China Contracts: Why Choosing Foreign (non Chinese) Law is Almost Always a Bad Idea

China COntract Lawyer

My law firm’s  International Dispute Resolution lawyers have been getting an influx of cases from investors wanting to sue Chinese companies in U.S. courts for corporate governance violations. Nearly every time their plan is to sue the Chinese company for having violated “minority shareholder rights” or for breaching fiduciary duties owed to fellow investors. There are usually two big problems with these proposed lawsuits.

First, as we discussed in The China Stock Option Scam, it is not possible under Chinese law for a Chinese domestic company (as opposed to a WFOE or a Joint Venture) to have foreign shareholders. Second, even if — as is often the case — we are not dealing with a true case of foreigners purportedly owning shares in a Chinese company, the duty owed to the foreigners will be based on China corporate governance laws, not those of the United States. When we tell our potential clients (and even their lawyers) that China law will apply to their corporate governance issues, their response is usually something like, “but our contract calls for disputes to be resolved in a U.S. Court” or something that indicates this just never occurred to them.

A contract provision calling for disputes to be resolved in one country’s court has little to no influence on the law that court will apply to the case. Most importantly, it is difficult to imagine a thoughtful American judge applying U.S. corporate governance law to a transaction that took place wholly in Mainland China involving Chinese entities.

I thought of these corporate governance cases today after reading a really nice analysis of the Second Circuit’s recent decision in the big Vitamin C Antitrust Litigation, holding that U.S. courts must “defer to a foreign government’s interpretation of its own laws.” This analysis notes that this decision should hardly be a surprise and that it will likely have far-reaching implications:

That should hardly be a controversial proposition, but up until now, lower courts have treated the interpretations of foreign governments regarding their own laws with varying degrees of deference, ranging from strict deference to outright skepticism. But now, the Second Circuit has put litigants on notice that the principles of international comity have to be applied in cases implicating the laws of other sovereign nations.

The Second Circuit’s ruling will affect a wide spectrum of legal issues facing foreign companies and financial institutions, ranging from subpoenas to asset restraints, and from enforcement actions to discovery requests, as well as substantive matters such as antitrust law, intellectual property, and securities laws.

Without going into the Vitamin C case facts and the Second Circuit’s legal ruling, I will just say that if you are going to do a transaction in China that involves your getting equity or even profit-sharing from a China-based entity, you should just assume Chinese law is going to apply to any subsequent dispute you might have against that China-based entity. And this will be true regardless of whether or not your contract (or something else) entitles you to bring your dispute in a U.S. court.

This means when doing a deal involving equity in or profits from a Chinese company, you should at least know that China’s corporate governance laws put more value on the contracts you sign and less on shareholder protection laws than does the United States. Minority shareholder protections in Chinese companies come pretty much entirely from the agreements executed by the parties. There is no paternalistic government sitting above the transaction providing legal protection for shareholders that do not protect themselves.

This is why we advise our clients in this area (as in all other areas of Chinese law) not to rely on default provisions of Chinese law for protection. You must protect yourself with a clear written contract that sets out exactly what is intended. Chinese courts are quite good at enforcing clear contracts. Chinese courts are not good at protecting naive shareholders from their own failure to protect themselves.

The deeper issue with the Vitamin C case is that it explodes a common myth about litigation in the U.S. Many people mistakenly believe that if they provide for litigation in the U.S. the U.S. court will then apply U.S. law to a transaction otherwise governed by foreign law. This is simply not true.

Take an obvious example. Say the transaction involves transfer of real property. Does anyone seriously think a U.S. court sitting in New York state would apply New York law to determine whether real estate was properly transferred in a province in China? Far too many times, our China employment lawyers have had to explain to companies that a provision in an employment contract with a China-based Chinese employee calling for application of U.S. law is going to be completely ignored by 100 out of 100 Chinese judges that see that. The same applies to the area of corporate governance and to any other area where the substantive law of a foreign country completely controls the transaction.

For this reason, foreign parties who believe using contractual provisions requiring litigation in their home country can replace what they see as “unfair” Chinese laws are simply making a mistake. What will actually happen is the parties will be required to prove Chinese law in a U.S. court, a difficult, time consuming and expensive process. This is usually exactly the opposite of what the U.S. party assumed would happen in this situation.

For more on choosing your dispute resolution jurisdiction, your choice of law, and your ability to enforce U.S. judgments in China, check out the following:

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