Transfer of risk and INCOTERMS
A contract can be viewed as an allocation of risks and rewards for a given transaction. We shall now focus on the issue of the point at which certain risks pass from the supplier to the buyer.
First, it is important to differentiate between the meaning of the words ownership, delivery and risk. Transfer of ownership is determined by clauses in the contract. Ownership may begin before the completion of the manufacturing of a product, if, for example, the buyer pre-finances the supplier. Alternatively, ownership may be transferred some time after delivery, if the goods are procured on credit.
The place and time of transfer of the documents of title is specified in INCOTERMS, to be discussed later. It is linked directly to the delivery of the goods and transfer of risk. The titleholder is the only person who can make a claim for loss or damages against the insurance contract. Transfer of title is referred to in the INCOTERMS as ‘taking delivery’.
What are INCOTERMS?
INCOTERMS refer to the set of international rules for the interpretation of the chief terms used in foreign trade contracts first published by the International Chamber of Trade in 1936 (now International Chamber of Commerce) and amended in 1953, 1967, 1976, 1980, 1990 and 2000. The reason INCOTERMS are periodically revised is to ensure that they represent current practice. Although the use of INCOTERMS is optional, they can reduce difficulties encountered by importers and exporters.
Format of INCOTERMS
Each Inco-term is referred to by a 3-letter abbreviation. The International Chamber of Commerce (ICC) recommends that ‘INCOTERMS 2000’ be referred to specifically whenever the terms are used together with a location. For example, the term FOB (free on board) should always be accompanied by a reference to the exact place to which delivery is to be made. An example of the correct use of an Inco-term is FOB Liverpool INCOTERMS 2000.
The INCOTERMS provide in each case precise definition of the responsibilities of the buyer and seller at all stages in the movement of goods. They define, for instance, a point in the journey at which risk for damage to, or loss of, the goods passes from the seller to the buyer. The INCOTERMS also define who must arrange and pay for various costs such as transport, loading and unloading, customs clearance at the ports of export and import, insurance and other services.
The INCOTERMS are contractual terms, not laws such as might be enacted by a legislative authority, and the use of them in the procurement contract does not avoid the need for a separate contract for the carriage of goods involved in the sale. The parties agree to be bound by them and thus, must specify clearly the appropriate version of INCOTERMS applicable. The most recent version of INCOTERMS is INCOTERMS 2000, which came into force on 1st January 2000, and is a revision of the INCOTERMS 1990.
INCOTERMS are grouped into four categories, each denoted by the first letter of the three-letter abbreviation:
1. Under the ‘E’ term (EXW), the seller only makes the goods available to the buyer at the seller’s own premises. The carriage of the goods is arranged by the buyer. Risks and costs are transferred to the buyer when the goods are made available to the buyer. There is only one Inco-term in this category. In the Malaysian scenario, this delivery term is quite common if you buy from overseas suppliers in Western countries. You can appoint forwarders or shipping agents to work with their shipping counterparts overseas to arrange pick up from suppliers’ premises and deliver all the way to your company in Malaysia.
2. Under the ‘F’ term (FCA, FAS and FOB), the seller is to deliver the goods to a carrier appointed by the buyer. The carriage of the goods is arranged by the buyer. Risks and costs are transferred to the buyer just after crossing ship’s rail. In Malaysia, it is quite common for us to use FOB for sea shipment if we purchase commodities from overseas such as China, Taiwan or even United States.
3. Under the ‘C’ term (CFR, CIF, CPT and CIP), the seller has to contract for carriage, but without assuming the risk of loss of or damage to the goods or additional costs due to events occurring after shipment or dispatch. In other words, risk is transferred to the buyer just after export clearance and costs are on the seller up to import clearance at the named destination. CIF term is commonly used in Malaysia for local truck shipment from local suppliers. Basically, buyers do not pay any shipping cost or engage in any custom clearance as the goods will be delivered to buyers’ premises.
4. Under the ‘D’ term (DAF, DES, DEQ, DDU and DDP), the seller has to bear all costs and risks needed to bring the goods to the place of destination. The carriage of the goods is arranged by the seller. Risk transfer occurs to the buyer just before import clearance and costs are to the seller up to the import clearance when duty is unpaid. When duty is paid, the seller bears all burdens through import clearance.
As trade develops, business people in different countries or sectors develop terms to describe the obligations of buyers and sellers. As long as one is in a domestic setting and the trade terms are common, the parties can use these to set terms in their contracts that specify their respective obligations with reasonable comprehension of what is intended. If a dispute about the term arises, the local courts will determine the meaning of the term or the relevant jurisprudence can be looked at to define the term.
In international trade, however, the types of terms that are developed in one country as opposed to another and the manner in which one country’s court interpret a term vary. Two businesspeople who attempt to come to an agreement may use a term thinking that the term means the same thing for each of them. However, this term may have different meanings in different countries and it is possible that misinterpretations will arise.
INCOTERMS provide a standard so that all the parties know that when a term is employed it is used in the INCOTERMS sense. This means that both parties can have some security about their rights and obligations, and that the risk of ambiguity is reduce, though not eliminated. There are advantages and disadvantages of using any INCOTERMS for the benefit of any party. It really depends on the purchasing power and negotiation power of both parties in order to finalise on the INCOTERM used. In this case Procurement would negotiate the best INCOTERM for the benefit of its company and at the same time to achieve win-win situation for both parties.
Transfer of risk and contractual obligations
Foreseeing the transfer of risk is a key aspect of preparing the contract. By using INCOTERMS, the risk of loss and damage can be shifted in different ways between the supplier and the buyer. It is up to the parties to select the means that is appropriate for their contract and, if necessary, modify the INCOTERMS used.
When products ‘at the seller’s risk’ are damaged or lost, the seller may be prevented from completing its obligation to deliver according to the terms of the contract. In this situation, the buyer will not have to pay the purchase price and may resort to legal remedies available to recover any losses incurred because of the default.
When damage or destruction occurs to products ‘at the buyer’s risk’, the buyer will have to bear the loss. The buyer must still fulfil its obligations to pay the seller. It will be up to the buyer to claim for damages on insurance companies or transport operators, as appropriate. Such claims may involve both contracts for procurement and carriage as well as mandatory international legal conventions.
|Please read ‘Incoterms 2000’ on pages 320 – 330 of Chapter 13 from your textbook Procurement Principles and Management, 10th edn, England: Prentice-Hall, Pearson Education Limited by Baily, P, Farmer, D, Crocker, B, Jessop, D and Jones, D (2008).|
|Question to activity 4.3
||Suggested answer to activity 4.3