China MOUs and LOIs: Use Them at YOUR Peril

The other day, I and another of my law firm’s China lawyers were emailing with a reporter regarding how Memoranda of Understanding, (MOU) and Letters of Intent (LOIs) are so different in China than in the United States and how that difference often causes early discord between Chinese and American companies.

We started the discussion by talking about the differences in the meaning of Memoranda of Understanding and Letters of Intent (between China (an essentially civil law country) and the United States (a common law country):

In the common law tradition like that in the United States, MOUs and LOIs means little. Only a signed deal really counts. This is not true in the civil law tradition. In the civil law tradition, there is the concept of good faith negotiation. Under that concept, it is not acceptable to simply walk away from an MOU/LOI if that would constitute “bad faith.” Common law lawyers hate the concept, but it is deeply ingrained in the civil law tradition. In fact, it is a core concept in the Chinese contract law of 1999. Since the traditions are so different, you can see where conflicts may arise.

In practice, the Chinese side often will try to turn an MOU/LOI into a concrete commitment when it suits them and ignore it when it does not. This is how most Chinese companies behave and it should be no surprise. The problem is that under Chinese law the Chinese side might be justified in insisting that the MOU/LOI  is binding if the behavior of the foreign side constitutes bad faith.

What is bad faith? The standard example is signing a China MOU/LOI and then negotiating with another company at the same time without informing the company with which you signed the MOU/LOI and then using the MOU to keep one party from taking the initiative on a venture. And then you sign a deal with the other party, cutting the first party out of the deal. This sort of strategy is not rare in common law countries, particularly in the mining/minerals and other natural resources businesses. Under the common law, the party cut out under this scenario usually has no claim. Under Chinese law and under civil law, the party that has been cut out has a claim under the bad faith doctrine.

Very few common law lawyers are even aware of this issue or they say that the Chinese are “wrong.” However, China is a civil law country. It makes no sense to say the Chinese are just wrong. In fact, to the extent that the matter is subject to Chinese law, the Chinese are “right” by definition.

We then discussed how this difference in laws so often leads to problems arising between Chinese and American companies:

The impact of this difference is that we frequently see the following: American company comes back from China and shows us their five page MOU/LOI and says they now want to work on a contract. We tell them what they have given us is probably a contract. They tell us that we are wrong. We tell them to tell their Chinese counterpart that they now want a contract and see what happens. Pretty much every time, the Chinese company tells the American company there is no need for a contract and then the American insists there is and then the Chinese party thinks the American is being a jerk. The parties have already gotten off on the wrong foot.

We then summed up the problems:

There is a major gap in legal systems here. It is not culture, it is the legal system itself. Both sides are behaving in a manner consistent with their own legal system. But in the end, both sides look to the other as though they are acting in bad faith, when in fact both sides are doing nothing more than trying to reach a deal as best they know how.

And the thing is that neither side has malevolent intent. The Chinese side just puts more stock in the MOU than the American side. The American side will sign the MOU thinking it is nothing, and planning to turn it over to their attorneys to draft the final agreement.

And then the problem starts when we tell the American company that the MOU it just signed is almost certainly a legally binding contract and that it is virtually certain the Chinese side sees it as a contract and that the contract is terrible and that “it needs the following ten additions/changes.” The American company then goes back to the Chinese company with the ten things that need to be changed or added and the Chinese company then gets offended because it thought it had a deal and that only super minor things needed to be resolved and that those would be resolved over time. So now you have a situation where what could have been a good relationship starts off on the wrong foot or fails to start off at all.

What do you think?