Self Enforcing China Contracts With Powerful Companies

In China Contracts: Make Them Enforceable Or Don’t Bother, we talked about what should go into a China contract to make it enforceable. In this post, we go deeper into the issue of contract enforcement in China.

Foreign businesspeople doing business in China often tell us that “contracts with Chinese companies are not worth the paper they are written on.” When told this, we usually ask whether they have first hand experience where this was the case. In the rare instance where they do, we ask to see the contract that did not work for them. Recently, a German investor told us of a situation where the Chinese side of his joint venture deal violated the terms of all the contracts and he was unable to find any remedies.

After looking at his contracts, it was clear to that his contracts were all completely unenforceable. They were the type of contract we discussed in our previous post on this issue. We told him: “you are correct, the contract you executed is in fact not worth the paper it is written on. Some contracts are very valuable, some are not. Enforceability depends on a number of factors.” These contracts are unenforceable because they were not drafted to be enforceable.

In our previous post, we said that when you enter a contract with a Chinese company you must ensure the contract is actually enforceable in China, and we set out the basic rules required to achieve that goal. We also noted you should consider who the Chinese party is on the other side of your deal. The China lawyers in my law firm have had good success in using China’s court system to enforce contracts. However, China’s court system works for enforcing contracts against a Chinese company only if the Chinese court sees both parties as equals.

When we succeed in China’s courts, both parties are WFOEs (Wholly foreign owned entities) or the dispute is between a WFOE and a foreign company. In this sort of situation, it is natural for the Chinese court to see the parties as equals. Most of the disputes we handle, however, are between foreign companies and privately owned Chinese companies. This is the typical situation where a foreign purchaser of Chinese manufactured goods makes a claim against a Chinese manufacturer based on quality or intellectual property infringement.

Surprisingly, in these cases, the Chinese courts tend to treat the parties as equals. In fact, in the intellectual property infringement area, many Chinese companies complain that Chinese courts actually favor the foreign side over the Chinese entity. That is, the Chinese courts just assume the Chinese company is an infringer and then move to determining what to do about the infringement.

But what happens when the Chinese party to the contract will not be treated as the equal of the foreign entity? For example, what if the Chinese party is a major state owned enterprise, or the sole large employer in a provincial town or (most dangerously) is private, but owned or controlled by a family member of a powerful government official or owned or controlled by the Chinese military or police. For this type of party, it is likely the Chinese court will treat the Chinese party better than it treats the foreign party and the likelihood of securing a favorable court decision against the Chinese party is low.

So what should you do when entering into a contract with the above sort of “powerful” Chinese entity? American and European companies when faced with this sort of situation far too often simply ignore the true risks and enter into exactly the kind of unenforceable contract we described in our previous post. The foreign party reasons that it will be impossible to enforce this contract in China, so I will provide for some fanciful solution such as arbitration in New York as an alternative. But this is a mistake. If the contract is not enforceable within China, it will not become enforceable by avoiding Chinese jurisdiction and then having to come back to China to get it enforced there. All this does is make it easier for a Chinese court not to enforce your contract. Smaller companies often abandon all hope of any sort of contract protection and draft their own or just use purchase orders. These approaches are invariably a mistake.

When doing a deal with a powerful Chinese company, you should enter into a contract that follows the basic rules for an enforceable contract in China. China has great respect for the written word. Even in difficult situations, it is surprising how effective it can be to threaten a law suit in China based on an enforceable, Chinese language contract. However, for the threat to work, it must have at least some teeth, and that requires a contract that works.

In contracting with a powerful Chinese party when you know contract enforcement will be difficult, you should develop a way to make your contract self-enforcing. You should use the contract as a device to structure the business relationship in a way that allows you to enforce it yourself. This can be done in many ways, including the following:

  • The best way is to do nothing under the contract without being paid first. If the deal involves your company delivering product to the Chinese company, write a contract that provides you don’t ship a thing until after you receive payment. If the transaction involves your company providing services to the Chinese company, you draft your contract to be clear that you will not be  providing any services until after you have a substantial deposit from the Chinese company. Chinese companies will fight this kind of structure and requiring it oftentimes will put a kibosh on your deal. But so what? If the Chinese company refuses to pay you sufficiently in advance, you should just figure they never intended to pay you in full. Possession is indeed nine tenths of the law, and in dealing with Chinese companies you should remember this.
  • Where there is inherent risk in your transaction (payment risk, quality risk), you should cover the risk with standard risk management products such as a letter of credit, a bank guarantee, escrow or insurance. The key to protecting yourself in one of these ways is to use a truly neutral third party professional not located in China. Any risk management product offered by a Chinese entity such as a bank or insurance company is of little to no value.
  • Design the product you provide to your Chinese company so you can retain a key component of it until you are paid in full. For example, make your manufactured product in such a way that you can hold on to a key chemical or physical component required for it to work and not provide that key component until paid. For a software product, require the use of a password or software key you can change each time a new payment is due. Sometimes this sort of thing can be done with a service as well, if you can hold back on the critical elements of it until the end.

There are many other techniques you can use to all but guarantee payment from Chinese companies, depending on the nature of your business and the transaction. The interesting situation in China is that Chinese companies fully understand what is going on when they are presented with a self-enforcing contract. It often surprises foreign business people to find that Chinese companies will willingly sign off on an onerous, 30 page long common law contract but adamantly refuse even to discuss a China-enforceable, clearly written Chinese language seven page long self-enforcing contract.

The reason for this dichotomy is simple. First, even the most powerful Chinese companies are afraid of Chinese courts when the legal issue involves business rather than politics. Second, in the case of a self-enforcing contract, the Chinese company recognizes such a contract takes away their power to act arbitrarily or unfairly. Since the kind of powerful entities I am discussing here are accustomed to being arbitrary and unfair, they (rightly) view self-enforcing contracts as risky and threatening.

Well connected Chinese companies often refuse to execute a fairly written, self-executing contract. In that situation, the best response for the foreign party is to weigh its risks and seriously consider walking away from the deal.