- Background
In South Korea, a significant disparity exists between large companies and SMEs, with unfair subcontracting transaction practices prevalent in the market. To address these issues, the government has legislated and implemented the Fair Transactions in Subcontracting Act (the "Subcontracting Act"), which primarily focuses on obligating the issuance of subcontract documents, prohibiting the establishment of unreasonable subcontracting prices, and preventing unfair reductions in subcontracting prices.
Moreover, the global economic crisis triggered by COVID-19, rapid increases in prices, and the sharp rise in raw material prices following the Russia-Ukraine war have formed a nationwide consensus that fluctuations in raw material prices should be reflected in subcontracting prices. In response, the subcontract price adjustment system was enacted under the Act on the Promotion of Mutually Beneficial Cooperation Between Large Enterprises and Small and Medium Enterprises (the "Mutually Beneficial Cooperation Act") enforced by the Ministry of SMEs and Startups ("MSS") and the Subcontracting Act enforced by the Korea Fair Trade Commission ("KFTC"), which took effect since October 4, 2023.
Similar systems exist in other countries; for instance, the U.S. employs an economic price adjustment system for federal government procurement contracts, while Japan regulates contracting price adjustments under provisions related to public procurement within the Public Accounting Act and the Local Autonomy Act.
Still, South Korea is the only country mandating the inclusion of a price adjustment clause in private transaction contracts. The implementation of this system has generated confusion in the market, primarily due to the burden of legal risks and challenges in drafting adjustment agreements. The following will introduce the content of the subcontract price adjustment system and examine the legal issues arising from its implementation.
- Contents of the Subcontract Price Adjustment System
The subcontract price adjustment system mandates the incorporation of a price adjustment clause in a consignment and commission contract when a company commissions the manufacturing, construction, processing, or repair of goods to another company. Subsequently, the commissioning company is obligated to pay the subcontract price adjusted in accordance with the agreed-upon terms. This system is stipulated in both the Subcontracting Act and the Mutually Beneficial Cooperation Act, which features consistent provisions regarding the requirements, procedures, and regulations of the system.
For the subcontract price adjustment system to take effect, there must be a major raw material that constitutes at least 10% of the subcontract prices. In this context, the subcontract price refers to the total amount that the commissioning company agreed to pay the commissioned company for the delivered goods and represents the total delivery payment for the entire contract, not the amount for a single order.
Raw materials refer to necessary materials for manufacturing the goods, including both raw and processed materials. This category includes, but is not limited to, natural materials, compounds, processed goods, and intermediate materials. However, it excludes expenses such as labor costs, rent, and electricity bills.
Not all consignment and commission transactions are required to include a price adjustment clause. Exemptions apply if (i) the duration of the consignment and commission transaction does not exceed 90 days; (ii) the price of delivered goods does not exceed KRW 100 million; or (iii) both the commissioning and commissioned companies agree not to include the price adjustment clause. In such cases, there is no obligation to incorporate a subcontract price adjustment clause into the contract.
Moreover, the system prohibits the abuse of position in a transaction with a price adjustment clause, any acts that evade legal obligations, and the failure to faithfully consult on the application of the subcontract price adjustment system with a commissioned company.
- Legal Issues Related to the Implementation of the Subcontract Price Adjustment System
(1) Risks in Identifying Major Raw Materials
The subcontract price adjustment system becomes applicable when there is a major raw material that constitutes at least 10% of the subcontract price. Therefore, the first challenge in applying this system is confirming the scope of major raw materials. While it is possible for contracting parties to mutually agree to include a price adjustment clause in their contract for materials or factors other than major raw materials, such cases are expected to be exceedingly rare in practice.
Therefore, the incorporation of a price adjustment clause in a contract necessitates the commissioned company claiming the existence of major raw materials and the commissioning company verifying the claim. In this process, the commissioning company inevitably has to request information on prime costs from the commissioned company. This issue of requesting prime cost information may also emerge after signing a contract with a price adjustment clause. When there are actual fluctuations in raw material prices, the commissioning company needs to request the purchase history of raw materials that are used during the contract period to assess whether to apply the price adjustment clause.
A commissioning company may request prime cost information from the commissioned company, within a necessary and minimal scope, to enter a contract with a price adjustment clause. However, as the Subcontracting Act prohibits the request to provide technical data and the Mutually Beneficial Cooperation Act prohibits unjustifiable requests to provide managerial information, a question is raised regarding the extent to which prime cost information can be legitimately requested.
(2) Risks of the Evasion of Law When Agreeing Not to Include a Price Adjustment Clause
If a commissioning company fails to faithfully consult with the commissioned company regarding price adjustments, abuses its position in the transaction, or evades the legal obligation to include a price adjustment clause in the contract by fraud or other improper means, the company may face regulatory restrictions.
Therefore, a commissioning company and a commissioned company that agree to exclude a price adjustment clause from their contract, which is a valid exception to the mandatory obligation, have to issue a separate agreement stating the reasons for not including the price adjustment clause in detail.
From the perspective of a commissioned company, the company might agree not to incorporate a price adjustment clause due to the bothersome process involved in verifying the presence of major raw materials, disclosing prime cost information, and determining the calculation method of the price adjustment. Additionally, in consignment and commission transactions involving the small-batch production of diverse products, the application of the obligation to include a price adjustment clause may vary depending on how the produced items are specified.
However, there is an issue regarding how authorities can verify whether such an agreement is an attempt by the commissioning company to evade laws or a voluntary agreement. The authorities have no choice but to rely on reports from commissioned companies and subsequently conduct investigations. However, not every relationship between a commissioning company and a commissioned company is vertical, and there is an additional risk that reports by commissioned companies may potentially constrain the business activities of commissioning companies.
(3) Conflict with the Provision Prohibiting Reduction of Subcontract Price
The Subcontracting Act aims to assist prime contractors and subcontractors in transacting on equal terms, promoting a fair order in subcontract transactions. This act prohibits reducing subcontract price on the grounds that the price of commodities or the price of materials, etc., at the time of payment of subcontract price has fallen compared with the price at the time of supply, etc. (Article 11(2)6 of the Subcontracting Act).
Meanwhile, the subcontract price adjustment system is not solely operated for commissioned companies; if raw material prices fluctuate, commissioning companies may also request a price adjustment. Therefore, the system can be used as a measure to bypass the prohibition on subcontract price reduction. Furthermore, from the perspective of commissioning companies, there is a risk associated with a price reduction based on a price adjustment clause being perceived as an unjustifiable subcontract price reduction.
- Conclusion
In addition to the issues mentioned above, various other challenges exist in the process of including a price adjustment clause into a contract, including determining the scope of adjustment, formulating a suitable adjustment formula, and establishing the timing for adjustments. It is natural for a system to encounter various issues until it settles, and regulatory laws that involve the modification of existing transaction forms and partial restriction of private autonomy are particularly more challenging to settle naturally. Therefore, authorities (the MSS and the KFTC) have repeatedly expressed their intention to rigorously sanction any attempts to evade laws concerning the enforcement of the subcontract price adjustment system.
However, for the fair enforcement of laws, it is necessary to provide clear guidance in advance. Considering the consistency in the provisions of the Mutually Beneficial Cooperation Act and the Subcontracting Act regarding the subcontract price adjustment system, it would be more appropriate to regulate the system under a single law instead of implementing a dual-track approach, such as having the MSS execute the Mutually Beneficial Cooperation Act and the KFTC execute the Subcontracting Act separately.
Furthermore, in accordance with the social consensus that fluctuations in raw material prices should be reflected in the contract price, the mutual cooperation between commissioning and commissioned companies for the establishment of the subcontract price adjustment system is highly important at this juncture.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
