Trade Finance Contrats and terms

TRADE FINANCE CONTRACTS AND INCOTERMS

International Commercial Terms (Incoterms) were first instituted by the International Chamber of Commerce (ICC) in the year 1936 in Paris, France. As a direct result of the proliferation of international trade preceding WWII, the ICC discerned the need to promulgate a standardized set of shipping (international trade) terminology that could be recognised and accepted by both buyers and sellers in different jurisdictions. The then principally European members of the Chamber jointly birthed the Incoterms, that were later revised to the ICC’s 2010 reference guide of Incoterms and more recently to the ICC Guide to Incoterms 2020. Since their establishment, the Incoterms have become the universal language referenced by international trade participants whether they are filling out a purchase order, completing a certificate of origin and packaging and labelling a shipment. Incoterms ensure that participants have mutual understanding and help parties not to make costly errors in formulating and settling international trade contracts and the subsequent shipments of goods. Appropriate use of Incoterms in formulating an international sales contract also assists in providing unambiguous clarity to transacting parties, establishes cost certainty, and alleviates the probability of arguments and fall-outs with either clients or suppliers.?As a consequence of utilizing the wrong Incoterms or using the terms without proper comprehension of the implications of the choice can culminate in unbudgeted costs, unnecessary delays and disgruntled clients.

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VARIOUS TYPES OF INCOTERMS

The most recent version of Incoterms, Incoterms 2020 consists of eleven terms that are divided into four broad categories derived from the first letter of each term. The four broad categories are ex works (departure) represented by the letter E, main carriage unpaid depicted by the letter F (e.g FAS), main carriage paid represented by the letter C (e.g COF) and arrival represented by the letter D (e.g DAP). The categories of Incoterms are determined by the delivery destination and are also a function of whose responsibility it is to cover costs of each section of the journey. The groups of terms are then further divided into sub-categories that are based on different scenarios.

Group E of Incoterms largely lay the responsibility transaction on the buyer. The duty of the seller is only to ensure that the goods destines for export are located at the seller’s premise or another agreed address where from the buyer loads and plans to clear the goods before export. In group of F of Incoterms, the seller bears the responsibility to deliver the goods to the buyer’s agreed mode of transportation. Thereon, the buyer then assumes all risks as well as costs. The sub-groups under group F on Incoterms include;

?§?Free Carrier (FCA) – under FCA, the seller will avail the goods to the transporter or buyer’s recommended person at the seller’s premises or at an agreed location. After the goods have been received by the transporter or nominated person, all risks then migrate from the seller to the buyer.

§?Free Alongside Ship (FAS) – under this sub-incoterm, the seller is required to deliver the export goods to the buyer’s selected carrier a time upon which risks are transferred to the buyer and must be specified.

§?Free on Board (FOB) – This sub-incoterm entails that the seller delivers the export goods on-board of the buyer’s carrier of choice at agreed port. All risks and costs of damage or loss are transferred when the goods are onboarded onto the carrier. FOB and FAS are incoterms related to the shipment of goods via water channels.

The third category of incoterms is group C. Under this group, it is the seller’s responsibility to bear all costs up to the selected destination port. The moment the goods are on-boarded onto the buyer’s carrier of choice, all risks migrate to the buyer of the goods. Sub-categories under group C incoterms include;

§?Cost and Freight (CFR) – cost and freight incoterm is very similar to Free on Board, with the only difference being that the seller carries an additional responsibility to settle costs of delivery of the export goods to the buyer’s selected destination.

§?Cost, Insurance and Freight (CIF) – Cif, gives the seller an additional duty to insure the buyer against the risk of damage or loss. CIF and CFR are also terms related to the shipment of goods via waterways.

§?Carriage Paid To (CPT) – under CPT, the seller’s only responsibility is to deliver the goods to a stated destination without having to insure them.

§?Carriage and Insurance Paid To (CIP) – CIPis similar to CPT, with the only difference being that the seller has to insure the goods.

Incoterms in group D refer to the destination of goods and includes the following sub-categories;

§?Delivered at Terminal (DAT) – refers to when the seller is obliged to deliver the subject transaction goods to an agreed destination, and once the goods have been safely delivered, the seller is absolved of responsibility over the goods. Under this incoterm, the seller is tasked with full responsibility for the subject goods up and until when the goods are delivered to the agreed destination.

§?Delivered at Place (DAP) – This is the second incoterm in class D, which describes a situation when the seller is given the responsibility to deliver the export goods in a state that is ready for unloading at the nominated place of destination. The seller thus has full responsibility over the export goods up and until they are delivered to the agreed place of destination.

§?Delivered Duty Paid (DDP) - The seller under this incoterm is responsible for all the costs and the risks that relate to the delivery of the export goods to the buyer's designated destination. The responsibility also covers costs of clearing goods for export and import, ensuring the payment of any duty and lastly executing any necessary customs formalities. The below diagram shows all the incoterms and stages for the transfer of risk between the buyer and the seller;

INCOTERMS 2020 VS INCOTERMS 2010

The International Chamber of Commerce (ICC) ensures that incoterms and rules are?reviewed?and updated regularly that is every ten?years with the previous incoterms’ edition having been published in 2010. By reviewing the incoterms and rules constantly, ICC makes sure it responds?to various concerns put forward by?users of Incoterms?and to the dynamic changes prevailing in the global market to keep the terms abreast and relevant?and suitable to both local and global trade. The primary changes?effected in the latest edition of the?ICC’s?Incoterms 2020?aim to address, amongst other issues,?revised?security requirements on parties, enhanced clarity on?the allocation of cost along with tackling?insurance concerns by parties.?

One common question that is often raised by trade finance professionals is whether trade contracts that refer to previously issued versions of incoterm rules will still be valid.?The simple answer is that each contract will continue to be governed by the version of incoterms rules that were prevailing when the parties entered into the contract. Similarly, if the subject contract only referred to incoterms’ rules but with no reference to a specific year, then the incoterms rules version subsisting at the time of contracting will therefore be applied in settling any eventual disputes. Best practice however is to always refer to the latest version of incoterms rules.

Summary of the changes

The first major change from the 2010 incoterms rules refers to the Bills of lading. Under the revised 2020 incoterms rules, FOB (free on board) term should not under normal circumstances be utilised for container shipments. This is primarily because the seller/ exporter usually does not have control of the cargo or container once the goods arrive at the designated port of export or destination of export prior to the container being loaded. However, FOB will mean that the seller or exporter assumes responsibility for all the risks and costs of the export transaction, port terminal handling and loading costs and or risks. Sellers are therefore advised to adopt FCA (Free Carrier). Despite this change, several sellers and exporters continue to use FOB largely because the letters of credit from most financial institutions often require that the seller provide an onboard bill of lading in order for the seller to receive payment. Since the seller under FOB is directly responsible for loading of goods, they usually have a higher probability of gaining access to an onboard bill of lading. In an effort to encourage users to adopt FCA, the ICC has changed FCA to incorporate the possibility for the buyer along with the seller to mutually agree that the seller will be allowed to get an onboard bill of lading.

A second revision to the 2010 incoterms rules is the one regarding insurance under CIF (carriage insurance and freight) CIF and (carriage and insurance paid to) CIP. The incoterms rule of CIP entails that the seller or exporter is only liable for delivery of the export goods to the nominated carrier but ensures payment of the transportation and insurance of export goods to the agreed destination. CIF follows a similar line of thought, with the exception being that it can only be utilised for waterway or maritime transport. In the incoterms 2020 version, CIF maintains the same requirements for insurance as was the case with incoterms rules 2010. On CIP incoterms rules 2020 has enhanced the level and degree of the requisite insurance to be provided by the seller. This is primarily because CIF is most commonly used along with large quantity commodity trades. Moreover, CIP is most commonly used for transportation of manufactured goods, since manufactured goods usually tend to require enhanced degrees of insurance. Even though CIP and CIF oblige the seller to provide insurance, ICC generally recommends that trade finance parties consider if any additional insurance cover is necessary to mirror the potential and magnitude of risk of damage to the export goods during transit.

Thirdly, incoterms rule (delivered at terminal) DAT in the incoterms rules 2010 was revamped to (delivered at place unloaded) DPU. Under the incoterms rules 2010, DAT meant that the goods were considered delivered once they were unloaded at the nominated destination. Since DAT limited the location of delivery of the goods to a terminal, in the current incoterms rules 2020, the reference to a particular destination was removed to ensure the rules are more general. Delivered at place unloaded (which is a rule that can now be utilised for various modes of transportation).

Lastly, there were also changes made to the security requirements in incoterms. In recent developments, export goods transportation security requirements have increasingly become more pertinent in international trade transactions, and as such, the incoterms 2020 reflect this change by elaborating on the security requirements for each and every incoterms rule. For instance, (carriage paid to) CPT now includes a specific responsibility that requires the seller to comply with any and every security-related requirement for transportation of goods to the agreed destination. These security-related requirements often bring on more costs and risks as well as delays if not they are not fulfilled by the parties.

ECONOMIC IMPACT OF INCOTERMS

Often times, because international trade practitioners have familiarity with incoterms rules, they end up?taking the readily available option of following obtaining standard industry practices or will simply stick to the incoterms utilised in a previous export sales transaction with either the same customer or a customer in the same industry.?Although this approach may work, there are a number of positive reasons why manufactures including those in the small to medium enterprises (SME) sector, should meticulously evaluate their available choices of incoterms rules in any upcoming trade contracts

One such benefit of deliberately selecting particular incoterms rules?is the possible opportunity to access more?favourable and expedient?trade finance products.?Invoice Discounting?is one of the increasingly prominent product of trade finance which involves the funding of an invoice which becomes a subsequently tradeable asset with realisable tangible value thereby allowing the manufacturer to gain access to working capital finance to fund the production and also shipping of export goods whose payment would otherwise have only been received from the customer some 30-90 days later.?However, it is critical to note that an invoice will only be financed by financial institutions after a certain point where transfer of responsibility and risk for the export goods transpires between the seller or exporter and the buyer or importer.?Thus,?if the exporter wishes to?maximise?the possible length or tenure of funding, it becomes fundamental for him or her to select a particular set of incoterms rules?that expedite the bringing forward of the transfer of ownership and risk to the importer to a period that is as early as possible.??

Incoterms and rules closing remarks

As conclusion, it is critical to reiterate that?the effective and efficient completion of a trade transaction is not solely a function of the available choices of the most expedient and appropriate incoterms, but it?also relies on the meticulous drafting of trade contracts that satisfy the contractual needs of both the buyer/ importer and seller/ exporter equally.?Practitioners thus need to keep abreast with both revisions in incoterms and rules as well as international trade best practices.