Incoterms and Letters of Credit: How the Two Work Together

An Incoterm and a letter of credit do different jobs, and problems arise when a company chooses one without thinking about the other. The Incoterm decides delivery, cost and risk. The letter of credit decides what documents you must present to get paid. Those two sets of requirements have to be compatible, and quite often they are not.

Why the two collide

A letter of credit is a bank's promise to pay against documents. Banks deal in documents, not goods. If the credit calls for an on board bill of lading and you present something else, the bank refuses, whatever actually happened to the cargo.

The friction is this. Your Incoterm decides when delivery is complete. If delivery under your rule happens before the goods are on a vessel, you may have fully performed your obligations and still be unable to produce the document the bank wants.

The FCA problem, and the 2020 fix

This is the classic case, and it explains a lot of otherwise odd contract drafting.

FCA is the correct rule for containers. Delivery is complete when the seller hands goods to the carrier named by the buyer, which happens at a terminal or yard, before loading. Because delivery is complete at that point, the seller has no right to require the carrier to issue an on board bill of lading. But letters of credit routinely demand exactly that document.

Sellers responded by using FOB instead. It let them get the document and get paid, at the price of carrying risk until the container was loaded, which is the wrong risk profile for containerized cargo and the reason so much Gulf documentation still shows FOB on box shipments.

Incoterms 2020 introduced an optional mechanism. The parties may agree that the buyer instructs the carrier to issue an on board bill of lading to the seller once loading occurs. The seller then has the document the bank requires while keeping the correct FCA risk profile.

Two conditions. It is optional, so it must be written into the sale contract. And the letter of credit must be consistent with it. Agreeing the mechanism in the contract while the credit still demands something incompatible achieves nothing.

Which rules fit letters of credit comfortably

The sea rules. FOB, CFR and CIF were built around vessel loading, so an on board bill of lading falls out of them naturally. For genuine bulk cargo this is straightforward and remains the norm.

CIF and CIP. These require the seller to provide insurance, which suits credits that call for an insurance certificate. Remember the 2020 split: CIP requires all risks cover, CIF only the minimum. If the credit specifies a cover level, check the rule matches.

The delivered rules. DAP, DPU and DDP sit awkwardly with letters of credit. Delivery completes at destination, often after the bank would expect presentation, so payment and delivery fall out of step. They are usually better paired with open account or documentary collection.

EXW. The seller may have no transport document at all. Rarely a good fit.

Practical checks before you sign

• Read the document list in the credit before agreeing the Incoterm, not after.
• Confirm the named place in the Incoterm matches the ports or places named in the credit.
• If the credit calls for an insurance certificate, make sure the chosen rule actually obliges someone to buy insurance. Only CIF and CIP do.
• Check that the insurance level in the credit matches the rule. CIP gives all risks, CIF gives minimum cover.
• If you are selling containers under FCA, agree the on board bill of lading mechanism in writing and make sure the credit accepts it.
• Watch the latest shipment date against your delivery point. Under a delivered rule your obligation runs well past loading.

Where this goes wrong

Most letter of credit rejections we see are documentary rather than commercial. The goods shipped, the buyer wants them, and the bank still refuses because a document does not match the credit. An Incoterm chosen without reading the credit is a common root cause.

The fix is procedural. Whoever negotiates the sale terms should see the draft credit before the Incoterm is fixed. In many companies those are different people who never speak, which is precisely why the problem persists.

Our Mastering Incoterms 2020 course covers the documentary implications of each rule, and Incoterms training explains what a full program covers. For the underlying rules, start with the Incoterms guide.

Frequently asked questions

Why do banks ask for an on board bill of lading?

It evidences that goods were actually loaded onto a named vessel. Banks pay against documents rather than goods, so the document is their proof of shipment.

Can a seller get an on board bill of lading under FCA?

Not automatically, because delivery under FCA completes before loading. Incoterms 2020 added an optional mechanism where the buyer instructs the carrier to issue one to the seller, and it must be agreed in the contract.

Which Incoterms suit letters of credit best?

The sea rules FOB, CFR and CIF fit naturally, as does CIP. The delivered rules DAP, DPU and DDP sit awkwardly because delivery completes at destination.

Does a letter of credit replace the Incoterm?

No. The letter of credit governs payment against documents. The Incoterm governs delivery, cost and risk. Both appear in the same transaction and must be consistent.

What insurance level applies under CIP and CIF?

Under Incoterms 2020 CIP requires all risks cover at the Institute Cargo Clauses A level. CIF requires only minimum cover.