Getting the Most Out of Your China Contract

June 11, 2014 Posted by China Briefing Reading Time: 6 minutes

SHANGHAI — Contracts are the building blocks upon which business relationships are founded, providing two or more parties with a clear description of the expectations, terms and repercussions at stake in their mutual transactions. For foreign companies sourcing in China—whether via a representative office, service company, foreign-invested commercial enterprise (FICE), or sourcing agent—contracts are an important mechanism for risk control.

Today, long-term purchasing contracts are the gold standard for sourcing from China. While it is possible for foreign buyers to purchase products from Chinese manufacturers without entering into a contract, this is generally not recommended based purely on a cost-risk analysis. Compared with the previous atmosphere of fast and loose deals, today foreign companies are much more emphatic on using well-written contracts to hold their suppliers to the same standards of business practices as in their home countries.

Despite the often cited problems with the rule of law in China and the continuing importance of guanxi in business transactions, the country ranks 19th in terms of enforcing contracts out of 189 economies surveyed by the World Bank’s Doing Business Project. Though the enforcement of contracts in China remains imperfect, it has improved significantly over the past decade, and a well-written contract is always more desirable than no contact at all—as even the threat of enforceability can result in more honesty in one’s dealings with Chinese partners. Conversely, business incentives built into a contract can provide added motivation for one’s partners to live up to their end of the bargain.

However, there are numerous ways that a China contract can become worth less than the paper it is written on: for example, if a Chinese court finds insufficient evidence to enforce a contract’s provisions or determines that the law has been erroneously applied, or if a Chinese company ordered to pay an arbitral award lacks or effectively obscures its assets (as in the case of bankruptcy or insolvency). In the face of these risks, the following are some basic measures businesses can take to ensure the enforceability of their contracts with Chinese suppliers.

Due diligence—A basic background check should be among the first steps taken when entering into a business relationship with a new Chinese company and can be the difference between a mutually beneficial partnership and being swindled by one’s suppliers. Suppliers should be carefully chosen and willing to accept basic customer-side inquiries and inspection of their operations. For an extra level of security, buyers can request audited statements from the supplier or confirm the supplier’s registration at the local AIC.

Law and court system—To ensure that a contract with a Chinese entity will be legally enforceable, it is necessary to identify which body of law, and which court system, will govern its provisions. While it may be tempting for foreign business owners to go with the law and courts of their home country, except in certain rare situations, this makes it nearly impossible to enforce the terms of a contract. For example, Chinese courts will not enforce judgments issued by U.S. courts, making these useless unless the Chinese party happens to have assets in the U.S. This is despite China’s status as a signatory to the New York Convention, which theoretically requires it to recognize and enforce arbitral awards of other signatory countries, including the U.S. Additionally, certain issues can only be governed by Chinese law, including aspects of intellectual property ownership, labor laws, land ownership and insolvency. For these reasons, it is highly recommended that foreign businesses specify Chinese law and Chinese courts as governing their contracts with Chinese suppliers.

Language—The question of which language a contract should be written in is seemingly a trivial one, however, this has the potential to render even the best written contracts unenforceable. Not only are Chinese courts not mandated to accept monolingual foreign language contracts (e.g., contracts written exclusively in English, Japanese, or Swahili), but even if accepted, such contracts will be translated by the court itself, on a basis unknown to the plaintiff.

Bilingual contracts contain their own problems, principally in determining which language will be the controlling language and in ensuring uniformity in the translation between the two. In the eyes of a Chinese court, a bilingual contract that does not specify which language is the controlling version will automatically default to Chinese as the authoritative language. Alternatively, in the event that both languages in a bilingual contract each claim to be the controlling version, the Chinese will again be accorded primacy.

Production oversight—Companies should take special precaution to ensure the specificity of payment, delivery and liquidated damage clauses included in their supplier contracts. It should go without saying that secured payment methods such as bank letters or credit or third-party escrow are always preferable to higher-risk methods such as credit card and wire transfers. Ideally, payment should be tied to the actual delivery of goods to the buyer. Breaking up production into discrete phases, with specific targets and monitoring procedures, can help ensure that the buyer retains control in the overall production process and further increases risk control, despite the added costs. The contract should also be attentive to the threat of defective products and establish clear liability in this regard. It is therefore recommended that contracts include a provision precluding the Chinese manufacturer from subcontracting out some or all of the manufacturing order.

Chops—Any discussion of contracts in China would be incomplete without addressing the issue of company chops (aka seals), as these are at once a necessary component of empowering contracts and a common method by which companies are defrauded. A document affixed with an official company seal carries the binding commitment of the company’s legal representative. Given the legal power invested in company chops, it should come as no surprise that the use of phony chops, or the unauthorized use of legitimate chops, can pose a significant risk to the enforceability of contracts in China.

A company’s first line of defense against fraudulent chops should be to examine them for certain provisions governing their design and application: chops must be round, no larger than 4.5 cm in diameter, with a five-point star at the center surrounded by the Chinese name of the company, and must be stamped using red ink. Further measures to ensure that the seal affixed to a contract by one’s Chinese partners is genuine include comparing the contract with other documents previously sealed by the company, or with company materials such as business cards or the business license. Even more stringent measures may include dispatching a Chinese attorney to the local government to compare with the company seal on record.

As a specialist foreign direct investment practice with 11 offices across mainland China, Dezan Shira & Associates provides businesses with a comprehensive range of services to ensure the enforceability of contracts with their partners in China, ASEAN, and beyond. From due diligence, to contract advising and reviews, to securely managing company chops, Dezan Shira & Associates is your partner for growth in Asia. For further information, please email china@dezshira.com or visit www.dezshira.com.

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