Procurement contracts and INCOTERMS; How to ensure your supply contracts are not INCO-mpatible with INCOTERMS
Baker McKenzie Australia 27 Jun 2019
Australia is currently in the midst of an ‘infrastructure boom’ and is experiencing high levels of construction activity in many major industry sectors including in the government, commercial and renewables sectors. This boom has sent the demand for equipment, plant and material skyrocketing and straight onto the ‘critical path’ for the delivery schedule of many projects. In 2018 alone, the Sydney Metro project for example procured a staggering 399,945 tonnes of concrete and 68,477 tonnes of steel. The skills shortage in Australia, and the drive for more competitive pricing, has also meant that much of the equipment, materials and plant sourced for these major projects is procured from overseas. It is not uncommon, in supply arrangements of this nature, for the parties to incorporate ‘International Commercial Terms’ (Incoterms) into their procurement contracts.
Incoterms were developed by the International Chamber of Commerce (ICC) to promote a common understanding between the parties of their respective operational obligations within various delivery arrangements. Whilst they are intended to operate as an international set of procurement rules to give clarity to parties’ respective risks and obligations in the procurement chain, issues can arise when they are incorrectly incorporated into supply contracts.
Whilst Incoterms have been widely adopted in many domestic and international supply arrangements around the world, including in Australia, they are often incorporated by reference into ‘off the shelf’ or ‘precedent’ supply contracts with insufficient thought and consideration given to the specific Incoterm selected and what aspects of their supply contracts need to change to properly incorporate the relevant Incoterm. This failure results in supply contracts that contain inherent inconsistencies with the Incoterms selected. These inconsistencies create uncertainty and may give rise to potential disputes. Supported by both anecdotal and empirical evidence, Stapleton, et al. (2014) write, for example, that many shippers unknowingly misuse Incoterms or use less than ideal Incoterms, leaving themselves vulnerable and without control in their supply chains.
Given the increasing criticality of a Project’s supply chain to its overall success, it is essential for suppliers and buyers alike to ensure that the use of Incoterms is well understood and that their supply contracts properly incorporate them. This article explains the different types of Incoterms and identifies issues that parties should consider when drafting their supply contracts and incorporating Incoterms.
What are Incoterms?
Incoterms were first created by the ICC in 1936. They are revised regularly to reflect modern changes in trade. In 2010, the most recent set of Incoterms were published consisting of eleven trade terms that define the role of the buyer and seller within various delivery arrangements. Incoterms are intended to create certainty between parties by delineating how costs, control and liability are shared, without the need for extensively detailed clauses in the supply contract. Relevantly, Incoterms apply only to the sale of goods, not the leasing or hiring of them or any other commercial transactions. Incoterms can be divided into two broad categories, based upon the mode of transport envisaged:
Incoterms that apply to multiple modes of transport (including land,
air and waterway transportation):
- EXW (Ex Works)
- FCA (Free Carrier)
- CPT (Carriage Paid To)
- CIP (Carriage and Insurance Paid To)
- DAT (Delivered at Terminal)
- DAP (Delivered at Place) and
- DDP (Delivered Duty Paid)
Single-modal Incoterms that apply to sea and inland waterway transportation only:
- FAS (Free Alongside)
- FOB (Free On Board)
- CFR (Cost and Freight) and
- CIF (Cost, Insurance and Freight)
There are various factors that will influence which Incoterm should be selected in a particular supply arrangement. Some of these factors include:
- mode and method of transport envisaged;
- parties’ expertise in transporting goods and obtaining customs clearance;
- nature and quantity of the goods being procured;
- insurance arrangements for the particular project; and
- whether goods can be consolidated with other orders that are being purchased in, or delivered to, a similar location.
The various Incoterms are described in more detail below and rank the seller’s obligations in increasing order.
- EXW: “Ex Works” is a delivery term under which delivery occurs when the seller makes the goods available for collection by the buyer at the seller’s premises or at a named place (i.e. at a factory or warehouse).The seller is not responsible for loading the goods nor clearing the goods for export. The buyer bears all costs and risks associated with collection and transport.
- FCA: “Free Carrier” is a delivery term under which the seller is responsible for delivering the goods to either the buyer’s carrier at the seller’s premises or at another named place (e.g. a freight terminal) for further transport by the buyer. If the named place is the seller’s premises, delivery is completed by the seller when the goods have been loaded onto the buyer’s carrier. All subsequent costs and risk transfer to the buyer at this point. In any other case, delivery is completed by the seller when the goods are placed at the disposal of the buyer’s designated on-carrier on the seller’s transport ready for unloading. The buyer will bear all costs and risks from this point forward including the cost of unloading and transferring the goods to the buyer’s on-carrier. In both scenarios, the seller must clear goods for export. The buyer is responsible for import clearances and duties.
- CPT: Under “Carriage Paid To”, the seller is responsible for arranging and paying for the loading, unloading and transportation of the goods to a named point, typically in the destination country. Under this delivery arrangement, the seller has fulfilled its obligations of delivery when it hands the goods over to the specified carrier, not when the goods reach their final destination. Accordingly, risk will pass to the buyer once the goods have been tendered to the relevant carrier. The seller is responsible for clearing goods for export but has no obligations in respect of import clearances/duties.
- CIP: As the name suggests, “Carriage and Insurance Paid To” is the same as “Carriage Paid To”, but with an additional obligation on the seller to insure the goods. All other obligations remain the same. Accordingly, the seller will fulfil its obligations when the goods are insured and tendered to the designated carrier. It is important to note that Incoterms only require the seller to obtain a minimum level of insurance cover.
- DAT: “Delivered at Terminal” is a delivery term under which the seller is responsible for placing the goods at the buyer’s disposal at a terminal or other named place (such as quay, warehouse or container yard) at the agreed port or place of destination. The seller bears all cost and risk involved in transporting the goods and unloading them at the agreed terminal. The buyer bears all costs and risk associated with collecting and transporting the goods from the terminal to their intended final destination. The seller has no obligations in respect of import clearances/duties.
- DAP : Under “Delivered At Place”, the seller is completely responsible for delivering the goods to a named place at the disposal of the buyer on the arriving means of transport. The buyer bears the costs and risk associated with unloading the goods from the arriving means of transport and import customs clearance/duties.
- DDP: Finally, “Delivered Duty Paid” requires the seller to deliver the goods to an agreed address at the disposal of the buyer. Costs and risk transfer to the buyer when the goods are ready for unloading at the agreed address. The seller bears all of the costs and risk involved in transporting the goods to the destination, including export and import clearances/duties.
- FAS: “Free Alongside Ship” is a delivery term under which delivery is made when the seller places the goods alongside the vessel nominated by the buyer at the named port of shipment. It is the seller’s obligation to clear the goods for export. The buyer bears all of the costs and risks associated with loading, transporting the goods and import duties.
- FOB: Under “Free on Board”, delivery occurs when the seller places goods on-board a named vessel at a named port.  The seller is responsible for all costs and risk in placing the goods on-board the vessel as well as clearing the goods for export. All costs (including transport and import customs clearances) and risk transfer to the buyer once the goods have been delivered on-board the ship.
- CFR: “Cost and Freight” requires the seller to arrange and pay for the transportation of goods to a named ocean/inland waterway port of destination. The seller fulfils its obligations when the goods are placed on-board the vessel. The buyer assumes the risk once goods are on-board the vessel. The seller must clear the goods for export, but has no obligations in respect of import clearances/duties.
- CIF: “Cost Insurance and Freight” is the same as “Cost and Freight”, but with an additional obligation on the seller to obtain a minimum level of insurance. All other obligations remain the same. As a result, the seller must arrange and pay for transportation of the goods, place the goods on-board the vessel, clear the goods for export and insure the shipment. Once this is done, all costs (including import customs clearances and further transport from the named port) and risk transfer to the buyer.
Incorporating Incoterms into standard supply contracts
We set out below some issues to which parties should have regard when drafting their supply contracts and incorporating Incoterms.
Form of contract
As mentioned further above, Incoterms are only appropriate for use in connection with contracts for the sale and purchase of goods. It is therefore not appropriate to draft equipment hire arrangements (which may include delivery/transportation logistics) by incorporating Incoterms. Doing so creates a misnomer between the hire arrangement and the inherent sale and purchase assumption of the Incoterms. If parties to a hire arrangement wish to incorporate similar concepts to Incoterms in their hire arrangements then they need to do so in a more detailed and bespoke fashion, applying appropriate terminology changes.
Incoterms alone are also not sufficient to deal with every aspect of the sale and purchase of goods, even for a simple supply contract. Referring only to a particular Incoterm on a Purchase Order with no additional terms and conditions, for example, will mean that the contract does not deal with issues such as when title to goods will pass, testing and acceptance of goods, price, payment mechanisms, force majeure, breach of contract, termination and dispute resolution processes. None of these topics are addressed by Incoterms, which only address transportation related matters. Accordingly, these clauses, amongst others, must be provided for in the relevant supply contract.
Each Incoterm determines when delivery occurs and is not always consistent with other provisions of a standard supply contract or when goods will reach their final destination. Supply contracts must ensure that delivery clauses and any related defined terms, such as the “Date for Delivery”, “Date of Delivery” and/or related concepts of “Acceptance” accurately reflect the parties’ commercial intentions as to delivery and acceptance as provided for under the selected Incoterm. For example, many standard supply contracts merge conditions for delivery, inspection and testing of Equipment as preconditions to Delivery. Whilst this may be appropriate where the relevant Incoterm selected is DDP (ie where equipment is delivered to site), it may not be appropriate if the Incoterm selected was EXW (ie delivered at seller’s premises) as testing and commissioning of the equipment will likely take place at a later stage once the equipment has been delivered to the purchaser’s site and (where relevant) incorporated into the relevant works.
It is also important that parties understand the subtle differences of similar concepts within the Incoterms. For example, under C terms (ie those Incoterms which start with a “C”), the “named place” differs from the “place of delivery”. The named place under C terms is the place of destination to which carriage is paido. However, delivery takes place when the seller provides the goods to the carrier or places the goods on-board the ship (depending on which C term is used) and risk subsequently passes to the buyer. Misunderstanding these differences could be costly. In order to avoid this scenario, the delivery clause, and any defined terms, should clearly apply the correct Incoterm acronym.
It is also important for those drafting supply contracts that incorporate Incoterms to understand how the particular goods are physically going to be supplied (ie via what mode of transport, how they will be packaged etc). It is often the case that the person drafting the supply contract (typically an ‘in house’ or ‘external’ lawyer) will not be as familiar with the actual method of supply as the ‘procurement person’ on the ground. Gaps in understanding this process can lead to contractual drafting issues. For example, where goods are containerised, it is common practice that the containers are delivered to the terminal by the seller and not placed on-board the vessel since this is the responsibility of logistics intermediaries. If a supplier has been contracted to deliver FOB, but there are provisions in the supply contract which provide the supplier relief for delays beyond its reasonable control, a buyer may not be protected from late delivery if the reason for the late delivery is delays by the logistics intermediary. Conversely, if the supplier has accepted FOB delivery but does not have relief under the supply contract for a failure of those intermediaries to load the containers, the supplier may be faced with contractual liability for delay etc. notwithstanding it delivered the containers to port at the correct time. Hanjin Shipping’s financial troubles in mid-2016 caused many sleepless nights for sellers who inappropriately contracted under FOB terms in this regard. This is a cautionary tale to sellers and buyers alike.
Whilst the payment regime under each supply contract entered into by a party (whether a buyer or seller) will likely change depending on the requirements of their counterparty, it is important that regard be had to the Incoterm selected when drafting payment provisions in a supply contract. They should be drafted for consistency with the relevant Incoterms selected. For example, it is not uncommon for a precedent supply contract to contain ‘catch-all’ provisions placing the responsibility for all costs and expenses in addition to the agreed contract price upon the Supplier. However, such a catch-all provision would not be appropriate if Incoterms DAT was selected. In addition, the payment milestones should generally align with the obligations of the seller under the relevant Incoterm. For example, if the payment programme provides that the seller will be paid in full once goods are “Delivered” then this may be premature if Incoterms FOB were selected as the buyer may want to hold back some moneys to allow for payment upon “Acceptance” (ie upon commissioning and testing after delivery to site).
Care should also be taken in drafting clauses which require payment via letter of credit. Problems can arise where documents called for under a letter of credit are not reflective of the relevant transfer in risk and obligations between parties. Ideally, documents called for must be ones that the seller can give or whose issue is under the control of the seller. For example, if a Bill of Lading is required as a term and condition of the letter of credit, FOB may be inappropriate from the perspective of the supplier as the loading of the goods onto the ship is outside of the seller’s control as previously mentioned. The buyer also controls the carriage of the goods and therefore may interfere with the issue of this document. If a Bill of Lading is required, C terms such as CPT and CIP would be more appropriate from the perspective of the seller. Terms and conditions of letters of credit are also strictly upheld by banks. Again, care must be taken to ensure that the terms and conditions of the letter of credit are reflective of the actual delivery method contemplated by the parties. For obvious reasons, a Bill of Lading should not be required if goods are being delivered otherwise than by ship.
Mistakenly, many believe Incoterms provide for the allocation of insurance obligations between the parties. With the exception of CIP and CIF, Incoterms do not require either party to take out insurance. As a result, it is important a supply contract specify how insurance is to be arranged between the parties and the level of cover required to be effected and maintained by the parties.
CIF and CIP only require a seller to take out a minimum level of cover. Minimum cover is often inadequate and this must be addressed within the contract if certain insurance levels are required. For example, minimum cover will not protect against contamination, theft, improper handling, breakage or penetration of seawater into the vessel.
Risk transfers at various stages in accordance with the relevant Incoterm. Supply contracts must ensure that liability clauses remain consistent and reflect the point at which risk is to pass between seller and buyer. For example, it is typical for supply contracts to provide that risk remains with the seller until final acceptance of the goods. Such a provision would be inconsistent with almost all of the Incoterms.
Licences and authorisations
Again, it is not unusual in a buyer-drafted supply contract for there to be provisions which provide that the responsibility for all licences and authorisations relating to the supply of goods sits with the seller (save for any express exceptions). Such a ‘catch all’ provision is again inconsistent with a number of Incoterms, which provide for who is responsible for exporting and who for importing the goods, and the associated licences and authorisations required. If EXW is the applicable delivery term, any clause which requires the seller to ensure all licences and authorisations are obtained to export the goods is inappropriate. Under EXW terms, the seller has no obligation to obtain export clearances. This is done at the buyer’s risk and expense. If the intention of the parties is that the seller should organise for this, FCA should be used instead.
If incorporated correctly, Incoterms can play a very useful role in supply contracts by maximising efficiencies both in the drafting process and ‘on the ground’ since they are universally understood and eliminate the need for extensive obligations. Too regularly though, the procurement of critical equipment on projects is done ‘on the run’ using supply contracts that are not consistent with the Incoterms specified in them.
All of these issues can be dealt with in quite a straightforward manner if proper consideration is given ‘up front’ to the terms of a supply contract and its consistency with Incoterms. There are different approaches that organisations can take, including:
- amending their supply contracts on a case by case basis depending on the Incoterm selected. This approach may be appropriate where a company seldom contracts for the supply or purchase of goods incorporating Incoterms; or
- preparing a supply contract that is sufficiently flexible with embedded options that turn clauses “on” and “off” depending on the Incoterm selected. This approach is appropriate where a company contracts regularly for the supply or purchase of goods applying Incoterms