Up Again Hong Kong: Suppliers and Contractors

Restructuring

1. Navigating the supply chain in a distressed market:

a. My company supplies goods and I am concerned about the solvency of my customers. Are there any steps I can take to mitigate risk/my exposure?

As a practical matter, suppliers should examine existing credit terms and consider whether to reduce the period of credit.

Suppliers should ensure that the contractual terms permit them to apply set-off of credit balances (if any) against any indebtedness outstanding.

Any well-drafted supply contract should contain a retention-of-title clause. These clauses allow the supplier to retain ownership over goods (and, in certain circumstances, the proceeds of sale) until the goods have been fully paid.

b. My company relies upon the supply of goods/services and I am concerned about the solvency of my supplier? Are there any steps I can take to mitigate risk?

Ensure that all goods which have been paid for and not delivered are clearly marked and identified as belonging to the buyer. The buyer should also ensure that the contract for sale includes a right to inspect the warehouse of the supplier to ensure the goods are properly identified.

Litigation and Regulation

2. How will legal disputes that have arisen as a result of COVID-19 or its effects (for instance, in relation to force majeure) be affected by restrictions being lifted and resuming business operations in whole or in part?

COVID-19 may have resulted in the imposition of restrictions (e.g. travelling and gathering restrictions) or cessation of business operations, which may lead to legal disputes.

By way of example, one party (Party A) may seek to rely on the doctrine of frustration (see below for meaning of the doctrine of frustration) or a force majeure clause (see below for the meaning of a force majeure clause) distribution contract as a result of the imposition of gathering restrictions. Legal disputes may arise when the other party (Party B) considers otherwise.

The doctrine of frustration is an established part of common law. A contract is frustrated where an event has happened that makes it impossible to carry out such obligations, or makes it only possible to carry out the obligations in a way that is very different from what was originally contemplated. In such cases, the contract will be at an end and the parties discharged from any further obligations.

Using the above example, if Party A relies on the doctrine of frustration, then it would generally claim that the distribution contract had come to an end at the time when the frustrating event happened – i.e. at the time the gathering restrictions were imposed. The parties’ respective obligation under the contract will be not be resumed when the gathering restrictions are lifted. When a contract is frustrated, the parties are discharged from the contract.

On the other hand, commercial parties may prefer greater contractual certainty by including express termination rights in contracts by virtue of force majeure clauses. Force majeure clauses operate so as to excuse performance of particular contractual obligations on the happening of certain specified events outside the control of one or more parties and makes the situation impossible for one or more parties to perform their obligations under the contract (these are known as force majeure events). It should be noted that there is no legal definition of force majeure, and what constitutes force majeure is a matter of contract between the parties and the wording of the force majeure clause.  Subject to specific wording of the force majeure clauses concerned, performance of the contract is usually suspended for a short period or the duration of the force majeure event, known as the suspension period. If the force majeure event is prolonged or permanent then the force majeure clause may allow either party to terminate the contract.

Going back to the above example, if Party A relies on a force majeure clause in a distribution contract instead of the doctrine of frustration, and assuming that the lifting of the gathering restrictions occurred before the end of the suspension period (i.e. before the termination of the contract is triggered), then the parties’ performance of the distribution contract may be resumed as a result of the lifting of the gathering restrictions. The effect to the parties’ performance of the distribution contract (if any) will be subject to the specific wording of the force majeure clause. In such circumstances, the dynamics of the legal disputes will likely be affected, while its extent will very much depend on the facts of each case.

3. How should you manage those disputes once COVID-19 restrictions are lifted?

First, review existing contracts to identify the force majeure clause, consider whether it applies as a result of the imposition of restrictions and, if it does, the extent of its application. If your existing contracts do not include a force majeure clause, you may consider whether the doctrine of frustration applies regarding the imposition of restrictions and, if it does, the extent of its application.

Second, identify and implement measures which can mitigate any potential consequences (in particular, any potential effects to the parties’ performance of your existing contracts) arising from the lifting of restrictions.

Third, follow closely to the developments of the imposition and lifting of restrictions so that appropriate measures can be implemented at a suitable time when the circumstances change.

Fourth, review the dispute resolution clause in your existing contracts and develop a commercial strategy to try to resolve legal disputes that have arisen or may arise as a result of the imposition of restrictions and the subsequent lifting of restrictions.

Fifth, if the parties want to continue working together in the future and the shared objective is to resume performance as soon as possible, in circumstances where no party is at fault, we recommend the parties try to communicate and understand more about the situations of both sides. Collaboration rather than legal battles may be the way forward.

4. What should you do when restrictions are lifted if you have suffered loss under a contract as a result of COVID-19 or the restrictions, but have not yet taken legal action in relation to that loss?

If you have not taken any steps to review your contracts, and especially your rights and obligations under the contracts, we recommend that you do so immediately.

Special attention should be given to the following areas:

  1. Review the relevant clauses under the contracts:
    • Governing law – you should check the governing law of the relevant contract, and the jurisdiction(s) where the obligations are to be performed (especially regarding any statutory or administrative restrictions regarding production, export/import and travel bans);
    • Force majeure events – you should review the relevant contracts to check (i) whether there is any force majeure clause; (ii) if there is one, whether its wording is sufficient to cover the outbreak of COVID-19 and any restrictions imposed by government authorities as a result; (iii) if it is sufficient, whether any notification and timing requirements for reporting the event are to be complied with on invoking the clause; and (iv) the consequences of the force majeure event;
    • Material adverse effect – parties may be entitled terminate the contract if there is an event that has material adverse effect; and
    • Variations – amendments agreed due to COVID-19 outbreak may need to be made in accordance with any contract variations clause (e.g. in writing).
  2. Assess how the performance of the relevant contract is affected by COVID-19, and whether any steps should be taken if it is desirable and legally feasible to terminate or vary the contract. Inaction for a prolonged period may be viewed as a waiver, and you should therefore start planning a roadmap as soon as possible.
  3. Consider whether you or your counterparties are required to take and have taken steps to mitigate the impact of COVID-19. For example:
    • where production halt has not been mandated in the applicable jurisdiction, what the affected party could have done to continue production during COVID-19 (e.g. protective measures, redeploying staff, recruiting part-time staff).
    • the affected party could have switched suppliers (e.g. used an alternative transportation company that is still in operation).
  4. Retain documentary evidence of steps you or your counterparties have taken, the reasons surrounding those steps, and steps taken to mitigate losses.
  5. If the contract contains notice provision on claims, notice should be issued on a timely basis and in accordance with the requirements of the contract.

In our experience, very often supply chain contracts would involve parties from different jurisdictions with multiple places of performance. This may lead to complex legal issues concerning conflict of laws. If so, we recommend you consult a lawyer.

5. Is there any risk of mass claims being brought against your business? If so, how would such claims be brought? Are third party funders able to fund such claims?

At the time of writing, the risk of mass claims in Hong Kong is low.

Though Hong Kong's common law legal system is well established, its class actions framework remains rather largely undeveloped. Unlike other jurisdictions with similarly advanced legal systems, Hong Kong currently does not have specific legal regime governing class actions or a set of procedures providing for separate forms of class action litigation, other than the only type of collective actions that exists in the form of representative proceedings under Order 15 Rule 12 of the Rules of the High Court (Cap. 4A).

As of today, maintenance and champerty still stand as criminal offences and torts in Hong Kong and would render a litigation funding agreement largely unenforceable in Hong Kong (except for claims brought by insolvent companies under limited circumstances, and for arbitration proceedings). Third-party funding is only permissible in arbitration in Hong King, not in court litigation.

6. What should I do about recording contractually or otherwise any of the changes put in place during the COVID-19 lockdown period?

Parties to a contract may agree to vary contract terms, but the variation must be recorded in accordance with the terms of the contract. For example, there may be a clause specifying that amendments are valid only if agreed in writing by authorised representatives of the parties.

If the contract does not specify any requirement for amendments, we would still recommend that the parties record in writing (and signed by authorised representatives) any amendment terms as agreed, to avoid any potential disputes in the future. Though oral agreements are generally enforceable in Hong Kong, disputes often arise as to issues such as the existence of an oral agreement, and what has been agreed.

In the event that the amendments, on their face, would benefit only one contracting party, it is advisable to record the amendments by way of a deed to avoid any arguments about a lack of consideration.

If any amendment has been agreed by the parties, the parties should review the entire contract to ensure the amended clauses are compatible with the rest of the contract.

7. Any return to normal will likely not be as immediate as the impact of COVID-19 when it started (e.g, sales/orders will take time to ramp up, raw materials will take time to flow through supply chains, etc.) what should I think about and do to best manage this in my contracts?

First, review your existing contracts to identify your rights and obligations, consider whether they have been affected by COVID-19, and, if they have, the extent of the impacts.

Second, consider moving to shorter-term contracts (e.g. three to six months) with your customers or suppliers/providers to provide greater flexibility for adjusting the pricing decision according to the supply/demand situation in the market.

Third, identify alternatives in the supply chain and consider including terms in contracts that can make use of such alternatives at time of disruption. For example, a supplier/provider may consider including provisions giving more leeway to the date of delivery should anything happens that delays the production and delivery of goods. On the other hand, a customer may consider including provisions allowing it to use an alternative supplier at time when the supplier/provider’s goods cannot be supplied as the production is too slow to meet demand, or when goods are unable to reach the designated destination due to border controls.

Fourth, enhance communication and consider including terms to that effect into contracts with your customers or suppliers/providers for the purpose of better managing the impacts of disruption together and minimising the risks of disputes. 

8. What additional protections or changes to existing provisions (e.g. force majeure) should I put into any new supply arrangements having regard to COVID-19?

Some contractual provisions may set out the consequences in case an unforeseen event occurs. These are usually referred to as force majeure clauses.

Such clauses would typically contain the following elements:

  • a range of non-exhaustive events that would be classified as force majeure events;
  • under what circumstances the force majeure clause would be triggered;
  • how the parties may trigger the operation of this clause, including any notice requirements; and
  • the consequences of the occurrence of such events.

Whether you are signing a contract as a customer or a supplier/provider, before you enter into a new contract it is important you review the draft contract to check:

  • whether there is a force majeure clause; and
  • whether the non-exhaustive examples of force majeure events or the definition of a force majeure event would likely cover epidemics/pandemics (i.e. including COVID-19).

If the contract does not contain a force majeure clause, in the event of an epidemic/pandemic like COVID-19, the contract may nonetheless be discharged under the common law doctrine of frustration, if the court is convinced that the event (COVID-19) would render performance of the contract physically or commercially impossible, or radically different from what the parties have agreed.

That being the case, arguably it would be better for parties to include a force majeure clause to agree in advance the consequences of the occurrence of such an event – for example, whether the time for a party to perform its obligations is to be extended, or the parties are discharged from further performance.

How the force majeure clause is to be drafted would depend on whether you are a supplier/provider or a customer under the contract.

For example, if you are a supplier/provider and you foresee the occurrence of a pandemic may make performance more difficult but not impossible (e.g. it would be more difficult to source raw material, and also at a much higher price), then the contract could be drafted in a way that the force majeure clause can be triggered in the event of a pandemic, which renders performance (i.e. the supply of goods) delayed.

On the other hand, if you are a customer, you should probably push for a more limited scope, so that the clause would only be triggered if, for example, the supplier/provider is unable to perform in the event of a pandemic. This would make it much harder for the supplier/provider to take advantage of the clause.

As for the consequences of the occurrence of a force majeure event, to allow for maximum flexibility, a customer may want to insert an option of terminating the contract if performance of the contract by the supplier/provider (e.g. the supply of goods) has been delayed for over a certain period of time due to the force majeure event (e.g. COVID-19).