Insurance And Cargo

Question from Mr. Abdul Majid, Pakistan:

Is it important to pay insurance for export of rice ?

I believe you are looking at the point of a seller or exporter, and whether or not a seller should take up cargo insurance when exporting rice. I would rather share an open ended comment.

One of the most important aspects on which the Insurance works is called "insurable interest". In layman term, it means you will either benefit financially from their safe arrival at the point of delivery OR you will lose out in the event of loss, delay or damage. Keyword here is "losing out in the event of loss, delay or damage". The events leading to loss, delay or damage to the goods are uncertain, they may or may not happen. Mostly are out of our control, like fire, war, accident, negligent, act of God, riot, theft, default, perils, etc. The fact remains, the possibility of any of these factors to happen is ever present.

The Hague-Visby Rules, article 4, clearly indicates disclaimer on the part of the carrier with regard to the loss of, damage or delayed to the goods. The liability of the carrier is very limited. It simply means, in the event of mishap, you would not be able to recover the value of the goods, you lost the cargo, capital and profits.

Now, the question is, it doesn't matter what goods you are exporting, are you willing to lose your cargo, capital and profit? Can you afford it? All the times?

Incoterms 2000 however, does not indicate "obligation" in A3 & B3 (Contract of Insurance) both for buyer and seller for all trade terms except CIF and CIP only. Buyer does not owe a duty to seller to procure insurance for his own benefit and vice versa. It is clearly not an obligatory, but this does not mean insurance is unnecessary. Of course insurance is an 'additional' cost which does not add value to the goods and considered 'gone' payment. But in the event the mishap happens, it makes a lot of different between gone and gain.

FOB and Cargo Insurance under LC

Question from Indian trader:

Insurance is a must why? To whom it is necessary? But sometimes the seller may feel that for FOB shipments,their responsibility stops on shipping the goods: This is not so,business should be a continuous process with another trader: If there is any negligence on the part of the buyer.It is prime responsibility of the seller to insure the goods: he can inform this and get the small amount from the buyer.

I don't quite get what you want to say. But I believe that you are saying the seller should take up cargo insurance if there is a negligent occurs on the part of the buyer.

First and foremost, in actual fact, transfer of risk from seller to buyer starts before the goods pass the ship's rail and on board the vessel or before the delivery point. If the buyer fails to arrange the vessel on the date and time as agreed, where seller is unable to load the goods, the risk passes to the buyer.

Secondly, buyer is also to bear the risk from the point of delivery onwards. On both situations above, buyer is said to have an "insurable interest" to the goods. Therefore, it is necessary for the buyer to procure cargo insurance even though it is not obligatory.

The question is, can the seller procure the cargo insurance for the benefit of the buyer on both situations above? Or can the seller take up cargo insurance for the benefit of the buyer under FOB?

Of course yes. The seller can also take up cargo insurance for the benefit of the buyer PROVIDED that the local law in both countries permit it. Both parties may agree on this arrangement and it must be precisely and expressly stated in the sales contract. This also applies to contracting a vessel. This however, does not change the important features of FOB term. It cannot be termed as "FOB+I" or any other weird terms just to signify that seller is to procure the cargo insurance. Under this situation, seller is not under obligation, but merely offering an ADDITIONAL SERVICE to the buyer. The accountability and responsibility to procure cargo insurance under FOB, still lies on the buyer.

Basic Operations

The documentary credit is the “traditional form of letter of credit created as a payment and financing mechanism for international sale of goods”. A typical documentary credit operates in the following way.

Suppose a seller in Malaysia wishes to sell some goods (e.g.: Palm Oil) to a buyer in Russia. Suppose further that the parties have not previously entered into any business relationship, thus they do not know each other. Although both parties are willing to enter into a relationship, they are very concerned about the other party’s financial reliability.

The seller wishes to get paid as soon as he has shipped the goods. He is afraid that, after shipping the goods the buyer may refuse to pay the purchase price, or even become insolvent. In both cases, the seller may have to engage himself into lengthy negotiations, or sue the buyer to seek enforcement of payment by the court, which will certainly incur great expenses. Not to mention the costs of shipping back the goods or storing them in the original country of destination until further actions.

On the other hand, the buyer is concerned that he may not get the goods in the agreed quality and/or quantity, thus he is not willing to pay unless he inspects the goods.

In a situation like this, where the buyer and the seller are distant from each other and transportation of goods is inevitable, it is impossible to have the seller paid upon shipment and at the same time allow the buyer to pay only upon inspection of the goods.

When difficulties such as distance, different currency (fluctuation of currencies), culture and foreign laws have to be dealt with, the parties are most likely willing to fall back on legal instruments, which reduce the risks both seller and buyer have to face in an international sale of goods.

One of these instruments created by the international trading community is the commercial letter of credit. By agreeing to a commercial letter of credit the parties invite a third, trustworthy party – a bank – into their relationship. Upon the buyer’s request, the bank will open a letter of credit in favour of the seller, agreeing “to assume the primary, direct and independent obligation to honour the seller’s draft presented under the letter of credit provided that complying documents specified in the letter of credit are tendered”.

This way the seller is assured that he will receive payment from an individual “paymaster” regardless of the financial situation of the buyer. On the other hand the buyer is also assured that payment will only be effected if the conditions, set by the buyer and appearing in the credit, are completely fulfilled.

In a basic letter of credit transaction three parties are involved: the buyer (usually referred to as the “Applicant”), the bank and the seller (usually the “Beneficiary”).

Revocable LC goes stealth under UCP 600

It is interesting to note that the concept of ‘revocable’ has no longer exists in UCP 600 where LC now is considered to be irrevocable to further strengthen the doctrine of ‘undertaking’. This has been highlighted in few of articles:

Article 2, “Credit means any arrangement, however named or described, that is irrevocable…”.

Article 3, “A credit is irrevocable even there is no indication to that effect.”

Article 10, “…a credit can neither be amended or cancelled without the agreement of the issuing bank, the confirming bank, if any and the beneficiary…”

These articles provide a guarantee to the seller that in any event, should the buyer wish to cancel the LC that has been issued, several parties must also agree to the said cancellation; issuing bank, confirming bank if any, and the seller. In another words, if the LC is to be cancelled, all parties must be aware of it and agree to it. In the absence of such cancellation notice and agreement, the undertaking of the bank to pay, shall stand in effect. The seller need not worry about getting paid and the buyer need not worry about making payment for his purchase.

So, premised on the above, trading parties especially the sellers, can be said to be in a safe harbour.

The question now is, is irrevocability an ultimatum? Is revocable LC no longer an option because the word ‘revocable’ has been totally deleted from the revised UCP?

The very beginning of UCP 600, Article 1, which reads “The Uniform Custom Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 (“UCP”) are rules that apply to any documentary credit (“credit”)(including, to the extend to which they may be applicable, any standby letter of credit) when the text of the credit expressly indicates that it is subject to these rules. They are binding on all parties thereto unless expressly modified or excluded by the credit.”

Firstly, this article says that all parties are bound by UCP 600 when the text of the credit expressly indicated that the LC is subject to these rules. Secondly, this article does not prohibit modification to any of the articles.

Finally, this article also does not prohibit exclusion parts of the articles. This article gives us an understanding that irrevocability of an LC is not an ultimatum as it allows and provides room for revocable LC to operate. It is therefore very important for seller and buyer to fully understand the implication of this article to avoid financial loss. The contract of sales should be expressly stated that the LC is subject to UCP 600 and INCOTERMS 2000. If, however, both parties agree to modify or exclude certain article or rules, this must also be expressly stated in the contract of sale to avoid further dispute.

Principle of Autonomy

If the seller ships the goods which are not up to the buyer’s expectation, can the buyer get the bank to cancel payment under LC? For example, the letter of credit says, ‘milk powder grade A’ but seller shipped ‘milk powder grade B’. Can the buyer instruct his bank to stop payment of the LC which has been issued to the seller?

Letter of Credits are separate contract from contract of sale and other contracts existing which bind the parties involved in an international trade transactions. This is clearly stated under article 4 and article 5 of UCP600. LC is only concern with payment and absolutely has nothing to do with goods.

The dispute in any of these contracts shall not form grounds for non-payment of an LC. Regardless of any disputes, seller is still entitles to payment under LC. Disputes between parties should be settled by litigation or arbitration or otherwise as stipulated in the contract. This principle is clearly emphasized in one of the popular cases, Hamzeh Malas & Sons v. British Industries Ltd.

The plaintif, a Jordanian firm, had contracted to purchase from the defendant, a British firm, reinforced steel rods to be shipped in two instalments. Payment was to be effected by way of two LCs. The first instalment was delivered and payment was obtained by the seller. The plaintiff then complained that the first instalment was defective and sought to enjoin the defendant from drawing under the second LC.

The court commented:

“…the opening of a confirmed LC constitutes a bargain between the banker and the vendor of goods, which imposes upon the banker an absolute obligation to pay, irrespective of any dispute there may be between the parties as to whether the goods are up to contract or not…A vendor of goods selling under the insurance that nothing will prevent him from receiving the price…”

Based on the judgment passed by the court of law, it is important to understand that in LC transaction, payment is 100% guaranteed but it is not an undertaking to guarantee the goods.

Doctrine of strict compliance

If the problem of interpretation of strict compliance is regarded from importer´s, exporter´s and banker´s view, it will lead to different results. The interest of the exporter can be easily determined: he wants to receive payment against the documents, even there are (relevant) mistakes.

So, an exporter will plead for the substantial compliance which offers more tolerances to him. A bank is interested to receive its charges and commissions without or with little risk. On the other hand, it must keep its reputation which can hardly been reached if every irrelevant mistake will lead to an obligation to refuse payment.

So, the interest of a bank is to make decisions on its own. For it, the literal compliance in a wider sense offers the best possibilities: obvious typographical errors do not lead to an obligation to refuse; on the other hand it can refuse payment in cases of doubt and is not obliged to examine the documents materially or finds itself as an arbitrator between applicant and beneficiary with the risk that it pays, but is not reimbursed and must lead a process.

Regarding the importer, it is not easy to say what interpretation of strict compliance he would prefer. Of course, he would not prefer the substantial compliance because it would lead to additional risks for him if his stipulations were not exactly fulfilled and the bank took up the documents in the belief that they are substantial equal. In such a case, a huge process risk would occur for him if he refused to pay the bank. But also it is not quite clear if the strict literal compliance offers more flexibility for him: the chance to give instructions to the bank if there are typographical or irrelevant errors make it possible to exploit the situation and claim new negotiations about the price with the beneficiary.

On the other side, a situation can occur when a bank has got own interests like financing the goods by credit: in such a situation, exporter and importer perhaps both want the sale contract to be fulfilled even there is an irrelevant error, but the bank refuses to pay because for example, the interest rates for a credit have been raised or because the credit-worthiness have been changed. So it is more secure for the importer if strict compliance is interpreted as wide literal compliance.

UCP 600

Effective July 2007, UCP 500 will be no longer effective in governing the application and operations of Letter of Credit. UCP 600 will be the new governing set for all parties concerned; bankers, traders, transport operators, insurance companies, lawyer etc.

One of the major changes is article 14(b). This new article defines the number of days required to hold the documents for processing or examining by banks. The ‘reasonable time’ in article 13(b) of UCP500, as expected, has been eliminated and replaced with a definite 5 banking days in UCP600. Now, the issuing bank, nominated bank or confirming bank (if any) shall each have a maximum of 5 banking daysto process, examine and determine whether the documents are in compliance with the terms and conditions of the LC. If the documents are to be rejected, the notice to this effect must also be made within this new time frame.With this new change, trading parties, buyer and seller can expect faster payment.

In addition to this, articles 16(c)(iii)(a) and 16(c)(iii)(d) provide comfort to the seller where seller has a control over the discrepant documents.In the event the bank refuses the documents due to discrepancies, it will hold the documents pending further instruction from the presenter on how to dispose the documents. Seller may also provide such instruction at the time of tendering documents to his bank. In this condition, even if the bank has decided to refuse payment, the bank somehow will act in accordance to the instruction given by the presenter. The bank either waits for the instruction from the presenter while waiting for the buyer to waive the discrepancies or acts accordingly to the instruction given by presenter on the covering schedule. This new article however may expose buyer to a new threat or rather create an opportunity to the seller when dealing with commodities. When price has appreciated and documents are discrepant, seller may not want to release the documents to the buyer.