Incoterms_® and Commercial Contracts

• What are the Incoterms® rules?
• How are the Incoterms® rules properly used?
• Where do you find the Incoterms® rules?
• Who is bound by the Incoterms® rules?
• Why should importers and exporters use the Incoterms® rules?

What are the Incoterms® rules?

The Incoterms® rules are standard ‘trade terms’ used in international and domestic sale contracts to allocate certain costs and risks between the seller and the buyer.

The best-known and most widely used of the 11 Incoterms® rules are FOB and CIF (sometimes also spelled f.o.b. or c.i.f.), but several other rules are very common as well.

By referring to an Incoterms® rule in the sale contract or export quote, the exporter and importer have a short-hand way of choosing from among a set of 11 different alternatives as to: 1) who must pay for transport, 2) who must bear the risks of loss of or damage to the goods during transport, and 3) who is responsible for customs formalities and duties upon export and import. Two particular Incoterms® rules (CIF and CIP) in addition place a specific requirement on the seller to obtain at least minimum insurance coverage for the goods.

In essence, the Incoterms® rules are a way of letting the buyer know what is ‘included’ in the sales price. By choosing an Incoterms® rule, the parties allocate transport costs and risks, as well as the responsibility for insurance and customs formalities, between seller and buyer.

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The obligations of the parties for each rule are grouped under the same main headings: SELLER’S OBLIGATIONS (A1-A10) and BUYER’S OBLIGATIONS (B1-B10). These are the 10 obligations that may fall upon the parties, numbered as follows:

There are 11 Incoterms® rules in the current version of the rules known as ‘Incoterms® 2010’ (ICC Publication No. 715) – 7 rules that may be used for any mode or a combination of different modes of transport (frequently known as ‘multimodal’ transport), and 4 rules that may be used only for sea and inland waterway transport (frequently known as ‘maritime’ transport). Within each of these two categories, the Incoterms® 2010 rules can be thought of as representing a stepladder of increasing responsibility from seller’s premises to buyer’s premises. Thus, in the rules for use with any mode or modes of transport, the Incoterms® rule that represents the minimum responsibility for the seller is EXW (Ex Works), which is generally used in cases involving delivery at the seller’s factory or warehouse. At the other extreme, the Incoterms® rule DDP (Delivered Duty Paid) represents maximum responsibility on the part of the seller, with delivery generally at the buyer’s premises.

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A buyer on EXW terms knows that nothing ‘extra’ (in terms of transport, customs clearance or insurance) is included in the sales price – the buyer must handle the entire transport operation itself. A buyer on DDP terms (‘Delivered Duty Paid’) knows that the quoted price includes all transport costs, risks and formalities up to the final destination. Between these two extremes, there are nine other Incoterms® rules, representing a range of options for the division of costs/risks between the parties. Please note, though, that there are potentially insurmountable practical difficulties involved in using either EXW or DDP – parties should proceed with open eyes when using these, and are well advised to read the Guidance Notes to both EXW and DDP at pages 15 and 20, respectively.

ICC derived the word ‘Incoterms’ from ‘International Commercial Terms’. ICC prefers to refer to the Incoterms® rules as ‘rules’ or ‘trade terms’, in recognition of the fact that they have multiple functions. People sometimes refer to Incoterms® rules such as FOB or CIF as ‘shipping terms’, ‘delivery terms’ or ‘payment terms’, all of which are much less satisfactory than ‘trade terms’ because they do not communicate the range of obligations covered by the Incoterms® rules: the Incoterms® rules cover not only transport, but also risk, minimum insurance coverage, packaging, customs obligations, etc. Note also that even though the first part of the word ‘Incoterms’ comes from a reference to the word ‘international’, the rules are equally applicable to domestic or intra-bloc trading, or customs union contracts.

The Incoterms® rules are periodically revised by ICC in order to take into account changes and developments in prevailing international trade and transport practices. ICC published the first version of the Incoterms® rules in 1936. Subsequent revisions were published in 1953, 1967, 1976, 1980, 1990, and 2000. The current valid version is Incoterms® 2010.

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Parties to a contract of sale are well advised to make reference to a particular version of the Incoterms® rules in their contracts, to avoid confusion if a dispute arises. If, for example, a contract were signed in 2009 mentioning simply ‘Incoterms’ and a dispute regarding the contract arose in 2011, a judge or arbitrator would have to decide whether the version of the rules applicable at the time of signing the contract – Incoterms 2000 – or the version in force when the dispute arose – Incoterms® 2010 – should be applied. Parties may choose any version of the Incoterms® rules they like (though they are advised to use the current version, which best reflects the current trading environment); the most important thing is that they specify clearly in the contract which version they intend to apply.

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How are the Incoterms® rules properly used?

The Incoterms® rules can be incorporated into contracts by simple reference, e.g. ‘FCA 38 cours Albert 1er, Paris, France, Incoterms® 2010’.

TRADERS SHOULD EXPLICITLY REFER TO ‘INCOTERMS® 2010’. To be certain to benefit from the Incoterms® rules, traders should link their contracts to the Incoterms® rules by explicitly referring to a particular Incoterms® rule in the quoted price. The common practice of quoting a price as follows, ‘$100/ton FCA New York’ (i.e. without an explicit reference to ‘Incoterms® 2010’) can be DANGEROUS. In the absence of a specific reference to the Incoterms® rules, the trader may lose the right to apply the Incoterms® rules to the contract. The contract may consequently be subjected to a national legal definition of a particular trade term, with surprising results. A more correct formulation of the above contract would be ‘$100/ton FCA New York Incoterms® 2010’.

In practice, it would appear that one of the most common ways of incorporating an Incoterms® rule into a contract is to include it in the General Terms and Conditions of the exporter or importer. This allows both the exporter and importer to ‘forget’ about specifying the application of the Incoterms® rules while they negotiate the other terms of the contract. Although this can be a helpful backstop, one wonders if it does not also lead some exporters and importers to conclude erroneously that the Incoterms® rules are mere ‘technicalities’ or details for the ‘fine print’. Such an attitude might lead traders to downgrade the importance of the choice of a particular Incoterms® rule, which could prove unfortunate, as we will see. Another common tactic is to place a reference to the chosen Incoterms® rule somewhere in the pro forma invoice. Whichever technique is chosen, reference to the Incoterms® rules should be clear and unequivocal and refer to the year of the current valid version of the Incoterms® rules (e.g., ‘Incoterms® 2010’).

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Where do you find the Incoterms® rules?

The Incoterms® rules are found in international sale contracts and any of the common documents that may evidence such contracts, such as a pro forma invoice or purchase order.

The legal nature of the Incoterms® rules is frequently misunderstood. The Incoterms® rules are creatures of contract, not legislation. The Incoterms® rules apply to a contract whenever the parties can demonstrate that they both intended the Incoterms® rules to apply. That is why it is important to explicitly incorporate the Incoterms® rules.

There are, however, important exceptions. If trade customs, general sales conditions, commercial usages or previous contractual dealings indicate that the parties intended to use the Incoterms® rules, then the Incoterms® rules may apply even in the absence of a specific mention in the sales contract. Under some legal systems, great weight is given to customs of trade and there may be a presumption that the Incoterms® rules constitute a custom of trade. In such countries, courts or arbitrators might take judicial notice of an Incoterms® rule to resolve a case, although no Incoterms® rule had been incorporated into the contract.

The Incoterms® rules have been longest known and understood in Europe. This may be due historically to the large number of exporting countries in Europe and the fact there is a high amount of intra-European trade. ICC is encouraged to see that understanding and use of the Incoterms® rules has been growing exponentially around the world, with newly opened countries, such as Myanmar, requesting training to bring their traders up to speed on this essential feature of commercial commerce. There is hardly a country in the world whose traders are unfamiliar with the idea of the Incoterms® rules – the challenge for ICC now is to educate users around the globe about how to use them most effectively.

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Who is bound by the Incoterms® rules?

The Incoterms® rules govern certain responsibilities between the seller and the buyer under the contract of sale; they should not be confused with the allocation of responsibilities between the shipper, carrier and consignee under the contract of carriage.

One of the most common misunderstandings related to the Incoterms® rules involves confusing the contract of sale with the contract of carriage.

Note carefully the distinction:

• Contract of sale – The Incoterms® rules are embedded in this contract, an agreement between the seller and the buyer.
• Contract of carriage – This contract is between the shipper and the carrier (or the carrier’s agent). Depending on the contract of sale and the chosen Incoterms® rule, the shipper may be either the seller or the buyer. This means that the contract of carriage is necessarily linked to the contract of sale, because whoever is obligated under the contract of sale to take care of transport will then become the shipper, and will have to enter into a carriage contract with a carrier (a company offering transport services, like a marine shipping line, and airline, or a freight consolidator).

The key lesson to keep in mind to avoid misunderstandings is this: The Incoterms® rules are not part of the contract of carriage. There is indeed a relationship between the Incoterms® rules and carriage contracts, because the choice of a specific Incoterms® rule may oblige the shipper to obtain a certain type of contract of carriage (such as a clean ‘on board’ bill of lading) with particular conditions. One reason for confusion is that terms in the contract of carriage may resemble the Incoterms® rules (for example, in their usage of the word ‘free’) – but traders should remember that these are separate contracts with separate sets of responsibilities.

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Many traders also appear to expect that the transport contract will automatically accord with the Incoterms® rule in the sales contract. It is indeed important that the transport responsibilities required by the Incoterms® rule in the contract of sale accord with the terms of the contract of carriage, but there is nothing automatic about it. It is up to the shipper to make the effort to give precise instructions to the carrier or freight forwarder so that the proper transport arrangements are made and so that the invoices for transport services are prepared accordingly. In some cases, inexperienced traders do not even inform the carrier as to the Incoterms® rule in the contract of sale, then profess surprise later when the billing for transport services does not accord with the Incoterms® rule.

Two Incoterms® rules, CIF and CIP, impose an obligation on the seller to pay for insurance coverage. They do not regulate the insurance contract itself, but merely the relations between the seller and buyer as regards insurance. The party responsible for the payment of the insurance coverage, i.e. the seller, will have to enter into a specific insurance contract. The mention of an Incoterms® rule in this latter contract does not allocate particular obligations to the parties to the insurance contract.

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Why should importers and exporters use and understand the Incoterms® rules in detail?

In order to understand the value of the Incoterms® rules, we might ask ourselves: what would happen if a trader forgot to use the Incoterms® rules, or failed to understand the allocation of risks/ obligations thereunder?

Let us consider the example of a transaction where the sale contract (or at least the pro forma invoice, if there is no sale contract) mentions ‘FCA’ but does not specifically mention ‘Incoterms® 2010’ or even ‘Incoterms® rules’. In such a case, if a dispute or uncertainty should arise, the traders would first have to ask themselves the preliminary question – where will we look for a definitive interpretation of FCA? Who decides what FCA means? The courts? ICC? In the absence of a specific reference to the Incoterms® rules in the contract of sale, it is possible that the only way to arrive at a definitive interpretation is to look to the national law. Unfortunately, this is a potentially complicated undertaking, as it requires one to ascertain which national law is applicable to the contract, which in turn requires an analysis of the conflict of laws rules of any national law that might be applied to the contract. Such a procedure sounds complicated, and it is. If there is litigation over the dispute, lawyers’ time may have to be spent studying all pertinent jurisprudence on trade terms, and this analysis can be very expensive. All of this is unnecessary if the parties simply remember to take the precaution of specifically incorporating the Incoterms® rules into the contract of sale.

Many international traders, unfortunately, have only a general idea of the differences between such Incoterms® rules as EXW, FCA, FOB, CIF or DDP. As a result, they are unprepared for certain common contingencies with respect to transfer of risk, loading/ unloading, customs clearance and insurance. Thus, for example one of the most common questions asked the ICC about the Incoterms® rules is: Who is responsible for loading (or unloading) the goods? As a matter of fact, the rule on loading varies from one Incoterms® rule to another, and this is an important area in which international trade professionals should develop their understanding.

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In light of the above, traders clearly need to understand the nature, extent and limitations of the Incoterms® rules’ coverage. The Incoterms® rules do not cover all possible legal or practical issues arising out of an international sale. The Incoterms® rules are merely a sort of contractual shorthand that allows the parties to easily specify their understanding as to: 1) the transport costs that the seller will cover; 2) the point at which risk of loss will be transferred from seller to buyer; 3) who must handle customs formalities and pay duties; and, 4) in the case of CIF and CIP, what are the responsibilities of the seller to provide insurance cover. All other important details should be dealt with specifically in the contract of sale.

For example, there is nothing in the Incoterms® rules on how the seller should transport the goods to the named delivery point. Thus, if a sale is ‘FCA Terminal 4, Buenos Aires Airport, Incoterms® 2010’ the buyer has no control – under the Incoterms® rules – over how the seller gets the goods to Buenos Aires; that is up to the seller, and is considered outside the remit of the FCA rule. However, in some cases it may be very important to the buyer that the goods be transported in a certain way, for example, in refrigerated containers. If this is the case, the buyer must specify in the contract how the goods should be transported up to the delivery point.

The Incoterms® rules cannot be expected to make up for a contract that is not sufficiently precise. In many cases it is advisable to include in the sales contract precise details on exact place and method of delivery, allocation of loading and/or unloading charges, extent of insurance, and mode of transport.

The Incoterms® rules cover only those cases where one party has an obligation to the other party to do something. The Incoterms® rules do not indicate when a trader should do something because it is prudent or advisable. This is frequently misunderstood. Thus, traders will ask why the seller is not obliged to insure the merchandise under a DDP sale, since it would seem obvious that the seller has to be responsible for the goods all the way to destination. Yet this approach confuses a business need with a legal obligation – the Incoterms® rules refer only to the legal obligations, and are silent on matters of common business needs and usages.

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Thus, similarly, a buyer of merchandise in an FCA contract has no obligation to take out insurance, and the Incoterms® rule FCA is silent on this matter. But since the risk of loss is on the buyer once the goods have been loaded, the buyer would be very foolish not to take out insurance.

One of the key areas not governed by the Incoterms® rules is that of the transfer of property or title to goods. In fact, there is no international legal harmonization as regards the transfer or title or property in international transactions. Thus, the matter is not resolved by the 1980 Vienna Convention on the International Sale of Goods (CISG).

Since the law on transfer of property rights differs from country to country, the parties to a contract of sale may wish to specifically provide for this matter in the contract, but only after determining what is permissible under the applicable law. Under many jurisdictions it is possible for the seller to retain title and ownership of the property until the purchase price is paid in full, even if this takes years. This ‘retention of title’ by the seller is usually set out in a clause in the contract of sale (see discussion above in the section on Contract of Sale). Thus, one typical question raised by newcomers to the Incoterms® rules is: Where are the provisions on transfer of property in the Incoterms® rules? Such a question may arise, for example, because the goods have been damaged or lost during transit, and the seller may be eager to find out if the damage occurred when the goods were still his or her property, or if the damage took place only after the goods had become the property of the buyer; this question is primarily of interest for insurance purposes.

However, these questions remain largely governed by national law alone. It is possible for the parties to add to their contracts, in addition to the Incoterms® rule, a clause that clearly establishes the place and manner of transfer of ownership/title in the goods. Drafting such clauses requires knowledge of the transfer of property laws of both countries involved, as well as their respective conflict of law rules with regard to such property laws. Seeking specialist advice is advisable.

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