Disputes over goods processing contracts: What should the ordering party pay attention to?

In today's production and trade activities, especially in the textile, footwear, electronics, furniture or food industries, the outsourcing model has become an important part of the supply chain of enterprises. Instead of investing in the entire factory, labor and production line themselves, many businesses choose to assign part or all of the production stage to outsourcing partners to optimize costs and improve flexibility.

When the partnership breaks down, the outsourcing business may fall into insolvency, cease operations or dissolve. 

However, in reality, disputes arising from goods processing contracts are increasingly common and complicated. Many businesses think that they are only "outsourcing parties", not directly producing, so there are few legal risks. But when a dispute occurs, especially in cases related to machinery, raw materials, advances, production progress or the termination of the contract, the re-processing party is usually the one who suffers greater damages.

Judgment No. 01/2019/KDTM-ST dated 22/02/2019 of the People's Court of Lien Chieu District, Da Nang City on the dispute [1] over the processing contract between Company A and Company M is a "case study" showing the significant risks of this type of contract if the outsourcing party does not build a strict contract management mechanism from the beginning.

When the contractor is "stuck" because of his own property

According to the content of the case, Company A rented a factory, invested in machinery and equipment and assigned all of it to Company M to use to carry out garment processing activities. The value of the machinery and equipment system was determined to be more than 537 million VND after depreciation.

In addition, Company A also advances Company M 300 million VND to serve production activities, with a reimbursement mechanism by gradually deducting each order. However, after many conflicts arose in the cooperation process, Company A terminated the cooperation and requested Company M to return the machinery and the remaining advance of more than 263 million VND.

The dispute began to arise when Company M did not hand over the machinery and did not return the advance on time. During that time, even though there were no more production activities, Company A still had to continue to pay the factory rent of VND 90 million per month.

It is worth noting that all machinery and equipment are actually owned by the outsourcing party. However, due to the asset management mechanism and contract terms are not strict enough, the outsourcing party is in a situation where it is unable to recover its own assets for a long time.

This is a fairly common situation in today's reality, especially in export processing industries. Many businesses, because they want to quickly deploy production, often prioritize commercial factors but neglect the development of legal mechanisms for asset control, cash flow management and handling plans when cooperation breaks down.

The principle contract cannot be just a "form"

One of the notable points of the case is that there exists a "Contract in Principle" between the parties in addition to specific processing contracts. The Court determined that the principle contract itself is an important legal basis for resolving disputes between the parties.

In practice, many businesses consider the principle contract to be just a directional document, while the implementation is mainly based on emails, orders or actual operating agreements. This is a potentially risky mindset.

In fact, when a dispute occurs, the Court often carefully considers the terms of the principle contract to assess the rights and obligations of the parties, especially for issues such as: Ownership of machinery and materials; Asset management mechanism; Obligation to repay advances; Conditions for termination of the contract; Obligation to notify in advance; Mechanism for handling consequences when the contract is terminated.

In this case, the contract between the parties stipulates that the termination of the contract before the deadline must be notified at least 6 months in advance. This is a very important clause because it directly affects the legality of unilateral termination of the contract.

Although the Court finally accepted the termination of Company A's contract, the proceedings showed that this clause itself became one of the major contentions between the parties.

This shows that, for the outsourcing party, the principle contract needs to be built as a "risk management mechanism", not just a prelude to the cooperative relationship.

The biggest risk usually lies in assets and cash flow

Another notable issue in the case is the dispute over the advance payment. In many processing transactions, the outsourcing party often has to advance money for the outsourcing party to pay workers' salaries, operate the factory or buy auxiliary materials. However, many businesses only have very sketchy regulations on this advance payment management mechanism.

In the case, although the contract has a 10% deduction mechanism for each order, when the cooperation relationship ends, Company M still owes more than 263 million VND. The court finally forced Company M to return this money to Company A. However, winning the lawsuit does not mean that the business will definitely recover the money.

In fact, many outsourcing enterprises have weak financial capacity, depending almost entirely on a large customer. When the partnership breaks down, the outsourcing business may fall into insolvency, cease operations or dissolve. At that time, despite the winning judgment, the outsourcing party still faces great risks during the judgment enforcement stage.

This is why the outsourcing party needs to pay special attention to measures to secure obligations from the outset, such as: escrow or guarantee requirements; establish an automatic deduction mechanism; limit the advance level; as well as building a mechanism to control cash flow and debt in real time; even ask the processor to place collateral.

Source: Government News

Machinery and material management: the "blind spot" of many businesses

One of the most important contents of the case is the dispute related to machinery and equipment for processing.

According to the case file, all machines have not yet been cleared for export customs even though the cooperation has ended. This shows that the outsourcing party has not built an adequate control mechanism over its assets.

In export processing activities, this is a particularly dangerous problem. Because in fact, many machines, raw materials or semi-finished products may be related to legal issues such as the temporary import – re-export regime; tax policies; regulations on the origin of goods to customs management.

If the property is seized by the outsourced party or does not coordinate the return process properly, the outsourcing party may face not only civil risks but also administrative, tax or customs risks.

In particular, in many cases, foreign enterprises or FDI enterprises are often named on customs records, while the actual management depends on domestic processing partners. When disputes arise, the outsourcing party is prone to fall into a passive position.

Therefore, the outsourcing party needs to build a stricter asset management mechanism through measures such as: (1) Making a detailed handover record. This includes a list of assets and clear identification codes; (2) Stipulating the right to periodic inspection, the right to emergency property recovery, the mechanism for handling violations and specific compensation in the agreement between the parties; (3) At the same time, strictly control customs dossiers related to machinery and raw materials.

From commercial cooperation to legal risk management

It can be easily seen that this case is a dispute that does not stem from a too complex fraudulent act, but mainly comes from the lack of a clear risk management mechanism by the parties from the beginning.

In the context of increasingly volatile supply chains, rising production costs and fierce international competition, outsourcing contract disputes will continue to increase, especially in export industries.

For the outsourcing party, the management of outsourcing contracts cannot only stop at the perspective of "purchasing production services", but needs to be seen as an asset management activity, supply chain management and overall legal risk management.

From a practical perspective, businesses should pay attention to at least five important issues:

Firstly, it is necessary to develop principle contracts and processing contracts with a strict structure and a clear mechanism for handling violations.

Secondly, it is necessary to strictly control assets, raw materials and machinery handed over to the processing party.

Third, it is necessary to limit the financial risks associated with advances and debts.

Fourth, it is necessary to have a mechanism to monitor the actual operation instead of just managing on paper.

Fifth, it is necessary to prepare a plan to deal with the breakdown of cooperation, including legal and operational plans.

In many cases, outsourcing contract disputes are not just a mere civil lawsuit, but can lead to supply chain crises, loss of customers, production disruptions, and damage to commercial reputation. And then, the biggest cost that businesses have to pay sometimes does not lie in the Court's judgment, but in the business disruption caused by the dispute. Moreover, when a dispute occurs, it not only does not break the cooperation between the parties, but the process of recovering assets and recovering damage is an arduous and unpredictable process.