Q198: What is the best Incoterm when exporting? (Part Two)

A198: This is Part Two of the answer; Part One is covered under A197.

To summarize Part One –

Assuming that they elect to use Incoterms Rules, then, as EXW and DDP are classed as domestic transactions and as the F-prefixed terms are prohibited, and further, with CFR/CIF and DPU all being physically unlikely if not impossible, the South African Seller has only two options when exporting,

These options are CIP (Carriage and Insurance Paid to) and DAP (Delivered At Place). There may be overriding conditions when the Seller cannot arrange insurance for the Buyer, in which case CPT (Carriage Paid To) might arise, but this is a poor second to CIP and should be approached with caution, particularly in seafreight.

In this Part, we need to look at how the Seller may make the choice between CIP and DAP, and what additional factors influence that choice.

Although choosing one Rule over the other depends on several considerations, the most important of these is the Seller’s risk appetite, and this is perhaps best measured by considering how the Seller is paid.

However, as Incoterms Rules deal primarily in the division of physical risk, the Seller’s physical risk-appetite should be the starting point and the Seller’s position in this respect may be readily determined by posing the following hypothetical question.

Imagine that you quote a price to your Buyer’s door, but, once you hand over control of the goods to your carrier and the goods leave your direct care, the whole supply is reported as lost, damaged, or stolen; what would your position be, with regard to your obligation to the Buyer?

Ignoring the implications of insurance or whether, as the Shipper, you may have recourse to the carrier, from the Buyer’s perspective would you replace the goods at your cost – yes or no?

If you would, if the intention is not to involve or inconvenience the Buyer but to replace the supply and re-execute the order, then your physical risk-appetite is high. You believe that you are selling the arrival of the cargo: until such time as the Buyer receives the cargo you clearly do not believe you have completed your contractual obligation.

This approach to the contract would be signalled by using the DAP Rule.

A D-prefixed Rule means that the Seller carries the physical risk in the goods right up to the ‘named place’ written into the Rule. DAP is the Seller taking the obligation to make the goods arrive at that named place in sound condition, in the correct quantity, and on a specified date, or within a range of permitted dates.

As I say, DAP indicates a Seller with a high physical-risk appetite.

However, there is a second solution to the challenge of the cargo not arriving, and that is for the Buyer to take the risk of this loss, not the Seller, and for the Seller to have no obligation to repeat the supply unless and until the Buyer places a second (new and unconnected) order with them.

In this model, the Seller is not selling the arrival of the goods but only the documentation that evidences the despatch of the goods, carriage prepaid.

This approach to the division of risk is signalled by using the CIP Rule.

A C-prefixed Rule means that the Seller takes the initial transport costs to the named place, but that the Buyer takes the physical risk of loss or damage to the goods while they are in transit. Under the CIP Rule, the Seller must arrange insurance against the Buyer’s risk in this regard.

The insurance component is the Seller’s cost, but the insurance is not for the Seller; the Seller only sells documents and has no need of cargo insurance.

CIP indicates a Seller with a low physical-risk appetite.

But business is not coincidentally about money. Business is all and only ever about money, and yet commercial terms do not inform us on how payment is to be made or when.

Commercial terms describe the actions and events that give the Seller the ‘right’ to be paid, but they tell us nothing about how or when that right is exercised.

For example, it is a contradiction (but not an offence) for the CIP Seller to offer unsecured credit to the Buyer. I say this as, should the cargo not arrive, there is a very real risk that the Buyer will refuse to settle.

Certainly, the CIP Seller having met their obligation to despatch the cargo, and on tendering the contract documents to the Buyer, will have the contractual right to be paid, but having the right to the money and actually having the money are two different things.

In comparison, it follows that if the DAP Seller has no right to claim delivery until such time as the Buyer receives the contract goods at the named place (in sound condition and in the stated quantity), that the Buyer may wish to hold on to payment until that moment, or a later date.

Taking a broader view, we might then create a connection between the commercial term and the payment condition; aligning the Seller’s physical-risk appetite with their financial-risk appetite.

But we must allow that this connection does not exist in fact and is independent from the text and intention of the Rules.

Yet if we see the means and method of payment reflecting and reinforcing the Seller’s physical-risk appetite, we might expect the low-risk CIP Seller to opt for a low-risk payment method.

We would expect the CIP Seller to be prepaid or, failing this, to have bank security triggered by the sale of documents (such as a Documentary Credit), given that the sale of documents is at the heart of all C-prefixed terms.

Conversely the high-risk DAP Seller might perhaps offer unsecured credit, linked to the successful acceptance of the goods by the Buyer. It need not be this way, of course. The D-prefixed seller might also secure a prepayment, but then the Buyer would need to accept that they have no leverage to make the Seller perform, should they fail in the obligations of the D-prefixed delivery.

From a purely South African perspective, note how the low-risk model of being prepaid in a CIP contract eliminates the Exchange Control risks for the Resident, and almost eliminates all the documentary and procedural risks of the zero-rated Vendor, whereas the high-risk model of credit under DAP dramatically increases the Resident’s Exchange Control risks and the Vendor’s VAT risks.

The overall position is that the prepaid CIP Seller has control of both the money and the cargo before they achieve delivery; whereas the DAP Seller at the moment of delivery has neither the cargo nor the money.

To the question then: What is the best Incoterm when exporting?

CIP, provided that the Seller has payment secured.

But if the Seller is perhaps in an intercompany relationship or involved in a long-term contract where they believe they have other leverage in the event of a disaster, selling DAP with unsecured credit remains an option. It is not a particularly good one but it remains an option, nonetheless.

In all matters of trade, always work within the constraints of your company’s risk appetite.

But to do so, of course, you must first know what your company’s risk-appetite is.

Some merchants have no idea what their risk appetite it, and they merely lurch from crisis-to-crisis making it all up as they go along. Why, some even appear to have the risk appetite to not bother with training, preferring to use experience as their teacher.

Although, to be fair, not everyone is that dumb.

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