China Contract Problems and Solutions

With China’s manufacturing economy continuing to slow, the international litigators at my law firm are getting an increasing number of calls and emails from companies (mostly American and European) who have not been paid for products or services they provided to Chinese companies or failed to get what they paid for to Chinese companies.

In just the last few weeks alone we’ve already gotten at least a dozen emails from American and European companies that provided products or services to Chinese companies and then did not get paid at all or did not get their final payment, with the amounts owed ranging from $27,000 to $4,500,000, along with the usual hodgepodge of emails regarding China factories that sold the foreign company’s own product out from under them or provided bad quality product. Our law firm declined to take on nearly all of these cases for one simple reason: the companies contacting us with their China payment problems did not have a written contract that gave us sufficient confidence to pursue their claims.

Now just to be clear, I am not saying these companies have no chance of recovering their money, because some of them probably do. But I am saying that my law firm (and most international law firms) is not interested in taking on these sorts of cases because we either do not want them on a contingency fee basis or because we are not willing to charge companies on cases we see as unlikely to be successful.

I am also not saying that the quality of the cases that come to us represent the universe of contracts with China or even the universe of contractual mistakes foreign companies that do business with China often make. In fact, I know it is otherwise and I say this for two reasons. First, the companies reaching out to us with payment problems are the companies that have not gotten paid or have received bad products and both of those things are at least ten times more likely to happen to a company with a bad contract or no contract at all. Second, the companies reaching out to us typically do not have their own international lawyers or they would have called them, not us. In fact, one of the first questions I ask someone with a China legal problem is why they are calling us and not their lawyer who drafted the contract and their answer is invariably one of the following:

  1. We did not use a lawyer.
  2. The lawyer we used does not know China.
  3. We used someone we found online and they turn out not to be a real lawyer. See China Lawyers: The Fakes and the Quasi-Fakes.

In other words, our law firm is getting a representative sample of companies that either did not know what they were doing internationally when they did their deal with their Chinese counter-party or, for whatever reason, chose not to do the right things to protect themselves. The companies that have used good international law firms and good international contracts (and that includes our own clients) pretty much never call us with China payment problems because they are a lot less likely to have such problems and if they were to have such a problem, they call their regular international lawyer, not us.

Foreign companies doing business with Chinese companies too often ignore the question of contract enforcement. In our experience, foreigners from all over the world routinely insist on contract provisions that effectively render their contracts unenforceable in China. That is, by their own efforts they make their contracts worthless, much to the amusement of the Chinese side of the business transaction.

There are three rules for making a contract effectively enforceable in China:

1.   Enforcement is in China through litigation in the Chinese court system.

2.   Governing law is Chinese law.

3.   Governing language is Chinese language.

And yet, my law firm’s China lawyers seldom see contracts that follow these three simple rules. The typical contract we  see drafted by American attorneys provides that governing law is the law of the home state of the US party (our last two were Iowa and Alabama), that the governing language is English and that enforcement is exclusively in the state court of the home state.

Why is this a disaster? The reason is simple. This type of contract violates rule number one, so we do not even need to discuss the other two rules. Chinese courts do not enforce US court judgments. Thus, any judgment obtained in a US court cannot be enforced in China. If the Chinese party has no assets in the United States, any judgment the US company receives from a U.S. court against its Chinese counter-party will likely be worthless. For why this is the case, check out China Enforces United States Judgment: This Changes Pretty Much Nothing. China also has a very bad record of enforcing the judgments from other countries as well, including sometimes even those countries with which it has judgment enforcement treaties.

Some attorneys have figured out this issue on foreign court judgments and provide for arbitration in the United States or in their client’s home country. These attorneys believe that because China is a signatory to the New York Convention on the Enforcement of Arbitral Awards and thus legally obligated to enforce arbitration awards from most countries in the world, it will do so. This is theoretically true, but the reality on the ground (as is so often true of China) is somewhat different. The fact is that arbitration awards can be problematic for China, for the following reasons, among others:

  • China has strong cultural (and lately political as well) aversions to enforcing foreign arbitration awards, particularly those from the United States, Canada, Australia, and the United Kingdom. Chinese courts will therefore often look for any decent reason they can to avoid enforcing a foreign arbitration award. This is especially true at the local court level. In certain types of cases there is some chance of prevailing on appeal. This is uncertain and the time it takes to appeal and win can be so long that the whole process makes little sense. Oftentimes, rather than issue a ruling saying it will not enforce the foreign arbitration award, the Chinese court will simply issue no ruling at all.
  • In many cases, the Chinese party will not participate in the foreign arbitration process, making any arbitration award a default award. Chinese courts (like courts pretty much everywhere in the world) are averse to enforcing default awards and the likelihood they will enforce a foreign default from an arbitration tribunal is low.
  • Put simply, Chinese courts do not like taking orders from foreign arbitrators. Chinese courts quite often view it is an affront to Chinese sovereignty to be told what to do by a foreign arbitrator and this leads them to ignore orders from an arbitrator.

But China is a modern country with a reasonably good legal system; the World Bank recently ranked China 5th worldwide in contract enforcement. This means that if you are looking to enter into a transaction with a Chinese entity, your best plan will usually be to draft the dispute resolution clause of that contract to mandate disputes be settled in China.

Though we sometimes see contracts that follow rule one and provide for litigation in China, those contracts far too often violate rules two and three by providing for the governing law to be the law of the home of the foreign party and for the governing language to be English. When I ask lawyers why they did this, their response is usually to note that Chinese law allows contracting parties to choose the law that governs their contracts so long as that law has some relation to the transaction and also allows contracting parties to choose the language that will govern their contracts.

These statements are technically true in that Chinese law does allow businesses to make whatever decision they want in these areas, but in the real world of Chinese litigation, calling for litigation in China under a foreign law and language is likely to be a huge mistake.

Take the governing law issue first. Under the Chinese system, the court will require the parties to prove what is the foreign law on any issue that is important for a decision. Thus, before any proceedings begin, the court will require you to prove all important aspects of foreign law. Proving the law on these points is time consuming and expensive. The same applies to a foreign language. When confronted with a foreign language contract, the court will engage its own translator. Often this translator is barely competent. On important points of translation, both parties will often disagree with the translator, leaving the judge in the hopeless position of having to choose between three competing translations of a language he or she probably does not know.

As you can imagine, a clever defense attorney in this situation can devise an almost infinite number of objections to any statement of foreign law or any translation from a foreign language into Chinese. Usually, the judge is not motivated to end these disputes, so the potential for delay is almost limitless. Even if the court gets to the point of making a decision, any chance of making use of preliminary relief is lost, which often means a major loss of settlement leverage.

Effective litigation in China requires quick and decisive action. In particular, Chinese litigation procedure allows for preliminary seizure of assets and other pre-judgment relief that can be remarkably effective in quickly resolving issues. See China Contract Damages Done Right. Using Chinese arbitration rather than litigation typically will preclude you from taking advantage of this preliminary relief, but generally Chinese arbitration works well and usually is preferable to foreign arbitration. But see How to Write a Bad International Arbitration Clause. Again though, litigation rather than arbitration is usually preferable.

We have in the last couple of years been seeing an uptick in another common problem foreign companies create for themselves with badly drafted contracts: the wrong party. We have written about this many times, most recently in China Contracts, But with Whom:

One of the most important things to do before entering into a contract with a Chinese company is to make sure you are contracting with the right company. The right company is usually the company with sufficient financial resources to cover you if and when things go bad. On one level this sounds incredibly obvious, but foreign companies get this wrong all the time.

This seemingly simple principle is often overlooked because many buyers of products manufactured in China contract with third-party sourcing companies unaffiliated with the Chinese company that actually owns the factory making the product. So when a product defect is uncovered, the buyer will only have legal recourse against the sourcing company with whom it contracted and not the actual Chinese manufacturer. The same thing is true when foreign companies contract with Chinese companies for services.

Oftentimes the foreign company will contract with the Chinese company’s parent or holding company in Hong Kong, Taiwan or Singapore that typically does not have assets beyond a few computers and a market-rate office lease.

Before contracting with anyone, you should do your due diligence and make sure the party you are paying is not a shell entity or a sourcing company with little or no assets.

The bottom line is that China-appropriate contracts with the right party work well, but contracts that are not tailored for China or are with the wrong party are typically worse than having no contract at all. In China Contract Drafting Scams: From Bad to Much Worse, we talked about how disastrous bad Chinese contracts can be and of how they so often are worse than no contract at all:

Roughly 40% of the China contracts we have seen done at shockingly low prices were so badly written as to be worse than no contract at all. Around 25% of these contracts appeared to involve a lawyer/fake lawyer who was paid by the Chinese side to “throw” the contract to the Chinese side. The remaining 25% of these contracts are roughly divided between those that are slightly better than nothing at all and those that are roughly the equivalent of nothing at all. In other words, you paying a really low fee for a Chinese contract gives you about 10-15% chance of doing better than doing nothing at all and about a 75% chance of doing worse. How do you like those odds?

In addition to contracts written in way that simply does not work, we also often see issues with the type of contract chosen. We see someone who paid for a bad NNN agreement when they did not even need an NNN agreement at all — what they really needed was a Product Development Agreement. And we have seen the reverse of this. We have seen licensing agreements when a distribution agreement was what was actually needed and we have seen the reverse of this. We have seen distribution agreements when a manufacturing agreement was needed. In other words, people are not only paying for contracts so badly drafted as to be worse than no contract at all, they oftentimes are paying for the wrong contract for their specific situation! See China Contracts Templates for $99 Each.

When our international dispute resolution lawyers get a matter where the contract is so bad that we do not think it fair to charge to take on the dispute, we usually write a short email saying little more than that we are not interested in representing them. When we get a matter where the contract actually works, we write a very short letter saying that we are interested in representing them and we will charge x dollars per hour or a flat fee to do so.

And as we wrote just yesterday in Do You Know What Your Chinese Language Contract Says?, our international dispute resolution lawyers are increasingly seeing dual language contracts where the Chinese language portion is different than the English language portion, and always to the detriment of the foreign company.

What are you doing with your China contracts to protect your company?