18 June 2020

Is Your Contract Fit for Purpose?

This article was written by Mark Schaub


Increasing numbers of international businesses are looking at China as a means to expand their footprint but also as a new revenue stream. There is undoubtedly genuine interest in China for international brands, products and know-how.

On the whole, international businesses have been very successful but the China of 2020 is very different from the China of 1990. International companies in growing sectors or in industries not directly affected by COVID (e.g. cosmetics, digital, SaaS, etc.) have seen modest growth. There are also opportunities in second and third tier cities. However, second and third tier cities pose challenges (i.e. finding and retaining expat staff, less familiar, etc.) not just opportunities.

There is a veritable gold rush and international companies often find themselves competing for the best Chinese partners. The Chinese partners will overall be very swayed by brand and performance. If your business is not highly ranked then it is important to find a unique selling point. This may include flexibility as to location but also how the projects are run and even how to proceed with the contracts.

Why Contracts Matter in China

Lawyers do tend to go on about contracts. In China, it is arguably more important to have a good partner than a good contract. However, ideally you should have both.

Many business people will complain “a contract in China is not worth the paper it is written upon”; “you can never enforce a contract in China”; “negotiations only start in China after signing” and so on. All these statements have a varying degree of truth but contracts still do matter in China.

The reasons for having a good contract include:

  1. Common Understanding

At least the contractual parties know that they share the same idea.

In one case, a Belgian businessman had conducted a number of meetings with a Chinese customer over the period of 9 months for the sale of a complex piece of equipment. The Chinese customer spoke some English himself and had his daughter acted as a translator as she had studied English at high school. The Belgian businessman was delighted about how quickly the Chinese customer had understood everything and his intense concentration. The Belgian would often speak for 20 minutes without interruption. At the end, the Chinese customer would simply agree. Curiously, most questions raised were on very simple issues or words. This was in fact not surprising as the Chinese customer probably understood virtually nothing, and his daughter may have only understood some of the opening statements. He only found this out when he finally had brought a Chinese speaker for “crossing the Ts and dotting the Is”. It turned out both parties had thought they were selling machinery! The contract was never signed.

  1. Useful for Day-to-Day Differences of Opinion

The contract will be important in discussions during implementation – it is very common for the commercial people to say “Mr. Wang, now that it is signed, we can put the contract in the cupboard and roll up our sleeves and start work”. 

This is a nice sentiment but implementation, like life, can often be complicated…and contracts will often be pulled out of cupboards…and when they are, it is good if the people reading them share an understanding of the terms. It should be noted that often the people reading the contract and trying to make sense of them were not the people at the table negotiating the contract.

I may have been lucky, but I have not to date been confronted by a Chinese counterpart who reads the signed contract and then says, “Yeah it says that…but I don’t care”. It is possible (indeed likely) the Chinese partner will perhaps interpret the wording differently, but in most cases provided the wording is sufficiently clear then this will greatly help in discussions.

  1. Enforcement 

Most parties hope that it never comes to pass but at the end of the day, the terms of the contract need to be enforceable if the parties cannot resolve their difficulties between themselves. This will be dealt in more detail below but many contracts for PRC education face great difficulties in enforcement and some are wholly unenforceable. 

The Goldilocks Contract: Not too complicated; not too simple

As Einstein said, “Make it as simple as possible and not any simpler”. Many people (ironically it seems to be often lawyers) forget that the purpose of a contract includes 1) committing to paper the common understanding with a partner; 2) be a guide for day to day work; and 3) in a worst-case scenario, having an agreement that is enforceable. 

Rather than having contracts that are suitable to the task, the drafts of contracts are often prepared with an “adversarial” approach. Rather than drafting a balanced agreement that will allow the parties to work with common purpose the first draft is commonly extremely one sided. Indeed the draft can create an impression of mistrust of the partner that would make an independent observer wonder why on Earth anyone with so much apprehension would wish to enter China.  

An adversarial approach is logical in criminal law (i.e. the diametrically opposed interests of the parties – defendant wishes to be found not guilty whereas the prosecution wishes to send him to jail) it may be a less appropriate approach for a collaborative endeavor. 

Experience is that the extremely one-sided contract approach is:

  • Far more difficult to negotiate;

  • Time consuming;

  • Foster bad will and thereby may lead to difficulties in future working together;

  • Makes the parties actual intentions unclear (what are the redlines if everything seems to be a redline?);

  • Many of the most difficult to negotiate provisions are also often most difficult/impractical to enforce in practice; and

  • Increasingly only an inferior Chinese partner will agree to obviously one sided contracts.

Accordingly, when preparing the contract, it is wise to consider the following:

  • Does the contract make sense? If I read it, do I understand what the parties wish to achieve? If I do not am I stupid? Will someone who works on this project in the future understand the contract?

  • Is the wording written in normal language, not legalese?

  • Is there a bilingual version?

  • Does it incorporate the US practice of “I REALIZE YOU WILL VERY MUCH DISLIKE THIS PROVISION AND INDEED IT IS UNFAIR, SO I AM GOING TO REALLY HIGHLIGHT IT BY TYPING IN CAPS AND BOLD” type provisions? This is unnecessary under PRC law and only highlights certain areas likely to infuriate the Chinese partner. This is very negative for the negotiation process and does not seem to provide any protection or advantage.

  • Is the other side clearly identified (or only by its English name)? Many companies face difficulties in enforcement as the counterpart cannot be identified.

  • Does the contract specify arbitration or courts, or is it silent? Is the choice enforceable?

  • Is the contract signed by the other side’s legal representative or stamped with the company seal? If not, it is unlikely to be enforceable.

But not too simple 

Although, long winded, extremely one sided contracts will likely have a negative impact upon the project it is important that the contract is sufficiently detailed to ensure the international company is well protected and that the project is clearly set out. Given the differences in legal systems, knowledge level of operating the business and culture it is important to spell things out in China. An example of this is a sign in a local hotel:

“Guest shall not engage in disturbances, gambling, drug taking, whoring, shooting. No guns, radioactive materials, fireworks, chemicals, poisons, explosives are allowed in room. The use of electric ovens, rice cookers, gas heaters is prohibited. Electric kettle not to be used to cook rice. Do not dry clothes on lamps. Guests shall not connect copy machine, facsimile transmission machine without manager approval. Raising poultry and livestock forbidden in room.” 
(Guest notice in a three-star hotel in Dashiqiao, Liaoning Province).

As seen from the above hotel notice, the Chinese often feel the need to very clearly set down the rules. Many a foreign hotel guest may feel that some items in the above notice are self-explanatory and that he/she would have abstained from the specified activities in any event. Despite this, it is clear the list was not based on theory but was no doubt a valiant attempt to combat actual bad behavior by guests.

For this reason, it is a good practice to prepare detailed contracts to stipulate matters specifically rather than rely upon assumptions. The more detailed the contract, the more it protects both parties from suffering a major misunderstanding.

When preparing a contract for China, it is recommended to draft the contract in both English and Chinese. We often have experiences with clients who believe that the deal is “done” and it is just the “paperwork” that needs to be completed. Generally, these clients are surprised that once the formal contract is presented to the Chinese party, the discussions re-commence. Often it will appear as if there had never been previous discussions.

We do recommend that companies insist on tough wording in their contracts for their redlines – typically this in relation to protecting the brand, governance, economics and exit. 

However, crucially it is more important in most cases to preserve your freedom rather than seek to compel your Chinese partner to take specific action. An example is the phantom fee provision in many Chinese collaboration projects, especially in education projects. This provision provides that in the event that the Chinese partner does not meet the roll out requirements as agreed then it will pay the international party as if it had. Such a clause is notoriously difficult to negotiate, patently unfair but perhaps more importantly is extremely unlikely to be ever enforced. If the project is in financial difficulties then the Chinese partner is unlikely to be able to make such payment much less continue to make such payment on an on-going basis. 

Further, if the first project ends in dispute, it would be an atypical international school that would wish to stand its ground and instigate complex litigation against its partner. Much more likely is that the school would immediately head for the China exit.

In addition, a dispute in respect of a phantom fee provision is always likely to be complex. Non-payment of a minimum license fee for the first location is relatively straightforward. However, holding a Chinese partner financially responsible for license fees for non-existent locations that the parties hoped to establish is much more complicated. Maybe the international party did not perform, possibly Chinese customers were not satisfied with how the business was operated, etc. The reason that the roll out has not succeeded is likely to be much more complex than a failure to make a payment. 

For this reason international businesses should insist that the contracts are designed so there is flexibility under the contract to take unilateral action (i.e. terminate the contract, stop trademark license; enter into an agreement with a different Chinese partner) rather than rely upon contractual terms to force the Chinese partner to meet targets or take other actions in the future. It must always be kept in mind that such contractual provisions will need to be enforced through courts. More on this later.

Chinese projects are similar to marriages. Sometimes these relationships will not work out. Mostly both parties are at least partially at fault. Divorces tend to be easier (or at least easier to work out) if you have a pre-nuptial agreement. Accordingly, at the same time as you are discussing China-wide conquest and undying co-operative spirit with your Chinese partner, you should also be contemplating how best to lay the ground for a possible parting of the ways (both contractually and otherwise) in case things just do not work out.

The Case for Chinese Law

Multinational companies are on the whole conservative and traditional especially when it comes to doing business in China. One of the ways that conservatism and tradition manifests itself in a China project is the choice of law. For the multinational company often the choice of their home jurisdiction’s law is a comforting choice as it is more familiar.  

Legally, it is possible under Chinese law to have the license agreements governed by the laws of the United States of America. However, it may not be wise to do so. For example, US law has a global reputation. However, many of the advantages of US law will not be relevant for a China project. 

One of the primary advantages of US law is that it allows parties greater flexibility than is generally the case under many civil codes that tend to spell things more out. In addition, if the law is silent judges will decide on law and precedent allows for constant evolution. 

However, this advantage is blunted in a Chinese project. Crucially, the collaboration will be primarily carried out in China and it will not be possible to exclude mandatory application of China law in material regards (i.e. in respect of foreign exchange restrictions, employment, registration of IP rights, visas for foreign nationals, taxation, changes in law etc.) – so there will be difficult contact points where there may be points of difference between US law and Chinese law. In these cases, Chinese law will prevail anyway – i.e. if US law and the contract allows foreign exchange to be freely transferred this does not mean that the Chinese banks and authorities will follow the term in the contract. Accordingly, the flexibility will in practice lead to uncertainty. To be clear, if a Chinese party wished to collaborate with a company in the US then US law would be the sensible choice. 

The second advantage cited for international jurisdictions is that they are more recognized choice for international business. It is very clear that in certain sectors, UK or US law is indeed the default choice for international parties – even if there is no British or American parties or geographic link to a project. 

However, selecting an international jurisdiction is normally done in specific sectors with a number of sophisticated and experienced parties in which complex issues have evolved over many decades. For the UK as an example, the most familiar sectors are banking and financing, maritime and shipping. For many businesses and sectors, English law is neither so universally recognized nor do those projects require the flexibility to evolve new business practices such as is needed for banking and finance projects. In addition, many projects are … well, less complicated than a shipbuilding contract. It should also be noted that Chinese contract law does not have any inherent bias against foreign companies. Chinese practice may but not the law!

Enforcement, Enforcement, Enforcement 

Another advantage of US law is the independence of its judiciary and the experience and reputation of its judges. 

However, these advantages only manifest if disputes are agreed to be held before US courts – if not, the US courts will not get to display their independence nor will the judges get to show off their experience.

And there is the rub. Jurisdiction is perhaps the most important article of a contract. You may have the world’s best contract but if you select the wrong jurisdiction, it is for naught as you will not be able to enforce your hard-negotiated contractual rights.

In some cases, the multinational company will insist upon US courts. As with US law does not contravene PRC law. Indeed a final judgment given by such courts may be technically enforced in a court of the PRC in accordance with the Laws on Civil Procedures of PRC, provided that the country in which such courts are located has a reciprocal relationship in respect of judicial assistance with PRC or such country and PRC are co-members of international treaty for judicial assistance. If no such relationship or treaty exists, then enforcement will depend on the discretion of the PRC court. It should be noted that in almost all cases the PRC courts will exercise their discretion to not enforce such overseas judgment. Accordingly, US courts is an excellent choice if your Chinese partner is asset heavy in the US. If not then other options should be considered. 

Accordingly, for these reasons most international companies entering into a contract with a Chinese entity will select arbitration. An award given by a formal arbitration organization against a Chinese party may be enforced in a court in the PRC pursuant to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards of New York, 10 June 1958 (“New York Convention”) and in accordance with the Laws on Civil Procedure of the PRC. For reference, the US, the UK, and the PRC are signatories of the New York Convention. Legally, a PRC court is only entitled to refuse to enforce such international arbitral award pursuant to the grounds outlined in Article V of the New York Convention (i.e. public policy or bias – both very difficult to prevail upon). 

Popular choices for arbitration in contracts with Chinese parties are Singapore, Hong Kong or CIETAC in Beijing. 

Despite this, in our experience, it is very difficult and time consuming to attempt to enforce an international arbitral award in China.

If arbitration is preferred then Hong Kong may be the best choice as there are regulations in place to allow for Hong Kong arbitration institutions to seek injunctive assistance from PRC courts. Other arbitration bodies do not have such advantage. However, these new regulations are largely untested.  

Chinese Courts

There is another possible choice: non-exclusive Chinese courts. Few international businesses consider Chinese courts. However, there are persuasive reasons for considering PRC courts including:

  • Better than their Reputation– Chinese courts have improved beyond recognition in the last 30 years. There may still be issues in respect of decisions in second and third tier cities or in enforcement (more about this later) but overall the court system works well. It should also be noted in most cases arbitration will also rely upon the Chinese courts for enforcement. 

  • Time and Cost Effective– In respect of many businesses, likely cases to escalate to a formal dispute are related to: 1) non-payment; 2) breaching of IP rights within China; or 3) reputational issues. In all these cases resorting to the Chinese courts is simpler, quicker and more cost effective. In addition, if you have a Chinese “onshore” contract you will be better able to enlist the assistance of the PRC administrative authorities. This is especially likely in respect of IP rights. The PRC administrative authorities are generally not generous with awarding damages but can be very effective in taking quick action to stop on-going breaches. 

For a payment dispute, this will typically be determined on the facts and will be of limited complexity. For an IP case, the advantages of the Chinese courts are actually even more persuasive. Firstly, in IP registration or dispute cases there will often be an interplay between courts and administrative bodies (i.e. trademark office). Secondly, courts are able to issue injunctions such as evidence and/or asset preservation orders and other remedies. At present Hong Kong arbitration does have such right but it is currently still largely untested. In addition, we assume few businesses will have the appetite to enter into a major litigation battle. 

For a reputational issue the advantages will are essentially speed and direct ability to take action. In the case of a major issue, the international company will be likely better served by taking direct action rather than awaiting for an outcome of arbitration.

Summary 

In China, anything good will be snapped up quickly. This will also apply to good quality Chinese partners for international projects.  Many multinational companies believe that an extremely strongly worded contract coupled with many rounds of negotiations will minimize the risk inherent in the project. This is true – it is highly likely that such projects will never materialize due to a lack of momentum in negotiations. 

Our preferred model is to have a generous time for internal deliberations in order to have all of the relevant stakeholders on board; consider the scale of the ambitions for China and the company’s redlines and then draft a balanced contract that is tough on the redlines but not having everything as a redline.

In most cases, a dispute in respect of a China project will not end before a court or in arbitration. The most likely reason for a break down in the relationship and a dispute will be due to the economic failure of the project. The most likely result of such a dispute will be that the international company will seek to exit the China market with little appetite to engage in expensive, disruptive and time consuming litigation. It is highly unlikely that the knee jerk reaction of an international company with a failed China project will be to start looking for the next opportunity in China. Rather the more conservative stakeholders will shake their heads sadly and say it was always clear this was going to end in tears. 

A good and clear contract will both greatly reduce the risk of a dispute and simplify resolution of a dispute if it arises. Tough yet difficult to enforce provisions greatly complicate settlement discussions. One side will see the situation as a clear breach whereas the other side will sees it as a patently unfair clause that should not be upheld. 

In respect of contracts, there should be no cause for concern in selecting Chinese law. The world’s second largest economy has built a clear basis for contracts and contract law does not have any bias against foreign entities. An advantage of selecting Chinese law is that there is no uncertainty as to where one country’s law ends and mandatory Chinese law starts. However, the greater advantage is that having an essentially “onshore” agreement facilitates enforcement by both Chinese courts but also Chinese administrative authorities. In practice, concerns of international companies will be more effectively dealt with by these measures than by offshore arbitration.  

There are good reasons for Chinese courts but most readers will not be convinced and rather plump for arbitration. If instinctively, the choice of Chinese courts is a step beyond the comfort zone then arbitration in Hong Kong is a reasonable choice. 

 

A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

Doing Business in China
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