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Exporters must ensure coordination of Incoterms and documentary requirements for LC payment.

Substantial information on Incoterms 2000 has been published and commentated in several venues. It is interesting, and perhaps somewhat disturbing, that within this mass of commentary, little has really been done to clarify the relationship between the chosen, specific Incoterm and the corresponding payment terms used by sellers. This relationship is fundamental, and more work needs to be done.

This article will focus exclusively on one aspect of Incoterm/Payment Terms coordination, the relationship between the "E" Incoterm or "F" Group Incoterms and payment terms under documentary letters of credit. While this may seem a particularly specific and restricted topic to address, it is in fact probably the most common source of problems and misunderstandings for buyers and sellers and their bank service providers when working with letter of credit terms. Sellers need to be particularly wary when structuring their guidelines for Letters of credit which buyers will use to make application. They must be scrupulous as well, when checking LCs issued on their behalf to ensure that the terms agree with their specifications. More than one hapless shipper has been amazed to find that protections they expected were not, in fact, available when it came time to collect.

A recent wall chart published on the Internet makes the following statement with respect to the "F" terms: "Payment of Freight Forwards fees may be controversial depending on the contract of sale." This perceptive, and seemingly innocuous, statement conceals a very important problem about which every credit professional and their sales management colleagues need to be especially careful.

Letters of credit are generally issued with a requirement that evidentiary documentation include an Ocean Bill of Lading. While this is not a requirement strictly imposed by UCP500, most banks do maintain a policy whereby they will require this. The reason is that the OBL is a negotiable instrument and is normally issued consigning goods under its aegis to the issuing bank. This contrivance allows the issuing bank to maintain an interest in the goods until such time as sufficient assurances are available to determine that counterparties to the trade have both complied with the requirements of the transaction.

The industry, in the agency of the issuing bank, its correspondent or surrogate (in the case of an LC which is freely negotiable and reimbursed in the country of the beneficiary) essentially sees compliant evidentiary documentation, upon satisfactory examination, as manifestation of performance by the beneficiary. From the point of view of the applicant, if the LC has not been fully collateralized at issuance, the bank is protected to the extent that it will not release the paperwork until it is secure. The bank, of course, further provides the service of completing performance on behalf of the applicant by tendering due payment.

Since goods cannot be claimed by an applicant until the OBL has been re-consigned, the system fundamentally uses the document as a gate-keeping device. This protects buyers and sellers. Buyers are protected because the OBL is a strong evidentiary indicator that what the applicant ordered, is what was, in fact, placed on board the ship. The seller is protected because there is added assurance that until compliance is verified by examination and the documents tendered to the applicant, the buyer cannot claim the goods at port. It is a workable system.

Now, since the OBL is created by the steamship line (typically using the Mate's Manifest, built off original Bills of Lading), which is officially engaged by the party responsible for payment of corresponding ocean cartage, or their contracted agent, the use of an Incoterm which does not permit the beneficiary (or its designated agent) to be the engaging party, causes there to arise an essential internal conflict within the transaction. The "E" and "F" Group Incoterms would imply that the applicant or its agent will pay the freight forwarding and ocean cartage, and thereby control the creation of one of the essential units of evidentiary documentation for most LCs--the OBL. However, the conventions of documentary LCs, for the protection of the bank and the beneficiary, would require that such documentation be created and under the control of the beneficiary or the beneficiary's agent, which, as can be seen--under the "E" term or under any "F" term--would be impossible.

Unfortunately, many bankers who--as a standard practice--will not issue without requiring an OBL as evidentiary documentation, will, at the same time, counsel their applicant clients that it is perfectly fine to issue a documentary LC in "F" term or "E" term format--which essentially does violence to the intention of the documentary Letter of Credit in the first place. From the point of view of the applicant, this might seem to be good counsel, because it essentially leaves all the control in the hands of the buyer. If, for some reason, the buyer is unhappy with the seller and does not wish to pay immediately, it can arrange for a discrepancy by submitting or instructing its agent to submit required evidentiary paperwork outside of the terms of the LC. This has happened more frequently to unwitting sellers than their banker consultants would like to admit, and is a risk about which most sellers remain blithely uninformed. As a result, this counsel by buyer's banks might constitute something of an unintended deception, providing a false comfort to sellers, who believe their transactions to be more secure than they are, in truth.

It is advisable that beneficiaries be very careful to avoid this fundamental pitfall. Credit Managers, in particular, should be careful to counsel their organizations not to accept LCs in a format calling for the Ocean Bill of Lading as evidentiary documentation with Less than a "C" Incoterm. Since most banks have a great deal of trouble in issuing LCs without calling for an OBL (they are sometimes constrained by their charters not to do so), it is a good practice to insist that the Incoterm governing the taking in charge of the goods under the transaction should minimally be CIF, which would require that the engaging party, for the purposes of creation of this essential piece of evidentiary documentation, be the beneficiary or the beneficiary's designated agent.

There is a final consideration which might be appropriate to mention at this point. Since most banks will not issue without the requirement for the OBL, this creates an additional difficulty for buyers who wish to do LCL transactions, who have intermodal transactions, or who are selling across contiguous international boarders using ground transportation. Under current conditions, buyers and sellers should agree to ask banks to issue documentary LCs for which an OBL is not a required document. If they can, they will eliminate many of the problems referenced above. Assuming the banker is willing to accept as evidentiary documentation a signed truck bill for an EXW transaction or other signed document for an "F" Incoterm sale, this can provide much greater flexibility. Due to the rapid evolution of strategies involving differing modalities for international cargo transport, it is not always possible to attend strictly to the traditional requirements for LC issuance--especially as these pertain to the inclusion of OBLs for evidentiary purposes. (It is often better, for example, to request CIP terms which allow for any mode of transport, as well as intermodal, in preference to CIF, which is strictly a marine term.)

The willingness of the bank to issue in a format not requiring an OBL would obviate the essential need for a "C" Incoterm, and would open the way for buyers to have documentary LC transactions which permit them more fully to control the international transport--and effect consolidation at their discretion, if needed--while still providing very solid protection to beneficiaries. To close the loop on this problem, and afford similar protections to ground, air and intermodal transactions, bankers and traders should advocate for policy changes in international venues governing the status of truck bills and airway bills, allowing these to be negotiable (issued in a "to the order of" format). Though there are potential impediments from the point of view of international law and some practical considerations to be overcome even domestically, as the case of marine transport shows, these roadblocks should not be insurmountable.

Kevin Reilly is Director, International, Baker Furniture. He is also Chair of International Credit Executives of Southeast. Contact Kevin by phone at 704.932.2686, or by e-mail at Kevin.Reilly@Kohler.Com
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Title Annotation:SELECTED TOPIC
Author:Reilly, Kevin
Publication:Business Credit
Geographic Code:1USA
Date:Jun 1, 2005
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