On Thursday 8 March, President Trump signed an order for the imposition of new tariffs on steel and aluminium products entering the US. This has sparked concern about the possibility of a resulting international trade war. This would be a daunting prospect for commodity traders, with the risk of escalation potentially threatening markets well beyond steel and aluminium. This article looks at the impact that the imposition of trade tariffs may have on commodity sale contracts and how commodity traders can prepare.
President Trump's announcements have drawn responses from the EU, Japan and China amongst others. The scope of anticipated protectionist actions has expanded, with Chinese officials considering tariffs on imports of US agricultural commodities such as soybeans and EU officials considering actions against US products ranging from orange juice to Kentucky Bourbon. The markets have also reacted: the prices of aluminium and steel have risen (the price of aluminium rose to a three year high) and it is possible that other commodities will be similarly affected. A recent report from The Economist Intelligence Unit suggested that a collapse in global trade due to US protectionism would have a very high impact on the global economy1.
Rising tariffs are likely to lead to an increase in costs and a slowing of demand for raw materials, and volatility in commodities markets.
The immediate risks to commodities traders are that commodity sale and purchase contracts become less profitable or unprofitable and even threaten the solvency of some counterparties. This in turn could lead to increasing defaults. In light of these risks, what can commodity traders do now to prepare themselves?
Identifying the Risks
Who is required to pay duties?
International commodities contracts usually stipulate that the obligation to pay import taxes is on the buyer and the obligation to pay export taxes falls on the seller. Standard form GAFTA and FOSFA contracts adopt this approach and it is also the allocation envisaged by the widely used Incoterms, FOB, CIF and CFR.
If tariffs spread to raw commodities, a sudden escalation in tariffs may increase the overall cost of a contract and render it commercially unappealing. Buyers are most likely to be affected by import tariffs but where traders are in a contractual chain, they will be acting as both seller and buyer.
Price review clauses provide a contractual mechanism to renegotiate the contract price in certain circumstances, for example a specified percentage rise or fall in the market. These may come into play if the commodity markets become volatile as a result of a trade war.
A force majeure (FM) provision has the effect of suspending or terminating an agreement upon the occurrence of one of a range of listed events. If tariffs are imposed, it does not automatically follow that affected parties will be able to rely on FM to excuse a failure to perform. FM will only be available to the extent that the contract expressly provides for it and the event prevents performance by a party. Performance at a higher cost does not entitle a party to rely on an event even if it falls within the FM Clause. Any ambiguity will be resolved against the affected party and if the circumstances preventing performance change, they may no longer be covered by FM provisions, even if the initial circumstances were.
In the absence of a specific reference, a buyer make seek to rely on more general language such as: "an act of a government or other governmental agency...not in existence at the time of signing the agreement and which directly affects the Affected Party's ability to perform its obligations..." Although apparently broad, such a clause would not be sufficient to excuse performance as a result of an increased import tariff unless the tariff prevented performance altogether.
Historically, when parties have tried to rely on FM clauses to avoid contractual obligations in times of market upheaval, the English courts have been unsympathetic. It seems very unlikely that the courts would change their previous view to find that a change in economic or market circumstances affecting the profitability of a contract constitutes a FM event.
In our view, there is little scope for a party to argue that a sales contract has been frustrated by the imposition of increased tariffs.
A contract may be discharged by frustration where an extraneous event occurs after the contract is agreed which is not caused by the fault of one of the parties and is not catered for in the contract (by a FM clause or otherwise), and where the event so fundamentally changes the nature of performing the contract that it would be unjust to require continued performance.
Normally, contracts are only discharged by frustration when they become impossible to perform. A contract will not be frustrated just because it has become substantially more difficult, or more expensive, for one party to perform.
Mitigating the Risks: Existing Contracts
Absent mutual agreement to renegotiate existing contracts affected by the US tariffs, commodities traders will be bound by the terms previously negotiated. It would be prudent to check whether particular contacts or counterparties are vulnerable to the risks identified above and review the likelihood of a counterparty performance default or insolvency. Consider too whether any contracts might become bad bargains for you.
Where higher risk contracts are identified, consider:
- Who will bear the burden if import/export duties are imposed – does the contract stipulate?
- Is there a relevant price review or force majeure clause?
- Should you consider trying to negotiate a price review clause or agree how to allocate any tariffs that are imposed with your counterparty in order to maintain the contract?
- If there is a risk of insolvency, does the contract include related termination provisions?
- What is your preferred outcome if a contract becomes at risk? Would renegotiation be preferable to termination? If additional time and concessions are granted to a counterparty, these should be carefully recorded in writing.
- If in a contractual chain, are you back to back?
- Consider whether your hedging strategy might be affected.
Being prepared: Future Contracts
For traders engaging in current or upcoming contract negotiations, there is scope to mitigate potential risks:
- Negotiate a clear allocation of risk and eliminate uncertainties wherever possible. Include a clause allocating responsibility for paying tariffs and a price review clause with clear terms as to when it will be triggered. Consider also the consequences if agreement cannot be reached following a price review.
- Consider whether you should include specific provisions for termination in the event of a counterparty insolvency. Will this be an advantage, especially if you are in a contractual chain – will it impact your ability to fulfil other contracts?
- Where possible, make sure you are back to back up and down any contractual chain, particularly in relation to FM, termination and price review.
- Consider whether short term contracts would be preferable while the full extent of any potential trade war is uncertain.
- Consider how your hedging strategy might be affected.
We are at a very early stage and it is not clear how far any market upheavals will spread, both geographically and in terms of commodities affected. Preparation is the best protection at this stage. There is scope for parties, whether buyers or sellers, to act now in order to reduce the impact that any future tariffs or trade wars may have.