Focus on types and features of long-term supply contract disputes

By Vincent Mu, Martin Hu & Partners
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In recent years, with the Chinese economy entering a relatively weaker phase after super rapid growth, disputes arising from long-term supply contracts have become a focus of attention in the legal service market. From what we have seen, with the shock of long-term supply contracts, hardly any industry has escaped unharmed, and in certain industries the “disaster” has been particularly severe.

牟笛 Vincent Mu 胡光律师事务所 资深律师 Senior Associate Martin Hu & Partners
牟笛
Vincent Mu
胡光律师事务所
资深律师
Senior Associate
Martin Hu & Partners

For example, since the entire iron and steel industry fell into the red in 2012, the production chain, including production and trade, has seen a huge number of disputes arise. Being unable to realise their raw material procurement obligations, upstream iron and steel enterprises have seen a sharp rise in disputes with their suppliers; and a great many downstream steel product trading enterprises, simultaneously battered by a sharp drop in steel prices and flagging steel demand, have fallen into economic difficulty, resulting in continuous friction with banks and other financial institutions. Statistics show that at the end of the first half of 2013, in Shanghai alone, non-performing bank loans arising due to the steel trade stood at approximately RMB150 billion (US$24.5 billion), and statistics on the non-performing loans of such private financial enterprises as private fund and small loan companies have yet to be compiled.

As a further example, supply disputes between supermarket suppliers and supermarkets have rapidly spread nationwide, causing supermarket enterprise operations to flounder. Following Tesco’s sale of a large portion of its China business to China Resources in the first half of 2013, there have been rumours that Walmart will close a number of its China stores or even pull out of the market altogether.

Taking into account his firm’s practice experience, the author will introduce two columns in successive issues to give readers an idea of the types and features of, and the strategies for responding to and guarding against, long-term supply contract disputes. In this issue the types and features of these contract disputes will be explored, and in the following issue methods of responding to and guarding against them will be examined.

Types of disputes

The word “supply” in a long-term supply contract easily leads directly to an association with sale and purchase contracts. However, the author believes that, taking into account what is actually occurring in the market at present, a broader interpretation should be given to long-term supply contracts. In addition to sale and purchase contracts, all types of such contracts as lease contracts, processing contracts, distribution agency contracts, etc., can be subsumed under long-term processing contracts. Even though the Contract Law classifies them as different types based on the different above-mentioned contract law relationships, in essence all of these types of contracts are of a “supply” nature, with their differences being only the specific thing supplied, namely things, use rights, tailor-made items or services.

Viewed from the perspective of the type of dispute, long-term supply contract disputes may be divided into two types: “alteration” and “termination”. In the former type, the objective of the party instituting the suit is not to completely avoid performing an executed long-term supply contract, but rather to revise the contract terms, particularly the key commercial terms. In the latter type, so-called “termination” needs to be interpreted broadly; in other words, the party instituting the suit wishes to completely avoid actual performance of the contract through rescission, invalidation, termination, etc. In this case, the means are clearly more radical. From what we have seen, the great majority of parties operate on the principle of “aiming higher to get what they want”, whereas in practice, those suits in which termination of a contract or alteration are directly sought are relatively rare.

Distinguishing features

Even though each specific case has its unique particular factual background, in general long-term supply contracts nevertheless have certain features in common.

First, long-term supply contracts generally have a material impact on, and in some cases even a decisive material significance to, an enterprise. In several of the material long-term supply contracts in which we have had a hand, the parties to the contract, in order to fulfil the performance conditions for “supply”, additionally needed to carry out a series of preliminary preparations such as company establishment, project construction, personnel recruitment, equipment procurement, etc. Under such conditions, once a dispute over “supply” arises, it necessarily signifies major monetary costs and opportunity losses for the parties to the contract. It is precisely for this reason that, horizontally, decisions on long-term supply contracts will usually go beyond the authority of the legal affairs department and involve the finance, technical and other such departments; vertically, they will usually exceed the control of the PRC area entity, rising to the level of the global headquarters. It can be said that the communication and decision-making costs in such cases far exceed those of ordinary cases.

Second, although the substance of the legal disputes surrounding long-term supply contracts is usually relatively simple, the financial and/or technical backgrounds may be supremely complex. The types of contracts enumerated above – sale and purchase, lease, distribution agency, etc. – are all contracts that are frequently employed in commercial intercourse, and legally speaking it is difficult to find novel points of dispute. However, with an ever increasing complexity and specialisation of business activities, these types of contracts often contain a large quantity of financial and technical details that are unfamiliar to in-house legal counsel and lawyers, greatly increasing the difficulty and pressure of work.

Third, long-term supply contract disputes are difficult to settle, but they often end in settlement. Precisely because long-term supply contracts involve material interests, it is difficult for the decision makers of either party to rashly reach a settlement with the other party without going through a legal procedure. Accordingly, notwithstanding the fact that long-term supply contracts are usually accompanied by a lengthy and meandering negotiation and discussion process, contract disputes seldom achieve a genuine resolution as a result. Because the amounts involved in long-term supply contract cases are huge, their adjudication and enforcement will also often face more obstacles, ultimately spurring the parties to settle the case in mutual compromise. It is precisely this seemingly paradoxical situation that informs parties that they should duly plan their strategies based on the internal logic of such disputes so that they always find themselves in a relatively proactive position.

Vincent Mu is a senior associate at Martin Hu & Partners

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牟笛 Vincent Mu

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