Managing Intermediary Risk in Successive Sales Transactions

Managing Intermediary Risk in Successive Sales Transactions

Isolation and system resolution

Definition of key terms

Chain sales: refers to two or more consecutive sales transactions for the same batch of specific goods. The typical feature is that the goods are usually physically transferred directly from the first-hand seller to the last-hand buyer, and the intermediary party often does not actually possess, store or process the goods.

Intermediary: In a chain trading structure, a market entity that serves as both the buyer of its upstream suppliers and the seller of its downstream customers.

Back-to-back contracts/clauses: In order to effectively manage risks, intermediaries set up clauses in the sales contracts they sign with downstream customers that correspond to or are linked to their purchase contracts with upstream suppliers, especially in terms of payment terms, delivery arrangements, quality standards, liability for breach of contract, etc., in order to achieve the synchronization of rights and obligations and the transmission of risks.

Financing trade: refers to an arrangement in which the parties to the transaction have no real intention to buy or sell goods, but use the signing of a sales contract as an external form of expression. The actual purpose is to provide financial coordination between enterprises. Often manifested as "called buying and selling, but actually borrowing". In the context of state-owned assets supervision, it is often called “false trade”.

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1. The legal framework of serial trading and the dual role of intermediaries

the Civil Code does not set special rules for "serial sales contracts", and its legal effect completely relies on the application of general contract law principles to each independent sales contract in the chain. A typical serial sale consists of at least two legally independent sales contracts. According to the principle of privity of contract, each contract in principle only binds the parties to it, and upstream suppliers and final downstream purchasers generally cannot directly assert contractual rights against each other.

In this structure, the intermediary plays the dual role of buyer (to the upstream) and seller (to the downstream). The core dilemma lies in the contradiction between the high degree of interdependence in business logic and actual performance (for example, downstream delivery depends on upstream supply, and payment to upstream depends on downstream repayment) and the legal independence of the two contracts. This structure naturally disperses rights and obligations, which can easily lead to inconsistent terms and blocked risk transfer, making the intermediary in a pivotal position face significant challenges. Therefore, intermediaries must carefully manage risks at each contract level and work hard to ensure the coordination of key terms in upstream and downstream contracts.

2. Main legal risks faced by intermediaries

As the hub of serial transactions, the intermediary is the center of risk aggregation. It not only bears the inherent risks of both buyers and sellers, but also faces unique risks arising from improper contract connection:

(1) Default risk from upstream suppliers

1. Risk of performance impediments: Delayed delivery, no delivery at all, or inconsistent quality and quantity of goods delivered by the upstream will directly result in the intermediary being unable to perform the contract to the downstream, constituting a breach of contract against the downstream, and facing claims, contract cancellation and reputation loss.

2. Risk of rights defects: If the goods provided by the upstream are subject to ownership disputes or third-party rights encumbrances (such as mortgages), resale by the intermediary may constitute a fundamental breach of contract and involve rights disputes.

(2) Default risk from downstream purchasers

1. Collection risk: The downstream party delays payment or refuses to pay, which directly affects the cash flow of the intermediary party, which may trigger its default on the upstream party and has to bear the cost and risk of recourse.

2. Risk of rejection: The downstream unreasonably rejects goods that meet the agreement, causing the intermediary to bear additional warehousing and transportation costs, and face resale losses and difficulty in recovering payment.

(3) Risks of inconsistent contract terms or improper connection

1. Mismatch of core terms: mismatch in key terms such as quality standards (lower upstream, higher downstream), delivery time (downstream earlier than upstream), inspection period (downstream shorter than upstream), payment terms (node, method, currency conflict), legal application and dispute resolution mechanism, etc., will directly cause intermediary parties to have difficulty in performance and risk exposure.

2. The inherent risks of “back-to-back” payment terms: Such terms are designed to pass on downstream payment risks, but their validity and interpretation can easily lead to disputes.

3. Validity determination: If the agreement is unclear (such as "arrange payment after receiving payment from the downstream"), the court may only interpret it as an agreement on the payment period, rather than as a condition for effectiveness. Unless it is expressly stated as a condition precedent (such as "only after..."), even if the downstream fails to pay, the intermediary may still be required to pay the upstream after a reasonable period [see Supreme Court (2021) Supreme Court Civil Application No. 5750 and other cases].

4. Risk of standard clauses: If the standard clauses are provided by an intermediary and are deemed to unreasonably exempt one party from liability, increase the liability of the other party, or restrict the other party's main rights, it may be invalid due to violation of Article 497 of the Civil Code.

5. Risk of failure to exercise rights: Even if the terms are valid, if the intermediary does not actively claim due claims against the downstream (for example, it only sends a reminder letter instead of litigation/arbitration), it may be regarded as "unjustly preventing the fulfillment of the conditions" (the Civil Code Article 159). Legally, the conditions are deemed to have been fulfilled, and the intermediary still needs to pay the upstream.

6. Mismatch in scope of liability: Differences between upstream and downstream contracts regarding liability for breach of contract (proportion of liquidated damages, scope of compensation, upper limit of liability), warranty, and claim procedures may cause the intermediary to bear far more liability to the downstream than the amount it can recover from the upstream, forming a "liability inversion."

(4) Risks related to the connection between ownership, risks and inspection links

1. Different ownership transfer time points: If the ownership transfer time points stipulated in the upstream and downstream contracts are inconsistent (according to delivery, or according to special agreements such as retention of ownership), the intermediary may neither receive payment nor have the right to the goods at a certain stage, or may cause ownership disputes when one party goes bankrupt.

2. Misalignment of the risk-bearing period: According to the provisions of the Civil Code or the contract, the risk of damage or loss of goods usually transfers with delivery. If the risk transfer nodes agreed between the upstream and downstream are different, the intermediary will directly bear the transportation or warehousing risks during the "vacuum period".

3. Conflict between inspection standards and procedures: If the inspection standards, methods, deadlines, and objection periods are inconsistent between the upstream and downstream, it may lead to "upstream passing, downstream rejection" or self-imposed losses due to missing the time limit for claiming to the upstream.

(5) General commercial and credit risks

Like all market entities, intermediaries also face risks such as the bankruptcy of counterparties, drastic market price fluctuations (especially for commodities), and logistics operation errors.

3. In-depth analysis of financing trade

Financing trade is one of the most hidden risks with the most serious consequences in serial trading.

(1) Identification standards and main features

"Financing trade" refers to arrangements for inter-enterprise financing under the cover of trade contracts. According to the regulations of the State-owned Assets Supervision and Administration Commission (such as State-owned Assets Supervision and Administration Commission [2023] No. 74) and judicial precedents, they usually have the following characteristics:

1. There is no real goods transaction or transfer of goods rights: "the order is delivered but the goods are not delivered" or "the goods rights are transferred empty", and the delivery is only completed through the transfer of documents.

2. Financing is the main purpose: the transaction motivation is to provide funds for a party in the chain, rather than to obtain goods for production and operation or resale for profit.

3. Closed or circular transaction structure: For example, A sells to B, B sells to C, and C sells back to A or its related parties.

4. Fixed income and risk isolation: The investor or channel party does not bear major commercial risks, and the income is a pre-fixed spread, rate or interest.

5. Related parties participate or designate counterparties: There is a related relationship in the transaction chain or the counterparty is designated by the financing party.

6. Abnormal pricing: "buy high, sell low" or "sell low, buy high" that clearly deviates from fair value, and the difference reflects financing costs.

7. Separation of nominal goods rights from actual control: The investor or intermediary holds the goods rights formally, but the actual control rights are still in the hands of the financier.

(2) Judgment boundaries

The court or regulatory agency follows the principle of "substance over form" and comprehensively evaluates the overall situation of the transaction, the true intentions of the parties, and the economic effects. Intermediaries need to be alert to the following "red light" signals: Is the transaction chain closed? Is the evidence of goods flow authentic and verifiable? Does the intermediary actually contact, control or inspect the goods? Is the profit model fixed income or market risk bearing? Are the prices unusual? Are the upstream and downstream contracts highly similar except for the price subject? Are counterparties related or designated? Does the transaction have reasonable business logic and value that transcends capital channels?

(3) Judgment of legal relationships in judicial practice

Courts usually follow a deductive logic ranging from appearance doctrine (examining external forms such as transaction processes, contract terms, capital flows, profits, goods flows, etc.) to intention doctrine (inferring the true intentions of the parties based on abnormal appearance). If the authenticity of the external buying and selling behavior is insufficient, and it can be proven that all parties (especially the investors and financiers) have a common loan agreement (need to rely on objective evidence such as internal emails, chat records, meeting minutes, etc. to meet the "high probability" proof standard), the legal relationship may be recognized as a lending relationship rather than a buying and selling relationship (see the Supreme Court's thinking in the "Tianjin Xuanmei Company Case"). If the evidence is insufficient to prove that the loan was consensual, the court will usually not easily deny the apparent sales contract relationship.

(4) Determination of contract validity in judicial practice

The current mainstream trend is that effective contracts are the norm. Courts generally do not automatically determine that a contract is invalid just because the transaction has a financing trade dress. Even if it is determined to be a lending relationship, as long as it does not involve the exceptions of invalid contracts stipulated in the "Judicial Interpretation of Private Lending" (including defrauding financial institutions for on-loan loans, using illegally raised funds for on-loan, professional lending, use for illegal and criminal activities, violation of mandatory provisions of laws and administrative regulations, and violation of public order and good customs), the hidden loan contract is usually deemed valid. The contract will be deemed invalid only if the above invalid conditions are met (see the determination of invalidity caused by professional lending in the "Guangzhou Development Bipi Oil Products Case").

(5) Legal consequences of being identified as financing trade

Once it is identified as financing trade, it will trigger serious civil, administrative and even criminal consequences:

1. Civil level

(1) Consequences of the validity of the loan contract: If it is valid, the principal and interest will be repaid as agreed (subject to the interest rate ceiling); if it is invalid, the principal will be returned in accordance with Article 157 of the Civil Code, and losses (mainly interest losses) will be compensated based on fault.

(2) Responsibility of the intermediary: If it is only a channel and the fault is minor, it may not be liable for repayment; if it is knowingly and actively participating and there is fault, it may be required to bear supplementary compensation or partial joint and several liability based on the degree of fault, the size of the role, and the profit situation.

(3) Responsibility of the guarantor: The guarantee contract is usually invalid due to the invalidity of the main contract. However, if the guarantor is at fault (guaranteeing despite knowing that the main contract is false), he must be liable for compensation within a certain proportion (usually 1/3 to 1/2) of the portion that the main debtor cannot repay.

2. Administrative level

(1) Penalties for state-owned assets supervision (for state-owned enterprises): face notifications of criticism, orders for rectification, reduction of benefits, admonishment talks, organizational handling, disciplinary sanctions, etc.

(2) Tax risk: It may be found to be falsely issuing special value-added tax invoices, and you need to pay tax, pay late fees and face fines.

(3) Financial regulatory risk: If you are found to be engaged in financial business in disguise, you may face penalties from the financial management department.

3. Criminal level

It poses a major risk to the enterprise and the relevant responsible persons, and may be suspected of falsely issuing special value-added tax invoices (subjective knowledge is required), illegal business operations (if it involves franchising or seriously disrupting market order), defrauding loans/bill acceptances/financial instruments (if bank financing is involved), contract fraud (if fictitious transactions are used to defraud property), and money laundering.

4. Special compliance requirements and high-pressure situation of state-owned enterprises

State-owned enterprises involved in serial transactions, especially when suspected of financing trade, face stricter supervision and more stringent accountability.

1. Hard constraints on state-owned assets supervision

According to the "Notice on Regulating the Trade Management of Central Enterprises and Strictly Prohibiting All Types of False Trade" and related documents No. 74 of the State-owned Assets Supervision and Administration Commission [2023], high-risk businesses such as idle orders, financing trade, circular trade without commercial substance, and pallet trade are clearly prohibited.

2. Extremely strict accountability for management personnel

Article 168 of the "Criminal Law": Crimes of dereliction of duty/abuse of power by personnel of state-owned companies, enterprises, and public institutions: due to serious irresponsibility (dereliction of duty) or abuse of power (intentional), causing heavy losses to state-owned assets, they will be held criminally responsible. Even if there is no personal motive for profit, illegal operations just to complete performance indicators may constitute a crime.

Other potential crimes: such as defrauding due to negligence in signing and performing contracts, illegally making profits for relatives and friends, etc.

5. Risk isolation and system resolution: building a prevention and control firewall

In order to effectively manage risks and avoid financing trade "minefields", intermediaries must build and implement a comprehensive risk management framework:

(1) Contractual prevention and control measures

1. Refined design and strict review of contract terms

(1) Accurately design "back-to-back" payment terms: Use clear and unambiguous language to make it clear that they are effective conditions rather than just performance deadlines; fulfill prominent reminder and confirmation obligations; set reasonable boundaries (such as intermediary collection obligations, maximum waiting period); consider linking them to downstream acceptance.

(2) Ensure a high degree of consistency and connection between upstream and downstream contract terms: strive for "mirror" benchmarking or logical matching in core elements such as subject matter, quantity, delivery, inspection, warranty, payment, ownership and risk transfer, legal application and dispute resolution.

(3) Set up a clear and operable breach of contract liability and relief mechanism: agree on liability linkage clauses; specify the calculation method of liquidated damages; and clarify the right to terminate the contract.

(4) Effective use of ownership retention clauses: It is stipulated in the sales contract that the ownership of the downstream property belongs to the intermediary party before the full payment is made (pay attention to legal conditions and registration confrontation effect).

(5) Design clear and reasonable inspection and objection clauses: clarify the standards, methods, and deadlines to ensure that the intermediary has enough time to assert rights to the upstream.

(6) Strive for unified dispute resolution clauses: Agree on the same dispute resolution method, jurisdictional court or arbitration institution and location to reduce the costs and risks of related disputes.

2. Guarantee measures

(1) Guarantee

Type: Common ones include performance guarantees, advance payment guarantees, payment guarantees issued by banks, or joint and several liability guarantees provided by a strong parent company, etc.

Advantages: Provides a second source of reimbursement independent of the counterparty itself. Once the counterparty defaults, the intermediary can directly claim compensation from the guarantor (bank or parent company), which is not entirely subject to the counterparty's willingness or ability to perform.

Disadvantages: Obtaining a guarantee usually requires payment of a certain fee (guarantee fee or bank fee), and the credit and counter-guarantee requirements of the guarantor (especially the bank) need to be met. The cost is high and the procedures are relatively complicated. The guarantee terms themselves may also have strict claims conditions.

(2) Insurance

Type: There are a variety of insurance products to choose from for different risks, such as: credit insurance (covering the risk of non-payment or bankruptcy of the buyer/upstream), cargo transportation insurance (covering the loss of goods during transportation), product liability insurance (covering the risk of third-party personal or property loss due to product defects), quality assurance insurance, etc.

Advantages: Transferring specific business risks (such as credit risk, freight risk, product liability risk) to professional insurance companies helps stabilize expectations and protect assets.

Disadvantages: Insurance premiums need to be paid; insurance contracts usually have deductibles, compensation limits and a series of exclusions, and not all losses can be fully compensated; the claims process may involve complex procedures and strict evidence requirements.

(3) Supply chain financial tools

Type: Such as reverse factoring (initiated by the buyer, using the buyer's credit to provide financing facilities to suppliers), accounts receivable financing, order financing, inventory pledge financing, etc.

Advantages: It can optimize the cash flow of the entire supply chain, suppliers can get payment in advance, and buyers can get longer payment terms, which helps to reduce financing costs, reduce risks, and strengthen cooperative relationships.

Disadvantages: It may rely on the credit and willingness of the core enterprise to participate. It needs to establish corresponding information system support and pay attention to compliance risks and operational risks.

For transactions with higher risks and significant amounts, or when cooperating with counterparties with poor credit records, the intermediary should consider using a "combination punch": while carefully designing back-to-back clauses in the contract, it requires upstream payment guarantees (such as bank guarantees), or purchases credit insurance or utilizes factoring services for downstream accounts receivable. For quality risks, in addition to back-to-back agreements, you can also consider introducing an independent third-party inspection agency. At the same time, we actively explore the possibility of using supply chain financial tools to optimize capital flow and reduce overall risks. By building a multi-layered risk defense line, the impact of a single tool failure is minimized.

(2) Non-contractual prevention and control measures

1. Implement strict and in-depth counterparty due diligence: conduct a comprehensive investigation of all counterparties beforehand (subject qualifications, equity structure and related relationships, financial status, operating capabilities, contract performance history, business reputation, litigation and compliance records), and carefully evaluate the authenticity and commercial rationality of the transaction background. The investigation should be in-depth and through multiple channels, and enhanced measures should be taken against high-risk transactions.

2. Closely monitor the flow of goods and document management: track and verify the actual flow of goods, cross-check authentic, coherent and consistent logistics documents (transportation contracts, waybills, warehouse receipts, inspection reports, etc.), and be wary of forged documents. Carefully review transaction documents (contracts, invoices, payment vouchers, and cargo title vouchers), and strive to ensure that the flow of funds, goods (or ownership certificates), and bills are consistent and consistent with business logic. Consider on-site inspections.

3. Strengthen the monitoring and management of capital flows: standardize collection and payment operations and keep complete flow records. Pay attention to abnormal payment behaviors (third-party payment/collection, fund detours, non-compliance with contracts, etc.).

4. Establish and improve internal control processes and systems: formulate special business guidelines; improve the approval and authorization system (especially multi-level, cross-department review of large-amount, high-risk transactions); establish a risk assessment and early warning mechanism; strengthen department coordination; conduct regular audits and inspections.

6. Adhere to business essence and build systemic risk management

The middle party in a serial transaction is like walking a tightrope, with both opportunities and risks. Financing trade, in particular, is like a hidden reef. Once touched, it may cause enterprises to fall into legal disputes, suffer huge losses, and even trigger criminal liability for relevant personnel. It is an untouchable "red line" for state-owned enterprises.

The solution lies in "compliance" and "professionalism":

1. Adhere to the bottom line of business logic: return to the origin of trade, carefully evaluate the true commercial value and risks of each transaction, and reject any form of false trade and channel business.

2. Build a systematic risk control system: Embed risk prevention and control into the entire business process, from due diligence, contract negotiation, performance monitoring to internal approval, forming a closed-loop management.

3. Strengthen the construction of compliance culture: Cultivate the compliance awareness of all employees and make compliance an intrinsic requirement and conscious action for business development.

4. Seek professional legal support: Make full use of the wisdom and experience of external professional lawyers in transaction model design, contract review, risk assessment, dispute resolution and other aspects to protect the company's steady progress.

In view of the complexity of the serial trading model, the professional nature of the financing trade identification, the seriousness of the potential legal consequences, and the continuous development and changes of relevant laws, regulations and judicial practices, we strongly recommend that all enterprises involved in the serial trading business, especially those that serve as intermediaries (especially state-owned enterprises), must seek and fully rely on the opinions and support of experienced professional legal advisors before conducting such business, when drafting and reviewing contracts, and during the entire process of contract performance and risk management. Through the early intervention and full participation of legal professionals, we can help enterprises more accurately identify risks, design compliant transaction structures, improve contract terms, standardize operating procedures, and formulate effective risk response strategies, thereby minimizing legal risks and ensuring the stable operation and sustainable development of enterprises in a complex and ever-changing market environment.