The Importance of Incoterms For International Contracts

In the last decades, for many companies, a strategic necessity results within the scope of globalization to use broader access to new markets and to take part in international business. Most pursued goals are market protection, cost minimization, capacity utilization and maximization of profit. Hence, world trade gains importance, and those goods are traded in larger numbers and diversities on international markets.

In addition, International Trade language is one of the most important and complex instruments. Even a small variation in wording can have a major impact on aspects of a business agreement, as in any business that is complex and sophisticated. From industry to industry word definitions often vary, especially concerning global trade. Such essential expressions as “delivery” can have a far different meaning in business than in the rest of the world. For business terms, to be efficient, expressions must mean the same thing. Often the contracting parties are not aware of different commercial customs in their respective countries. Misunderstandings, conflicts as well as litigations and the involved effort of time and costs are resulting from that. Therefore the ICC published the Incoterms. [1]

This paper deals with the various Incoterms, their meaning and their importance for an international sales contract.

1.1 What are Incoterms?

Incoterms (International Commercial Terms) are international rules set up 1936 by the ICC (International Chamber of Commerce) in Paris [2] for the definition of specified trading conditions in foreign trade regulating the essential seller’s and buyer’s duties. Thus, the parties reach an international standard interpretation of certain duties of the buyer and seller to avoid uncertainties and legal disputes. [3] Incoterms are planned for tangible goods, but despite this fact they can be agreed for services, licenses or software within the scope of the freedom of contract. [4]

They are internationally accepted as well as by the prevailing national court. But as they do not have any law status they have to be included in the contract explicitly to ensure validity. Also in the USA, the Incoterms find increasingly use as they had set many years on own rules (American Foreign Trade Definitions). [5]

Incoterms do not say anything about the transfer of ownership, the breach of contract and its consequences and exclusions of liability under certain circumstances. In this case, it depends on the governing law. [6] They rather affect essentially the following three points:

The point of transfer of costs

The point of transfer of risks

Business processing duties

Therefore they regulate who gets the documents of the goods and who pays possible customs costs; who is responsible for transport documents and their costs; who insures checks and packs the goods. [7]

Incoterms are only relevant for a sales contract, not for contracts of carriage, insurance contracts and financing treaties, which are important for carrying out an international commercial transaction for importers and exporters. Nevertheless the agreement between parties to use a certain Incoterms clause has also an effect on other contracts, for example a seller who has agreed on a CFR or CIF contract, is forced to choose no other transport than sea transportation as he has to present a bill of lading or another maritime bill of freight to the seller. Therefore other transportation methods are completely impossible. Furthermore in accordance with the documentary letter of credit, the required document depends on the planned mode of transportation. [8]

Pursuant to article 346 German Commercial Code [9] (HGB) the interpretation of Incoterms takes place first and foremost on the intention of the parties and secondarily on their objective purpose. The interpretation does not depend on the, if necessary, chosen national law but on international standard. Reference to Incoterms does not mean therewith that arbitration agrees with ICC Paris. [10] The ICC recommends the following standard clause:

“All disputes arising out of or in connection with the present contract shall be finally settled under the Rules of Arbitration of the International Chamber of Commerce by one or more arbitrators appointed in accordance with the said Rules.” [11]

Same obligations (since 1990) with identical phrases facilitate a standard interpretation. If possible, the same expressions have been used as in the UN sales law. [12] Flexible law applies as far as not contracted out validly through the Incoterms. All questions which are not stipulated in the Incoterms (for example conclusion of contract, defective performances [13] , settlement [14] and primarily transfer of ownership) are governed by the applying domestic laws to the contract. The Incoterms are not valid by law and as an exception as custom in terms of art. 346 German Commercial Code but only as far as the contracting parties refer to them in the sales contract. [15] The Incoterms are only valid when explicitly agreed between seller and buyer. Thus, they are not automatically valid. Moreover in the naming of, it is also important to mention the year of publication and place, for instance „FOB Bremen INCOTERMS 2000“. [16] However, it is still possible to refer to an older version of the Incoterms by contract but it has to be agreed ambiguously, like “EXW Incoterms 1990″. When there is no reference to a particular version of the Incoterms, in case of doubt one should refer to at the time of the conclusion of the contract relevant Incoterms. [17]

“By which law is the contract governed?” this question arises when making a contract between persons or companies located in different countries. For the purpose of determining the applicable law several regulations apply (as to formalities, capacity, etc.). The contract is governed by the applicable law of the contract concerning important validity, performance and interpretation. The parties may pick the law applicable to their contract. When there is no agreement, the applicable law is the law with which the contract has the closest connection. It is presumed that the contract has the closest connection with the country where the party who is to provide the contract’s characteristic performance has its habitual residence. That means a sales contract is governed by the law of the country where the seller is situated. (Art. 28 (2) EGBGB [18] (German Code on the Conflict of Laws) and also Art. 4 EEC [19] Rome convention on private international law).

When choosing German law for the contracting business obligatory norms of the German civil and commercial law, as well as individual agreements between the parties have priority over the Incoterms (§ 305 b BGB [20] ). Binding law has always priority. Dispositive law is used as far as not contracted out validly. [21] Furthermore despite the regulation of the international standard interpretation the Incoterms are judged by the German Unfair Contract of Terms Act (AGB-Gesetz) [22] , which has been recently integrated in the German Civil Code. International trade terms are not fully exempt from the operation of the Unfair Contract Terms regulations. Notably § 307 German Civil Code [23] applies.

1.2 How to choose the right Incoterm

There are several issues one should be aware of when choosing an Incoterm:

The regulations of the buyer’s country:

There are regulations in certain countries saying which terms must be used when goods are brought into the country. The main reason for this is that they want to gain advantage from the import rather than the export industry with the want for local shipping and insurance markets.

Standard practice:

Some countries do not have regulations saying which terms must be used. When a party offers less favorable terms (for example FOB rather than DDP) one could miss out on the business. For example it is standard practice for goods to be sold on a “delivered” basis.

The used transport method:

Some Incoterms are just for maritime and inland waterway transport (see chapter 2.2 “The choice of terms in dependence on modes of transportation”).

Availability of information:

The seller and the buyer should be able to meet their obligations under the chosen term because there may be occasions when a party is not able to clear the goods for import or to get an import license (then the DDP term cannot be used).

Customer service :

One should use a competitive term which is suitable for buyer and seller and not only important for one party to get maybe an advantage from that. [24]

When choosing an Incoterm clause, one has to be especially aware of matching the content of the clause in detail with the content of contract incidentally. [25] Furthermore the choice of certain Incoterms (although without validity for third party) has repercussions on the matching freight arrangements, letter of credit arrangements and insurance arrangements.

2.Structure of Incoterms

Due to clarity reasons, the 13 Incoterms are divided into four different groups beginning with the initial letter of the prevailing Incoterm. Legally not every group corresponds to one business type. In different groups one can find rather acceptance deals [26] (e.g. ex works (EXW), ex ship, ex quay), shipment contracts (e.g. FAS, FOB, CFR, CIF, carriage paid [27] ), arrival contracts (e.g. delivered ex ship (DES), delivered ex quay (DEQ), delivery duty unpaid (DDU), delivery duty paid (DDP)).

2.1 Terms

Group E: Departure

Ex works (EXW) is the only clause in this group.

The seller provides the goods to the buyer at the seller’s own premises.

Group F: Main carriage unpaid by seller

These three clauses affect the main carriage which is not paid by the seller but he delivers either free to the carrier only (FCA), free to the long side of the ship (FAS) or free on board of the ship (FOB), every time to the named place or rather the port of dispatch. F-Terms are shipment contracts. [28]

Group C: Main carriage paid by seller

The four C-clauses also affect the main carriage but only when paid by the seller. Either the seller pays only cost and freight (CFR) or cost, insurance and freight (CIF); both to the port of destination. With the clause “carriage paid to” (CPT) the seller even pays transportation to the point of destination. The clause “carriage and insurance paid to” (CIP) is the same as CPT but insurance is included. The passing of risk and cost of every C-term fall apart (“two-point clause” [29] ). C-clauses are also, like the F-clauses, shipment contracts because the seller fulfills his contractual obligations in the country of dispatch.

The seller must contract for the carriage of the goods without assuming risk of loss of, or damage to the goods or additional costs due to events occurring after shipment.

Group D: Arrival

All five clauses in this group are terms of arrival: delivered at frontier to the named place (DAF), delivered ex ship (DES), delivered ex quay (duty paid) (DEQ) to the named port of destination; delivered duty unpaid (DDU) or delivery duty paid (DDP) to the named place. The seller is not obliged to clear the goods for export in the country of destination except for DDP.

The seller bears all costs and risk. [30]

One differentiates between “one-point clause” and “two-point clause“. “one-point clause” means that the costs of transportation and the passing of risk take place in the country of distribution (E-, F- and D-Terms are “one-point clauses”). The C-Terms are “two-point clauses” as there are two critical points. The passing of risk take place in the country of distribution when handing over the goods to the carrier, nonetheless the passing of the costs take place in the country of destination when the goods arrive. [31]

2.2 The choice of terms in dependence on modes of transportation

Not every Incoterm is suitable for any way of transportation.

Any mode of transport

Group E

EXW

Ex Works (…named place)

Group F

FCA

Free Carrier (…named place)

Group C

CPT

CIP

Carriage Paid To (…named port of destination)

Carriage and Insurance Paid To (…named port of destination)

Group D

DAF

DDU

DDP

Delivered At Frontier (…named place)

Delivered Duty Unpaid (…named port of destination)

Delivered Duty Paid (…named port of destination)

Maritime and inland waterway transport

Group F

FAS

FOB

Free Alongside Ship (…named port of shipment)

Free On Board (…named port of shipment)

Group C

CFR

CIF

Cost and Freight (…named port of destination)

Cost, Insurance and Freight (…named port of destination)

Group D

DES

DEQ

Delivered Ex Ship (…named port of destination)

Delivered Ex Quay (…named port of destination) [32]

3. Incoterms in detail

There are ten obligations for seller and buyer that are corresponding to each other:

A

THE SELLER’S OBLIGATIONS

B

THE BUYER’S OBLIGATIONS

A 1

Provision of goods in conformity with the contract

B 1

Payment of the price

A 2

Licences, authorizations and formalities

B 2

Licences, authorizations and formalities

A 3

Contracts of carriage and insurance

B 3

Contracts of carriage and insurance

A 4

Delivery

B 4

Taking delivery

A 5

Transfer of risks

B 5

Transfer of risks

A 6

Division of costs

B6

Division of costs

A 7

Notice to buyer

B7

Notice to seller

A 8

Proof of delivery, transport document or equivalent electronic message

B 8

Proof of delivery, transport document or equivalent electronic message

A 9

Checking – packaging – marking

B 9

Inspection of goods

A 10

Other obligations

B 10

Other obligations

fig. 2: seller’s and buyer’s obligations; source: Ramberg, ICC Guide to Incoterms 2000, p. 70 et sqq.

When there is no obligation for the buyer or seller, after all there can result an obligation from applicable law or an individual agreement. [33]

3.1 EXW: Ex works (…named place) [34]

The seller is obliged to provide the goods at his premises (factory, works, and warehouse). In this term the seller has the smallest amount of obligation. Hence the buyer bears all costs and risks (i.e. shipping, insurance, export, loss, damage). Loading of goods is not an obligation for the seller. Are the goods to be loaded by the buyer, the FCA-term has to be used instead. [35]

3.1.1 Example for the obligations for the seller and buyer with the EXW-term

The seller’s obligation:

Provision of goods in conformity with the contract: The goods and commercial invoice must be made available by the seller correspondingly to the sales contract.

Licences, authorizations and formalities: When requested, the seller must give the buyer full assistance in getting any export license or other official authorization required for the export of the goods.

Contracts of carriage and insurance: No obligation

Delivery: The seller is obliged to provide the goods at the buyer’s disposal.

Transfer of risks: The seller must bear all risks of damage and loss.

Division of costs: The seller must pay all costs concerning the goods.

Notice to the buyer: The seller must inform the buyer where and when the goods will be provided at his disposal. The risk of a delayed or even no notice bears the seller. [36]

Proof of delivery, transport document or equivalent electronic message: No obligation

Checking – packaging – marking: The seller must pay the costs relating checking procedures (such as quality check, weighing, measuring, and counting) which are required for the purpose of providing the goods at the buyer’s disposal. Also costs concerning packaging must be provided by the seller.

Other obligations: The seller must give the buyer assistance in getting any documents the buyer may need for the import or export of the goods.

The buyer’s obligation:

Payment of the price:

The buyer must pay the amount included in the contract.

Licences, authorizations and formalities:

Any import or export licence or other official authorization must be obtained by the buyer at his own costs and risk. If necessary, he also has to perform all customs formalities for the transport through another country.

Contract of carriage and insurance: No obligation

Taking delivery: The buyer must accept delivery of the goods in accordance with the chapter “delivery obligation” of the seller, “notice to the seller” and “notice to the buyer”.

Transfer of risks: From the time the goods have been delivered, the buyer must bear all risks of damage and loss.

Division of costs:

The buyer must pay all costs concerning the goods from the time they have been delivered and also any additional costs by failing to take delivery when they have been placed at his disposal

Notice to the seller: The buyer must give the seller an adequate notice when he has decided the place of delivery and the time.

Proof of delivery, transport document or equivalent electronic message: The buyer must present the seller an appropriate proof of having taken delivery.

Inspection of goods: The buyer must pay any pre-shipment inspection costs.

Other obligations: The buyer must pay all costs and charges incurred in getting the necessary documents. [37]

There are some obligations which will not change no matter what terms are used. “Provision of goods in conformity with the contract” (A 1) and “Payment of the price” (B 1) always remain unchanged.

The advantage that the seller has in this clause is that he/she has the lowest costs and smallest amount of liability. The advantage for the buyer is that he has full control over the cost for the transport.

3. 2 FCA: Free carrier (…named place) [38]

The seller delivers the goods, cleared for export, to the carrier appointed by the buyer at the named place. At that point of time the seller has fulfilled his delivery obligation. If delivery takes place at the premises of the seller, he is responsible for loading. If delivery takes place at any other place he is not responsible for unloading. The seller must get any export license or other authorization at his own risk and costs and carry out and pay as well all customs formalities required for the export of the goods. In comparison the buyer must get any sort of import license or other authorization at his own jeopardy and costs. He also has to carry out all customs formalities required for the import of the goods. In addition, concerning the contract of carriage the buyer must assure the carriage of the goods from the named place at his own costs except when the contract of carriage is made by the seller (at the buyer’s risk and costs). [39]

A carrier is the person who is obliged to carry out, in a contract of carriage, the transport by road, rail, air, see, inland waterway or a combination of these ways of transport. If the buyer appoints another person than a carrier receiving the goods, the seller fulfills his obligation when delivering to that nominated person.

The advantage for the seller with the FCA term is that he has control over the goods for part of the transport, usually until the point of export. He also just has to pay for the domestic transport and arrange it. The advantage for the buyer is that he does not have to pay for the whole transport and can still pick the mode of transport to suit his needs. He also gets the control over the goods relatively early, at point of export in the seller’s country.

3. 3 FAS: Free alongside ship (…named port of shipment) [40]

The seller delivers when the goods are positioned alongside the vessel at the named port of dispatch. From this moment the buyer has to bear all costs and risks of loss or damage of the goods. The FAS-term obliges the seller to clear the goods for export. If the parties desire the buyer to clear the goods for export, this should be clearly indicated in the contract. The buyer must contract at his own costs for the carriage of the goods from the named port of shipment. [41]

3. 4 FOB: Free on board (…named port of shipment) [42]

The seller delivers when the goods cross the ship’s rail of the named port of dispatch. From this moment the buyer has to bear all costs and risks of loss or damage of the goods. The FOB-term obliges the seller to clear the goods for export. The FCA-term should be used when the parties are not going to deliver the goods across the ship’s rail. [43]

The advantage for the retailer with this term is that he has control of the goods until they leave the country. He only has to pay for the domestic transport and has to arrange it. The advantage of the purchaser is that he gets the control of the goods when they have been loaded onto the vessel. He also arranges sea transport with a carrier of his own choice.

3. 5 CFR: Cost and freight (…named port of destination) [44]

The seller delivers when the goods cross the ship’s rail of the named port of dispatch. He also bears the cost and freight which are necessary to transport the goods to the named port of destination. However, the risk of loss or damage of the goods, as well as additional costs that are attributed to events after delivery of the goods on board, passes from seller to buyer. The CPT term should be used when the parties do not intend to deliver the goods across the ship’s rail. The CFR term obliges the vendor to clear the goods for export. [45]

The advantage for the seller is that he can choose the carrier for export and has control over the goods until they reach the port of destination. His liability ends in the port of loading. The advantage of the seller is that he does not have to arrange or pay for the sea transport.

3. 5. 1 The importance of Incoterms – CFR example

As mentioned before, not every term is suitable for every method of transport. The following case shows how important it is to agree on a suitable term.

An exporter from Stuttgart sells glass tops to a customer in France on Incoterm basis. CFR Dijon. Due to geographical conditions the goods are packed in accordance to the regulations and shipped portage via train and truck. At the arrival of goods, more than half of the consignment are broken.

The buyer immediately applies to the supplier asking for replacement. The exporter replies that according to the CFR term, the buyer beard the risk of the damage as the risk taking passes to him. For the protection of that risk the buyer should have taken out transport insurance. The buyer refuses payment and the case litigates, as stipulated in the contract, to arbitration tribunal. The arbitration tribunal explains that according to the CFR terms. The risk taking passes to the buyer just when the goods had crossed the ship’s rail of the port of dispatch. However, as there is no ship involved and therefore no ship rail, the risk taking could not pass from seller to buyer. Although the seller wanted to achieve with the CFR term that the buyer should bear the risk of loss or damage during transportation, in result, he has to pay for the damage. [46]

3. 6 CIF: Cost, freight and insurance (…named port of destination) [47]

The CIF term correspond to the CFR term with the exception that the seller has to take out marine insurance against the buyer’s loss or damage of the goods for the duration of transport. This insurance with minimum margin requirements only exists with CIF and CIP terms and have to cover the purchase price plus 10%. So the buyer obtains insurance only on minimum cover. If the buyer should wish protection of a greater cover, he either has to make an agreement with the seller or to make his own additional insurance arrangements. The CIF term obliges the seller to clear the goods for export. The CIP term should be used when the parties do not intend to deliver the goods across the ship’s rail. [48]

The advantage for the seller is that he has control over the goods until they reach the port of destination. His liability ends in the port of loading and he has to pay only minimum marine insurance cover. The advantage for the buyer is that he does not have to arrange or pay for sea transportation as well as for marine insurance, unless he wants a greater cover.

4. Conclusion

In conclusion, Incoterms can make international trade easier but one should consider a number of issues when choosing an Incoterm. Incoterms should be used only for sales of goods and not for services. Another issue is the transport method used and one should consider which term is most suitable from a customer-service point of view.

One also has to be careful to consist of conditions and terms which are not defined by the Incoterms. If one party changes the usual Incoterm normally used by the seller or buyer, one should be aware of changes that will affect the costs like insurance. Therefore it is prudent for international trade partners to choose and negotiate with care the right Incoterm. As mentioned above, Incoterms offer parties an opportunity to clarify their roles by using internationally accepted contractual standards and thus reduce the possibility for cross-cultural misunderstandings, contractual ambiguity and disagreements.