an endeavour to privately regulate certain aspects of their international sales contract.

Documentary Credits (L/Cs in this example) are used by issuing banks and beneficiaries to do the same to their separate and unconnected international sales contract.

The seller and buyer are generally transacting with physical goods, whereas the beneficiary and issuing bank are transacting with documents. The issuing bank is not a party to the sales contract just as the seller, buyer and applicant are not parties to the L/C.

B1 of each Incoterms Rule establishes the buyer’s obligation to make payment but it does not confirm how or when payment will be made. This detail is found by referencing the terms and conditions of the sales agreement.

It is the sales contract which embodies the seller’s right to be paid: an L/C (or any bank instrument) is just one of several possible mechanisms that the parties may use to satisfy the buyer’s payment obligation.

The short answer to the initial question then is that as there is no connexion between the sales contract and the L/C contract, so there’s no connexion between the Incoterms Rules and L/Cs. But, as I mentioned in opening, there might remain a commercial need to find a connection for practical purposes.

Simplistically, the L/C is designed to accommodate trade’s use of transferable bills of lading (consigned ‘to order’) as representations of contractual delivery. These documents are tradable of themselves and are common in c.i.f. contracts. Without this ideal combination of a c.i.f. sale using the ‘to order’ bill of lading, the L/C is less effective.

For example, if the merchants transacted on an Incoterms Rules FCA basis via airfreight, using a master airwaybill as the trigger document for the L/C, then the parties would first need to accept that the L/C was not built with this combination in mind.

Therefore, in this model one of the parties will need to contemplate much higher risks than FCA or the L/C would generally and separately have created. This comes about from combining a ‘handover’ sales term (FCA) with an L/C requiring a ‘shipment’ document (the master airwaybill).

Although the L/C calling for that specific transport document may be at odds with an FCA model, such a combination cannot be said to be wrong; it is simply a high-risk combination for one of the parties. That party (in this case the seller/beneficiary) would need to contemplate if this mismatch appeals to their risk-appetite, or not.

As the seller/beneficiary: if the credit is triggered by documents which evidence shipment or the taking in charge of the goods by a carrier, then focus on those contracts where you (as shipper) have full control over such documents, and where your contractual intention was to sell documents rather than goods i.e., C-prefixed contracts where, as shipper, you will pay the freight and appoint the carrier.

The Incoterms Rule CPT would generate a handover document (evidencing that the goods have been taken in charge by the first carrier) whereas CFR would generate a transferable bill of lading (consigned to order), issued by a shipping line (or their agents) and evidencing the later event of shipment.

Of the Two, the multimodal CPT Rule is preferable as the beneficiary may present documentation much earlier than under CFR, and in so doing avoid any pre-carriage risks.

CIP and CIF are respectively the same except they add marine cover (against the buyer’s risks) to the seller’s obligations and costs.

But regardless of the specifics, in each of these models, the seller’s obligations are documentary. However, do not forget that the L/C is only a conditional guarantee of payment: nothing beats money in the bank up-front, compared to which the L/C is a very, very poor substitute.

As the buyer/applicant: if the L/C is triggered by documents which evidence shipment or the taking in charge of the goods by a carrier, focus on those contracts where you have full control over such documents i.e., F-prefixed contracts where, as buyer, you pay the freight and appoint the carrier.

The multimodal Incoterms Rule FCA would generate a handover document (evidencing that the goods have been taken in charge by your carrier) whereas the Rule FOB might generate a bill of lading (or any seafreight equivalent) evidencing shipment.

It is in the buyer’s interest to mismatch these documents and terms, and to procure on FCA terms but call for transport documents, such as bills of lading or airwaybills under the L/C.

As discussed above when looking at the seller/beneficiary’s position, this mismatch works for the buyer because it does not work for the seller. It places a risk on the seller (that shipment happens) that the buyer therefore avoids. It is a clever misalignment of conditions, reducing the buyer’s risk at the expense of increasing the seller’s.

As the buyer/applicant, try not to move out of the range of F-prefixed terms, but note that the L/C – however worded – is never fully in the buyer’s favour, and at best the applicant is only securing compliant documents not compliant cargo, which is always the buyer’s greater concern. No document guarantees the existence of the underlying goods.

All in all, we end as we began: there is no connection between Incoterms and L/C’s, but you may need to find one.

For the seller, the gold medal is a C-prefixed sales term (preferably CPT/CIP) combined with a credit calling for handover documents.

For the buyer, the gold medal is an F-prefixed sales term (preferably FCA) combined with a credit calling for the primary international transport document.

When and if you do make these connections they will serve the needs of the seller or the needs of the buyer – never both, and always at the expense of the other.

Source: Freight Training