China Contracts: Arbitration Versus Litigation

international litigation lawyers

Great discussion happening on our China Law Blog Linkedin Group on litigation versus arbitration in China contracts. The discussion started with a US lawyer posing the following question: “Should a Contract Between a Non-Chinese Company and a Chinese Company Require Courtroom Litigation or Arbitration?” He then went on to sort of answer it himself, with the following:

It seems to me under the NY Convention of 1958 that the following should be the practice of writing contracts:  1) If the dispute is over money damages only – Arbitration outside China is the best practice. Chinese courts have never rejected such arbitration awards and enforce them. 2) If the dispute is over money and personal property (molds for instance) then using Chinese courts is the preferred method. Counter-argument(s)?

I disagree somewhat in that Chinese courts oftentimes do not enforce foreign (and domestic) arbitration awards. The statistics on this look better than they should because Chinese courts often “reject” foreign arbitral awards by simply never hearing the case,  which itself acts not to enforce the award.

Another US lawyer then said she thought Hong Kong arbitration makes sense and China courts are to be avoided. I disagree with this in that even if true, many Chinese companies will not agree to arbitration, but I also disagree with this because Chinese courts do not have all that great a record in enforcing foreign arbitration awards.

A US law intern then said he “would always use an arbitration clause in any international contract, no matter what the contract was for. Particularly with China, since they are signatories (essentially) to the New York Convention, any arbitration award should be enforceable in Chinese courts, no matter what the contract is for.”  This answer makes some sense on paper, but it fails to account for what actually happens in real life.

A China and New York licensed lawyer then said that the distinction between a money damages and a personal property contract is not a good method for determining whether to arbitrate or litigate. I agree.

A US lawyer then said he “always” recommends “arbitration” because the Chinese court system is too unpredictable and too corrupt.”  See my thoughts above. And if Chinese courts are too unpredictable and corrupt, what makes anyone think this unpredictability and corruption just disappears when it comes time to enforce a foreign arbitral award. If anything, this is the best time for the courts to be unpredictable and corrupt.

A Chinese lawyer then said most Chinese courts are not unpredictable, especially when dealing with clear-cut issues and that “litigation could be the best pressure for a Chinese company.” I completely agree and note that this raises an absolutely essential point. My law firm’s international dispute resolution lawyers are always telling our clients about the benefits contracts that go beyond the ability to sue and enforce. In Chinese Contracts Matter I wrote how having a good China contract with your Chinese counter-party can “put a little scare into” them and thereby convince them to abide by the contract:

The best solution for this is to prevent it from happening in the first place and the best way to do that is to choose the right supplier and use a good OEM contract.  When we draft OEM contracts for our clients, we always put in a provision precluding the Chinese manufacturer from subcontracting out production. Without exception, the Chinese manufacturers have agreed to this provision and, again without exception (at least as far as we know), they have always abided by it.  The reason for this is simple.  The manufacturer may have twenty some companies for whom it produces goods, but probably less than half of them forbid subcontracting.  When the Chinese manufacturer is so busy as to require subcontracting, it makes sense for it to first subcontract out work for those foreign companies for whom it is NOT prohibited by contract from doing so.  I am always analogizing this to bike locks.  Even the best bike lock cannot prevent all thefts, but its efficacy comes from the fact that bike thieves generally find it easier to steal a bike with a poor quality lock or none at all than one that is difficult to break.

Any contract that makes your Chinese counter-party think twice about messing with you has at least some value.  My law firm is constantly settling cases with Chinese companies based on well-written contracts.  Chinese company clearly owes our client a million dollars per a well written contract and we settle for $650,000.  Had it been in the United States, we might not have taken less than $850,000.  But had there been no contract, my firm would not have even taken the case and settlement would likely have been for nothing at all or something really nominal.

Having a well written contract does not mean you will always win your China lawsuit if you are forced to sue on it, but it does mean you will have some leverage if things go wrong and it does mean you will at least have a chance. Having no contract means no chance.
Chinese companies do not like being sued as a lawsuit alone is damaging to their reputation. They especially do not like it if they are going to lose and if enforcement is going to be quick. Being sued in a Chinese court is generally viewed by Chinese companies as worse than being pursued via arbitration.

An American lawyer turned businessperson then voted for arbitration and mused about the best place. He pointed out that just about everyone knows about the benefits of Hong Kong, but he is a fan of Singapore. I do not think arbitration is always the answer, but I am a fan of Singapore over Hong Kong because the lawyers and the arbitrators tend to cost less in Singapore, but I would hesitate to pick it solely on this basis because Hong Kong arbitration awards are slightly more likely to be enforced on the Mainland than a Singapore one.

Then an American lawyer who frequently represents Chinese companies talked of how those companies like US litigation provisions because that increases their chances of being able to enforce a judgment against their American counterpart, but that testifying in a less formal arbitration setting is oftentimes better for Chinese witnesses. He then concludes that “there are often downsides and upsides to both settings and, therefore, I find the decision to choose the format (if given that opportunity) is fact specific and dependent on the nature of the dispute, the parties, and the forum options.” I completely agree.

Then a Canadian lawyer wrote what I consider to be the best answer:

For me it depends first on the most likely type of dispute, the desired remedies and the location of assets.

I read Chinese court decisions almost daily and find they are generally well-reasoned. The decision of the Shanghai Higher People’s Court in the Johnson & Johnson re-sale price maintenance case is an example of a particularly well-written and well-reasoned judgment.

Common law lawyers over-emphasize the issue of precedent. Civil law systems, including those of China, have other, more sensitive ways of ensuring that similar cases are decided in similar ways. I was first trained in common law.

Arbitration is good for large cases, where the remedy sought is money and the amount is over $5 million USD.

For amounts below that it should be remembered that it costs almost as much to have an arbitral award enforced by a court in China as it costs to go to trial. And a very basic arbitration can cost several times what it would cost to go to trial in China.

Further if specific remedies such as an IP injunction, or a seizure of certain assets is being sought, only a court can provide these remedies. Certain types of evidence may only be obtained by a Chinese court order. Arbitration outside China just adds substantial delay and risk to the enforcement of your rights.

The enforcement rate for foreign arbitral awards is about 70% to 80%. Not all are enforced. There are papers and books on this topic.

Chinese courts can be much quicker than many foreign courts. Completion of the matter in 6 months is not unusual. As do other civil law courts they rely more on documentary evidence than oral testimony, so usually there is no need for the foreign executive to attend. There is no discovery. You need to plan your evidence well in advance.

The World Bank Doing Business survey ranks the Chinese court system 19th in the World for the enforcement of contracts, based on time required, cost, and complexity of procedures. I think that this ranking reflects the points that I have used above.

My practice consists of a lot of distribution agreements and IP licenses. The amounts in dispute rarely get up to $5 million, the IP needs injunctive remedies, and the Chinese party usually does not have assets outside the country.

So we usually recommend Chinese law and Chinese courts.

He completely nails it and his comment is very similar to what we tell our clients. Breaking it down:

  • “For me it depends first on the most likely type of dispute, the desired remedies and the location of assets.”  Exactly.  In figuring out what we are going to put in the contracts we write between our clients and their Chinese counterparts, we first try to figure out the most likely breach of contract scenarios (either by our own client or by the Chinese company) and also the really critical breach of contract scenarios. A bad delivery of $100,000 in product might be likely, but that is going to pale in importance to the Chinese company taking over our client’s factory in China and ceasing all deliveries. So between those two, we would probably write the contract to provide our client with the best forum for dealing with its factory being hijacked.
  • “I read Chinese court decisions almost daily and find they are generally well-reasoned.” Again, completely agree. Yes, you should think hard about avoiding a situation where you find yourself in a Chinese court going up against a powerful company owner in some small city in China’s interior, but the judges in China’s larger and more sophisticated cities, particularly in the higher courts, are often not so bad at all.
  • “Arbitration is good for large cases, where the remedy sought is money and the amount is over $5 million USD. For amounts below that it should be remembered that it costs almost as much to have an arbitral award enforced by a court in China as it costs to go to trial. And a very basic arbitration can cost several times what it would cost to go to trial in China.”  I agree, but would hedge it a little by saying arbitration is “generally” good for large money damages cases.
  • “Further if specific remedies such as an IP injunction, or a seizure of certain assets is being sought, only a court can provide these remedies. Certain types of evidence may only be obtained by a Chinese court order. Arbitration outside China just adds substantial delay and risk to the enforcement of your rights. The enforcement rate for foreign arbitral awards is about 70% to 80%.” I agree and this is key. Much of the time, the biggest risk to foreign companies is not money or the one bad shipment or even a long delay. Much of the time, the biggest risk to foreign companies is the Chinese company running away with the foreign company’s IP or just continuing to manufacture and sell the foreign company’s product after the foreign company wants it to stop. No matter how you slice it, it will be faster, cheaper and easier to get injunctive relief or an injunction equivalent from a Chinese court than from a foreign or even a domestic arbitration panel. And it does bear mentioning that enforcement of foreign arbitral awards in China is well under 100%.
  • “Chinese courts can be much quicker than many foreign courts. Completion of the matter in 6 months is not unusual. As do other civil law courts they rely more on documentary evidence than oral testimony, so usually there is no need for the foreign executive to attend. There is no discovery. You need to plan your evidence well in advance. The World Bank Doing Business survey ranks the Chinese court system 19th in the World for the enforcement of contracts, based on time required, cost, and complexity of procedures. I think that this ranking reflects the points that I have used above.” I completely agree. Our law firm has been involved in cases where the Chinese court granted our client a remedy within weeks of our having filed the case.
  • “My practice consists of a lot of distribution agreements and IP licenses. The amounts in dispute rarely get up to $5 million, the IP needs injunctive remedies, and the Chinese party usually does not have assets outside the country. So we usually recommend Chinese law and Chinese courts.”  Ditto for my law firm, but I would add manufacturing contracts to the list where Chinese law and Chinese courts almost always makes sense, and for the same reasons as for the IP contracts. I also want to mention that if your contract is going to call for Chinese law and Chinese courts, that contract should be in Chinese.

The most common mistakes our China lawyers see with foreign company contracts with Chinese companies are the following:

•  The contract is governed by US or EU or some other foreign law.

• The exclusive forum for dispute resolution is litigation in a US court or some other country’s court in a country whose judgments China does not enforce

• The language of the contract is English.

Foreign companies often brag about having “forced” their Chinese counter-party into accepting these terms without realizing the Chinese side is usually happy to sign an agreement with these dispute resolution terms because it knows 1) if it wants to sue the foreign company, it will need to sue it in their home (foreign) country since very few countries enforce Chinese judgments and 2) it  just freed itself of any risk that an enforceable judgment will be entered against it. In other words, the Chinese company knows it just executed a contract that cannot be enforced against it. Since the terms of the contract cannot be enforced, the Chinese side can then be quite relaxed about the contract terms.

At the start of litigation, a Chinese court look at the contract’s dispute resolution provisions. If the contract provides for dispute resolution (litigation or arbitration) outside China, the court will refuse to hear the case. There are no exceptions to this. With respect to arbitration, as with most countries, Chinese courts will only allow arbitration in China if there is an explicit, exclusive China arbitration provision. A common trap is a contract that provides for either litigation outside of China or arbitration inside China. In that case, the Chinese courts usually refuse to honor a Chinese arbitration award because the arbitration provision is not exclusive.

It is therefore critical for every company that does business in China to ask a fundamental question: if there is a dispute under this agreement, am I most likely to be a plaintiff or a defendant. If your company will be a plaintiff, then you must ensure that your contract is fully enforceable in China. It is a bad idea to close the door to the Chinese litigation and arbitration by insisting on litigation outside China. The next step is then to draft your contract to maximize the chances you will get a good result in China.

Even though this all seems obvious, our dispute resolution lawyers pretty much every week have to give a potential client the bad news that their contract is unenforceable through their own efforts.

I hate to say this, but I think that the foreign arbitration versus China litigation split oftentimes is between law firms without the ability to draft Chinese language contracts and therefore claim Hong Kong arbitration is best and law firms that can draft Chinese language contracts and therefore want whatever best protects their clients, which oftentimes is China litigation. The fact that foreign (i.e., non-Chinese law firms) are allowed to participate much more actively in an arbitration than they are in a China court litigation is another reason why law firms favor arbitration over litigation even though this should ethically play no part in the decision.

And if the above is just not enough for you on China litigation versus China arbitration, I urge you to read the following:

Any questions?

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