To date the coronavirus has been primarily (and understandably) been seen through the prism of public health concerns.
However, it is clear the virus will lead to economic issues. China today is a major part of global supply chains. Germany may be particularly at risk given its high level of trade with China. China was Germany’s most important trading partner in 2019, with a volume of trade slightly above 200 billion euros.
The outbreak is likely to particularly hit the automotive sector which was already struggling. Wuhan is a major hub for China’s automotive industry. Also international automotive JVs still have not reopened their factories in China. International automotive manufacturers in Korea and Japan have already shot down production as their factories are cut off from Chinese components. If a plant in Wuhan stops work then this has the ability to disrupt work in a plant in Munich.
The main issue will be how quickly factories restart. It should be noted that most of the closure has overlapped with the Chinese new year holidays so much of the current production stoppage to date has been factored in. However, the situation may become more critical depending on how long factories continue to be shut down and the effect upon shipping.
German companies with exposure to China will likely see:
- Suppliers that cannot deliver on time or possibly at all, or want to change the goods to be delivered;
- Buyers seeking to escape contracts due to an unprecedented drop in demand;
- Shipping companies will face issues as cargo levels will not meet fuel costs;
- Some suppliers or buyers may face the risk of insolvency.
Likely means to escape contracts will include force majeure claims, claims to adjust contract due to change in circumstances or claims that letters of credit should be blocked for reasons of fraud. Shipping may be disrupted so that even if your components are ready for delivery the ship may not be. Trading with a supplier or buyer who may become insolvent will lead to a myriad of issues – a major one being whether one is still compelled to continue to supply.
Which Law Applies? – supply contracts with Chinese partners are not mandatorily required to adopt Chinese law. Accordingly, there is a chance that the contract may be subject to Chinese law or German law or in some cases a different law on the somewhat illogical basis that it is neutral to have a law that neither side is familiar with (Swiss law is popular). An added complication could be that companies have a framework agreement governed by Chinese law but make their purchase orders subject to German law. As will be seen below there are differences based upon the selection of the law.
Jurisdiction – probably the most important clause in a contract but often an afterthought. You may have the world’s best contract but if you select the wrong jurisdiction it is for naught as you will not be able to enforce your hard negotiated contractual rights. In some cases German companies will insist upon German courts. This does not contravene PRC law. Indeed a final judgment given by a foreign court may be technically enforced in a court of the PRC in accordance with the Laws on Civil Procedures of PRC, provided that the country in which such courts are located has a reciprocal relationship in respect of judicial assistance with PRC or such country and PRC are co-members of international treaty for judicial assistance. If no such relationship or treaty exists (as is currently the case) then enforcement will depend on the discretion of the PRC court. It should be noted that in almost all cases the PRC courts will exercise their discretion to not enforce such overseas judgment.
Accordingly, German courts are an excellent choice if your Chinese partner is asset heavy in Germany. If not, then if you are confronted with a problem with a contract you will need to consider the practical problems in enforcing said contract in China. If the contract has arbitration or Chinese courts then it is likely that such contract could be practically enforced against the Chinese partner.
Force Majeure Clauses – Often, supply contracts contain contractual clauses on force majeure events. There have already been high profile claims of force majeure being made by large state-owned companies in respect of commodities. It is clear that the virus outbreak has led to a huge drop in demand as well as to production shortage due to factory closures. However, force majeure is not carte blanc to walk away from contractual obligations.
The China Council for the Promotion of International Trade (CCPIT) has set up an online system to issue qualified applicants certificates of force majeure (available at https://www.rzccpit.com/). The CCPIT is a nationally recognized international trade and investment promotion agency. However, such certificates will not on their own be sufficient to support a force majeure claim. In Germany, such certificates will not be more than an indication that there might be a force majeure event.
Both under Chinese and German law a mere drop in demand or price are usually no grounds for claiming force majeure. The vast majority of force majeure claims of Chinese buyers will likely fail because the buyer will not take sufficient care to build a case to persuasively show the force majeure event prevents them from fulfilling their contractual responsibilities. However, a Chinese supplier whose factory was shut down by public order has better chances to successfully invoke such clause against its German customer. An official order will hardly exist in all cases. In most cases, Chinese suppliers invoke only general obstacles, which will usually not be sufficient to prove force majeure.
Change in Circumstances – Both German and Chinese law consider a material change in circumstance can be sufficient for relief to the affected contractual party or an adjustment of the contract even if there is no contractual clause on force majeure.
The PRC Supreme People’s Court does have an opinion requiring an adjustment in cases of force majeure if there is an objective situation that has changed the commercial realities of the contract. In such case a Chinese court may set aside a contract even if it does not prevent a party from performance.
Under German law, a contractual party is not obliged to fulfil a contractual obligation as long as this is not possible. Further, if there is a material change in circumstances which have become the basis of a contract, an adjustment can be required in exceptional circumstances. Therefore, a supplier that has to shut down its plant due to public order or could only fulfil the obligations by severely endangering the health of its employees can probably get relief from its contractual obligations. However, this does not change the German law principle that the risk to be able to resale the goods is generally with the buyer. In any event, economic consequences for both supplier and buyer need to be thoroughly considered under German law in a case by case analysis.
Allegation of Fraud in L/C – there have been a number of cases in which Chinese buyers have sought to have L/Cs blocked on the basis of a claim in fraud brought before a Chinese court. The drop in demand and drop in prices will increase the likelihood that desperate Chinese buyers may bring such claims.
What to Do?
German companies will be facing heightened risk of Chinese buyers and suppliers attempting to escape contractual obligations. The most likely claim will be for force majeure but do not underestimate Chinese buyers seeking to block L/Cs via onshore local actions. Most of the force majeure claims of Chinese buyers will likely settle or ultimately fail due to poorly constructed claims. Claims of suppliers might be more successful. However, we assume many German companies will not wish to burn their relationships with Chinese trade partners for the long term.
Claims based on a change in circumstance before a Chinese court will introduce a large element of uncertainty as the Supreme Court Opinion provides wide discretions to set aside contract. The same applies to claims in German courts, where a case-by-case analysis will be decisive.
Claims of fraud in L/Cs are problematic. Such claims are often employed to seek to obtain leverage for a better settlement. In such cases it is important to defend the case immediately and seek to avoid the Chinese courts.
German companies with Chinese suppliers or customers would be wise to check their contracts (especially as to governing law and jurisdiction) in order to assess how likely a force majeure claim or other action is and what their attitude towards such claim should be (i.e. find delays; agree to cancel; agree to a settlement etc.). German companies should take measures at an early stage – even before the expiry of delivery or other performance deadlines – in order to be ready to take legal action accordingly. In addition, they should examine whether the threat of non-performance or poor performance of their claims against Chinese companies may result in a breach of their own obligations towards their own customers: In this case too, the companies should assess the legal situation at an early stage and take appropriate measures.
Hopefully the crisis will pass in the near future, but it is still important to consider its effect upon on-going business.