How to align the letter of credit with the Incoterms rule
The letter of credit environment is by definition one of limited trust – sellers have concerns about getting paid, buyers want to be sure that the goods they ordered are supplied as per the contract, within the agreed timeframe etc.
A key principle of letter of credit usage is that all the documents called for should be ones that can be supplied by the seller (e.g. the commercial invoice) or whose issue is under the control of the seller – for example, the transport document, where the carrier takes instructions from the seller.
Why the “C” rules work best with letters of credit
Ideally, “delivery”, as defined by the agreed Incoterms rule, should be aligned with the presentation of compliant documents to the bank, because it is this event that triggers payment by the bank.
It follows that the only Incoterms rules that work well with letters of credit are the “C” rules – CIF, CFR, CIP, CPT. Typically the carrier gives the seller a bill of lading, which serves as a document for control of the goods. The bill of lading will evidence that freight has been paid by the seller, and also serves as a receipt for the goods that have been taken in charge by the carrier.
The bill of lading may also carry an on-board notation, indicating that the goods have been loaded onto the vessel at a given time and place. This is widely accepted as evidence that the goods have been despatched and are in transit. More of this later!
Why does this arrangement work well for both buyer and seller? In effect, the carrier takes the role of an independent third party, trusted to take charge of the goods at the beginning of the journey and to release them to the holder of the bill of lading at their destination.
However it should be noted that with some “C” rules, the alignment of the Incoterms rule with the letter of credit may not be perfect.
Consider this scenario. A container is being sent by sea. The Incoterms rule is CIP, so risk passes to the buyer once the container has been taken in charge by the carrier. However let us assume that the letter of credit calls for a bill of lading with an on-board notation, and that there is an accident to the container in the container yard.
The container is never loaded, so an on-board bill of lading is not issued. The seller is contractually “off risk”, but will not get paid under the letter of credit. So the seller must deal with the insurance claim – something that the CIP rule was designed to avoid in this situation – or must depend on the goodwill of the buyer to take care of this.
Implications of using other Incoterms rules
Let’s start with FCA and FOB, where the seller hands the goods over to the carrier, or loads the goods on board, but the buyer arranges the carriage. If the letter of credit calls for a bill of lading, then we have a situation where the buyer may be in a position to frustrate the transaction – perhaps by cancelling the carriage contract!
Without a bill of lading, the seller cannot make a compliant presentation and will not get paid.
Where there are compelling reasons to use FCA or FOB, there may be workarounds through special wording in the letter of credit. One formulation specifies alternative documents that may serve in the absence of a bill of lading – for example, a freight forwarder’s receipt.
The “D” rules – DDP, DAT/DPU, DAP – present different problems. Delivery now takes place upon completion of the main carriage – but what documents can the letter of credit call for? A bill of lading can serve as evidence of despatch of the goods, but not as evidence of arrival at the named place. So in the event of a mishap in transit, the seller can still get paid, even though delivery obligations have not been fulfilled.
But if the letter of credit calls for a receipt given by the buyer upon arrival of the goods, what is to prevent an unscrupulous buyer declining to accept the goods and provide such a receipt?
The documents – the devil is in the detail.
Anybody who has worked with letters of credit will know the frustration of having documents rejected by the bank due to apparently trivial discrepancies between the requirements of the credit and the documents that have been presented.
Not surprisingly, the Incoterms rules provide their own opportunities for error!
The SWIFT MT700 Letter of Credit message format does not have a separate field for the Incoterms rule. If specified on the credit, the rule will usually appear as part of “Description of Goods and Services”.
However there will be implications for documentary requirements, e.g. transport document and insurance document.
Where a rule such as CIP is used, the buyer will want to be sure that the seller has indeed paid for carriage to the agreed place, so the documents section of the credit will include wording such as “Bill of lading marked …. freight paid to Long Beach, California”.
Consider a transport document that is annotated with two separate statements:
Does this transport document signify that freight was paid to Long Beach?
Common sense would suggest that it does – after all, CIP is well known to mean that the seller pays for carriage to the named place.
However in the real world of letters of credit, documents such as these are sometimes rejected, using arguments along the lines that it is not the role of the examiner to understand terms such as CIP and apply this understanding to the case!