China Trade Terms: Just Do It Right

We are not being pedantic. We just want to help.

Listen everyone: if you purchase product from China, do not use FOB as a shipping term. Use FCA or CIF (my favorite) or even EXW. But eliminate FOB from your vocabulary starting NOW. After you do that, get a copy of Incoterms and learn what the above shipping terms mean and use them exactly as specified. Do not use the UCC. Use Incoterms only. Do not edit the terms. Just do do it right. If you do this, you do not need to read this post. But if you want some background, read on.

Before you decide this is just a trivial issue, think again. Before you go on, I want you to get on the Internet and look at some photos of the Tianjin Port after the recent tragic explosion. Now consider: reports are that over $600 million of autos and other items were destroyed while sitting in the port. Now think about who bore the loss of that destruction. Was it the seller or the buyer? Will any insurance company pay for the loss? Or did they escape the obligation to pay because in fact no insurance covered the items sitting in the port waiting for delivery? If you thought the issue was trivial before, maybe that $600 million bill will make you think again.

So think about it. You are a US or EU company that purchases product from China pursuant to a contract manufacturing arrangement. The completed product is packed into a container at your Chinese factory, transported from that factory to the port by truck. The container sits in a processing yard at the port for a week and then is finally loaded onto the ship.

There is a lot that can go wrong in this process. For today, we will consider the issue of risk of loss. That is, who gets paid if the container is lost? What happens if the truck carrying the container to the port is involved in an accident and the entire shipment is destroyed? What happens if the container is stolen from the port? What happens if there is an explosion at the port and the container is destroyed? What happens if the ship sinks in a storm in the Gulf of Alaska? What happens if the container is offloaded and the same misadventures happen before the container is delivered to you, the buyer, at your facility in the United States?

Risk of loss is determined by the shipping terms used for the transaction. For international shipments, shipping terms have been carefully developed over many years and are embodied in Incoterms as written by the International Chamber of Commerce. Incoterms cover virtually all of the important issues relating to the international shipment of goods. Selection of a single term resolves virtually all of the important issues. For this reason, every buyer must decide what term will be used and then operate in compliance with the selected term.

When I discuss this with clients, I find they are indifferent. When I insist they confront this issue, they become irritated. They suggest my insistence on precision is just an international lawyer’s pedantic obsession with no application to the real world of business. The opposite is true. Risk of loss is a fundamental issue for all international trade business. Failure to do it right is not a technical issue. Failure to do it right is a life and death issue for both sellers and buyers. The Tianjin explosion illustrates why.

So where does risk of loss transfer? This issue is decided by the choice of shipping terms. In my experience, most U.S. and EU buyers make the mistake of choosing Free On Board (FOB) as their shipping term. They make this choice as a pricing term. That is, they chose FOB to ensure the price of the product does not include the price of insurance and freight to ship the product from China to the U.S.

When they chose FOB, these inexperienced buyers do not account for their risk of loss. Under FOB, risk of loss passes only after the product has been loaded onto the vessel (crosses the rail). Since risk of loss transfers when the product crosses the rail, the buyer purchases insurance that covers the product at that point. Now ask yourself: who has the risk of loss from the time when the product leaves the factory until the time the product is loaded onto the ship? The answer of course is that the factory has the risk of loss.

But I have NEVER encountered a case where a Chinese company has purchased insurance for the brief period between when the product leaves its factory until it is loaded on the vessel. The factory just assumes the buyer has purchased insurance AS IF the risk transfers when the carrier takes delivery. But this is not true.

In my experience, during the period between delivery to the carrier and loading on the vessel, the risk of loss for the product is uninsured. If the buyer is aware that the product in uninsured, then that is a risk the buyer willingly assumes. However, once again, I have never worked with a buyer that understood they were taking this considerable risk with product they may already have paid for. That is, many Chinese factories will demand full payment at the time the product is put into the control of the carrier. They do not want to wait until the product is loaded on the vessel since they can never be sure when this will happen.

The solution to this problem is simple. Use the right shipping term. As the drafters of Incoterms clearly state, for modern shipping by sea, the FOB term should never be used. The proper term is Free Carrier (FCA). Under FCA terms, risk of loss passes when the shipment is put into the custody of the carrier. It does not matter where the carrier takes delivery. It may be at the factory or it may be at the port. Since the buyer can be certain where risk of loss passes, the buyer can be certain that it has obtained the appropriate insurance. The issue of insurance is not left to the seller. The responsibility and benefit of insurance rests on the buyer which is where it belongs.

A related and even more difficult problem arises when buyers define their own terms that simply make no sense. In this area, the problems arise when buyers confuse risk of loss, transfer of title and acceptance of product. In a recent case, I reviewed a contract where a buyer provided the shipping term would be FOB, but risk of loss would transfer only after the product was delivered, inspected and accepted. FOB means risk of loss transfers when the shipment is loaded on the vessel. It does not mean anything else.

For this reason, the language provided by the buyer simply did not make sense. In fact, there is NO shipping term that provides for transfer of risk of loss under these terms. In this case, the buyer has confused risk of loss with acceptance of the goods, two entirely unrelated concepts. But, by providing internally incoherent contract language, the buyer did nothing but harm themselves. The only possible result is that insurance for the product would be purchased on entirely random terms. If the shipment is lost, will the insurance company pay? If it pays, who will it pay: the factory or the buyer? Who knows.

The purpose of a contract is to make business terms more predictable. This failure to use standard terms in the standard way makes the situation less predictable, all to the detriment of the buyer. Why do that? It makes no sense to me. So just stop it and do the right thing. It’s for your own good.

3 responses to “China Trade Terms: Just Do It Right”

  1. sorry to draw your attention on a mistake in your text
    “risk of loss passes only after the product has been loaded onto the vessel (crosses the rail)”
    since 2010, the notion of rail has been abandoned and the risk passes to the Buyer when the goods have been “put to disposal onboard the vessel”…
    for the rest, I share your opinion : FOB is totally unadapted to modern shipping. The same occurs with CFR and CIF, because NO container shipping line in the world offers a freight which strictly covers the place of delivery/transfer of risk/cost of those incoterms. Consequently, there is necessarily always one, Seller or Buyer, who pays too much… if not both, fi when THC a port of destination are prepaid and shipping line collects them again from Buyer…

  2. Strictly speaking I don’t think EXW is possible in China because the buyer cannot do the export customs declaration. They can use a customs agent for customs clearance but the export declaration needs to be done by the exporter.

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