Ten years ago, my law firm’s China lawyers would get maybe one contract a month where our client was selling products to China. These days, we may get about that many every week. And just as Chinese companies selling products became adept at using contracts that minimized or even eliminated their risks, Chinese companies (particularly China’s biggest companies) have become adept at convincing the foreign selling companies to enter into contracts that are incredibly risky to the foreign company.
The below is a slightly revised email to which I was cc’ed, explaining to one of our clients its product selling risks under contracts proposed to it by various Chinese SOEs. I am running this email for three primary reasons. One, to show what some of the primary risks can be when selling products to China. Two, to show how China’s largest companies are so tough in their contracting. And three, to emphasize the need to think through your risks in any China deal.
1. At the outset of your doing this deal, you should consider your real risks here, not your theoretical risks.
a. Your PRC WFOE is a limited liability company. Whatever happens to that entity, it is not likely liability from that PRC entity will ever be imposed on your U.S. company as owner of that WFOE. The first step in protecting yourself is therefore to operate the PRC WFOE on a very lean basis. Do not acquire excessive cash or assets. Repatriate the WFOE’s profits as quickly as possible. Rent rather than own. Use debt rather than capital. This is what Chinese companies do to mitigate their risk and this makes sense for your China WFOE.
b. As your local staff has probably explained, it is rare for Chinese SOEs (State Owned Entities) to sue their suppliers for quality problems. It is also rare for Chinese courts to award big damages in product liability cases. So the risk of a major products liability judgment against your Chinese WFOE is low.
c. On the other hand, as you have already experienced, it is common for PRC SOEs not to pay their bills. Chinese SOEs typically use contracts in a two step process. First, they force their parts supplier to provide a substantial amount of product on credit. They do this slowly, but over a two or three year period they lure the supplier into complacency. Second, the SOE then uses the alleged violation of one of their contracts to justify refusing to pay you for the products they acquired on credit. I know of no product suppliers bankrupted by products liability claims in China, but I know plenty that have gone under due to non-payment for product delivered or to charges for late delivery or trivial defect claims, or both. Once you are bankrupt, you have no way to dispute the claims and justifications for non-payment/imposition of charges. Chinese companies are ruthless; they never seem to care about bankrupting their suppliers. They assume there is a replacement ready to take over.
2. We therefore need to determine your real risks and then address those real risks in order of priority. As I see it, your real risks are as follows:
a. Basic Business Terms: Price, quantity, delivery date, method of shipment: none of this is clearly set out in the contracts being proposed to you by your buyers, and all of the assumptions radically favor your buyers.
b. Payment: You are being required to provide substantial amounts of product on credit. This is never good in China, as the recent decision, as is evidenced by ____________’s recent decision to withhold payment to you.
c. Price: Many of your buyers want to hold you to the requirement that they receive the “best price,” rather than a system where they stick to your published price or the specific price agreement with them. We should fight against this.
d. Unclear Acceptance and QC Procedure: These contracts are unclear on the acceptance and QC procedures upon delivery and this lack of clarity allows for infinite delay in payment. We need to change this.
e. Unclear and Unreasonable Demands for Off Site After-Sales Service: These contracts are written as to give the buyers essentially unlimited free after-sales service. That is not acceptable.
f. Unreasonable and Unclear Late Delivery Penalties: These contracts set forth unreasonable and unclear penalties for late delivery and they mandate that you deliver early and on credit to an SOE manufacturer controlled warehousing facility. We need to stretch out and clarify your delivery times and late delivery penalties.
The above are your real risks. Though product liability and product recall damages are also a real risk, they are a low risk for China. The greater risk in China is that this kind of claim will justify non-payment as described in 2.a. above. I also note that 2.f. late delivery claims can be significant in China. The threat of suing you on such claims could be easily used to compel you to take costly measures for delivery (air freight/express courier) or for out of sequence manufacturing that damages your relations with other customers. This sort of thing is very common in China — we had one company who came to us for a “contract adjustment” after having to spend millions of dollars in air shipping auto parts so as not breach its supply contract. You should treat the provisions on late deliveries as one of your biggest risks.
3. You are in a position where you need to address your China risks head on. There is be no way to avoid the risks with a workaround such as sales agency or third party manufacturer sales. Your first step for dealing with your risks is to identify and prioritize your real risks. If you cannot acceptably mitigate these real risks, you will need to evaluate your overall risk of operating in China and decide whether or not it makes sense to continue doing so. As I stated in my earlier email, Chinese entities usually mitigate these risks by minimizing product sales on credit and by minimizing assets available for seizure to pay litigation damages.
Let’s talk tomorrow about the above.