China Contracts Matter

China contracts

Renaud Anjoran left the following interesting question on the China Law Blog LinkedIn Group this morning:

What is the value of the Chinese Court System?   I have been reading Dan and Steve’s China Law Blog for a while. They keep asserting the value of legally binding contracts, and note how good Chinese courts are at enforcing them. The World Bank rankings also support this view.

On the other hand, I regularly read about how useless the Chinese court system is. For example, in his latest book, Andrew Hupert writes:

“Bringing suit in China is generally considered a terrible option. It is at best a last resort.”

“A Chinese businessman, when confronted with a rigid set of rules and a counter-party he does not feel a connection with, will immediately start figuring out a way to game the system. When you give him a thick contract document, he sees an instruction manual, and that fixed corporate structure is really the set of rules to a game he plans on winning.”

“The court system offers incomplete remedies at best and has been known to be quite harmful to foreign interests.”

Opinions? Who is right?

My short answer is that both sides are right. My longer answer is that only my side is correct.

Let me explain.

Andrew Hupert says that “bringing suit in China is a terrible option. It is at best a last resort.” I completely agree with Andrew on this. As anyone who has been involved in litigation anywhere in the world will tell you, it is a horrible thing. It is expensive, time consuming, and imperfect. Litigation signifies the end of discussion between parties and, as such, it should only be undertaken after all other avenues have been exhausted. As I am constantly telling clients, “if you have to sue, you have already lost. You can win the litigation, but even so, you will have lost.”

I also completely agree with the quote about how “the court system offers incomplete remedies at best and has been known to be quite harmful to foreign interests.” Again though, this quote holds true everywhere because this is the nature of litigation virtually never brings anyone a complete remedy. If you are owed $250,000 and you sue and the court awards you $250,000 and the other side pays you in fairly prompt order, you still have not achieved a complete remedy. What about the time you spent trying to settle the case before suing? What about what you might have done with the $250,000 had you received it sooner? What about your attorneys’ fees in dealing with the problem? What about all the time you and your employees had to spend on the case?  Litigation is not a complete remedy, which just underscores why it should always be a last resort.

As for foreigners doing poorly in Chinese courts, that too is true. Again though, if you are Citibank, would you rather be a defendant in a court in Manhattan, New York City or Manhattan, Kansas?

So what if litigation is horrible and time consuming and fraught with risk and not always fair? What does that have to do with contracts in China? Shockingly little. Renaud, everyone tells me that no matter what you do, you will always have quality problems with your Chinese factory. Should I take that to mean quality control is a waste of time?  Of course not. Contracts are no different.

There is huge value in having a contract with your Chinese counterpart. Way back in 2006 in an article no longer on the Internet, I explained why corruption and unfairness and run of the mill judicial imperfections are overrated and no reason to just give up on contracts:

Every time I tout the fairness of China’s courts, I feel called upon to make clear I am not a naif. I fully realize Chinese courts virtually never rule against the government when central government policy is at issue. And, when I am talking about fairness, I am completely ignoring criminal and political cases. I also recognize that even though China’s courts are controlled from Beijing, the chances of getting a fair trial are much greater in prosperous commercial cities like Shanghai, Tianjin, or Qingdao, than they are in a small city in Anhui Province. I know too that a foreign company prevailing against a powerful local company in a Chinese court is always going to be less likely than if all parties are of the same strata.

So China’s courts are not always fair.

But, they are fair way more often than credited by the western media and I am absolutely convinced (as are all the Chinese lawyers with whom we work) that they are fair often enough to make it as ill-advised to do business in China without written contracts or Intellectual Property (IP) protections as to do business that way in the West.

Even if China’s courts are fair only 60% of the time, this is enough to cause the rational Chinese businessperson to make decisions based on legal ramifications.

There is a commonality to judicial corruption worldwide. Corrupting a judge is expensive. The greater the amount at issue in the case, the more the judge will charge for a favorable decision. The more publicly visible the case, the more the judge will charge. The more the judge has to trample the law to reach the decision for which he or she is being paid, the bigger the bribe will need to be. Local trial court judges (who are most likely to know the lawyers and/or the parties) are more likely to be corrupt than appellate court judges. Supreme Court Judges are the least likely to be corrupt.

All of this means that even in the most corrupt legal systems, the better your contract, the more it will cost your opponent to prevail and the better your chances will be as you climb each step of the court system and the more it will cost to change that.  When I tell clients this, their reaction is usually, something like, “great, all this means is that my opponent will need to pay the judges half a million dollars to beat me, rather than only $10,000. That still doesn’t help me.”

Oh but it does.

If the other side is going to need to spend $500,000 to beat you, they should be willing to settle with you for even more than that. They should be willing to pay you more than the judge will cost them because settling with you has a greater certainty of finality and a much greater certainty of their not getting arrested for bribery. If you have no contract or a lousy contract, the other side may be unwilling to pay you anything, figuring a small judicial bonus is all it will take to assure legal victory or that you will choose not to sue at all.

Chinese courts generally fairly resolve commercial disputes and they are continuing to improve. China’s courts already are sufficiently fair that Chinese businesses for the most part do consider the legal ramifications of their actions and act accordingly.

Bottom Line: There is no justification for failing to take legal precautions by using written contracts and IP protections when doing business in or with China. Those who justify their failure to do things by the legal book in China because “the courts don’t enforce the law there anyway” are both empirically wrong and foolish.

Even if you never intend to sue anyone in China, it makes sense to have a good contract for China. There are three main reasons to have a good contract, and suing and winning in court is only one of them. Another reason is to make sure you and your Chinese counter-party are on the same page. We actually wrote about this very topic just a few weeks ago, in Chinese Product Supplier Delivery Dates: Your Contract is Key:

One of the most common problems we see between foreign companies and their Chinese manufacturers is “late” delivery.  I put late in quotes because many times I think the problem is not so much that the Chinese manufacturer was late, but rather that the contract and the foreign buyer were unclear on the actual delivery date requirements.

Let me explain.

When my law firm’s international manufacturing lawyers draft a China Manufacturing Agreement (a/k/a Product Supply Agreement), we are always very careful regarding delivery times. Most of the time, our clients come to us with a term sheet or an oral agreement with their Chinese manufacturer dictating something like 30 days for delivery. We like strictly tying the Chinese manufacturer to the “agreed-upon” delivery date with a liquidated damages provision tied to late delivery. See China Manufacturing Agreements: Make Liquidated Damages Your Friend. Just by way of example, we might put into the Agreement a provision saying something along the lines of delivery shall be within 30 days and for every day beyond thirty days the Chinese manufacturer shall be required to pay US Company 1% of the purchase order price within ten days.

Perhaps more than any other contract provision, we tend to get blow-back on the delivery time provision from the Chinese manufacturer. Oftentimes when faced with the reality of having to pay a set amount for late delivery, the Chinese manufacturer gets serious about delivery times and reveals it cannot make deliveries within the previously “agreed” time frame. Our client usually realizes it is better to get real agreement (even if longer than originally anticipated) before ordering, rather than getting late delivery after ordering.

The other, somewhat related issue we face on delivery times is that when our client comes to us and says it has agreed with its Chinese manufacturer to a 30 day delivery schedule, we then have to figure out 30 days from what. We typically go with 30 days from the issuance of the purchase order, but oftentimes the Chinese company pushes for it to be 30 days from its receipt of payment or 30 days from its receiving proof of payment.

Bottom Line: 
 Certainty is important for delivery dates and the best way to achieve that certainty is with a written contract, in Chinese, that sets out your delivery expectations and the penalties that will accrue if your manufacturer fails to meet them.

The third reason to have a good contract is to put a little scare into your Chinese counter-party. I call this the “bike-lock theory of Chinese contracts” and I wrote about this too way back in 2006 also for a publication that also no longer exists:

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 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. The international dispute resolution lawyers at my law firm constantly settle cases with Chinese companies based on well-written contracts. Having a well written contract does not mean you will always win your 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, but hey, it’s your choice.

No way am I going to back down on this one. Who’s with me? Renaud?

5 responses to “China Contracts Matter”

  1. Very thoughtful response. Thanks Dan. 
    I agree with you on the value of contracts. Many importers have told me “but China doesn’t care about rules and laws, and the courts there are a joke”. Now I know what to respond to them, and where to point them if they want to read the long answer!

  2. blah, blah, blah, blah….all your points are meaningless if China does not have a functioning legal system with a reliable and independent judiciary. In the end, if you are in China, you have nothing at all to lean on no matter what kind of contract you have written and how well you think you’ve boxed in your contracting party. Even if you insert arbitration clauses, once you win your binding arbitration in Hong Kong, good luck collecting. Basically, the Chinese side will do business with you when its to his advantage to do so. If it becomes in his advantage to default, then your are left helpless. This is the reality no matter how much you wish and hope it were different.

  3. Dan, 
    I’m lawyer from Brazil, and I completely agree. Most of the importers here do not enter into agreements with Chinese suppliers, for Brazilians deem it to be too complicated and also feel that is slows the negotiation way too much. However,  they almost always get in trouble. On the other hand, I have barely seen any major problem arise, whenever there is a written contract. 
    By the way, Brazilian courts are much slower than Chinese ones, to the point of a simple lawsuit taking 10 years. In spite of that, no Brazilian is his right mind will make a deal without a written agreement. Again, just like you said, it is worth not taking chances. 
    Adler Martins

  4. Regardless of what many people may think about China and it judicial system, having a well written contract is the best protection any company can have when doing business in China.  Usually the people who complain about the Chinese judicial system does not work are the ones without a contract in place.  Also because so many people get screwed in China it would seem like there is nothing much that can be done.  From my experience over the years in China, the only time factories ever pay for late delivery, defective products, etc was when we had a well written contracts in place.   Things might not be perfect in China but you have to know how to get their attention and a solid contract is one way on keeping the balance of power when doing business in China.    Without a proper contract is like forfeiting your advantage.     

  5. Great post.
    I was having an informal discussion today with a representative of a home-lender which involved providing them with feedback on loss mitigation in the home foreclosure litigation process.
    My first thought was “avoid litigation”.  
    Even if a lender wins a judgement through the court system for the outstanding balance of the home loan, plus fees and costs, it’s not really a “win” against a borrower who cannot make minimal loan repayments in the first place.  It also wastes time when a mutually better arrangement, such as a short-sale, or renegotiation of the original loan terms could be made.
    My second consideration was in regard to where there were “failures” in the settlement/negotiation process.   More to the point; there are “rules” in place that govern litigation, and somebody from both parties is definitely making assessments about whether or not it’s “worth it” to proceed with litigation, settle, or renegotiate.  There is always an aspect of “risk” associated with litigation. 
    Although it’s a separate area of law, I consider the Federal and State statutes that govern home foreclosure procedure a kind of “extension” of the loan contract- when a borrower goes into default.  A failure by either party to comply with those clearly defined rules can be costly- having nothing to do with fairness or justice regarding the original complaint.  
    More specifically, clearly defined contract terms and mutual understanding of those conditions is never going to be an absolute determination of  whether or not “justice” prevails through a court system.  It’s not even a determinant of whether either party will uphold those terms,  but it sure seems like a good place to start.
    Is it that expensive to establish a quality contract in China?  I guess my next question is-what are the overall “success rates” (in China) of settlement/renegotiation when no contract, or an insufficient contract is in place?

Leave a Reply

Your email address will not be published. Required fields are marked *