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The China MOU (Memorandum of Understanding). Use Them At YOUR Peril.

Posted in Basics of China Business Law, Legal News

The other day, Steve and I were emailing with a reporter regarding how Memoranda of Understanding, (MOU), are so different in China than in the United States and how that difference often causes early discord between Chinese and American companies.

Steve started the discussion by talking about the differences in the meaning of Memoranda of Understanding (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, an MOU 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 if that would constitute “bad faith.” Common law lawyers hate the concept, but it is deeply ingrained into 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 into a concrete commitment when it suits them and ignore it when it does not. This is how most people 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 is binding if the behavior of the foreign side constitutes bad faith.

What is bad faith? The standard example is signing a China MOU and then negotiating with two parties at the same time without informing the two parties and using the MOU to keep one party from taking the initiative on a venture. And then 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.

I then talked about how this difference in laws can so often lead 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 me their five page MOU and says that they now want to work on a contract .  I tell them that what they have given me is probably a contract.  They tell me that I’m wrong.  I tell them to tell their Chinese counterpart that they now want a contract and see what happens.  Virtually every time, the Chinese company tells the American company that there is no need for a contract and then the American insists that there is and then the Chinese party thinks the American is being a jerk.  The parties have already gotten off on the wrong foot.

Steve then summed up the problems:

Dan’s point is dead on. 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 completely 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.

I then concurred with Steve:

Correct.  And the thing is that neither side has malevolent intent.  The Chinese side just puts a lot more stock in the MOU than the American side. The American side will sign the MOU thinking its nothing and planning to come back and 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 that the Chinese side sees it as a contract and that the contract is terrible and that “it needs the following ten things.”  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 only super minor things needed to be resolved and 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.

Bottom Line: MOUs are different in China and failing to realize this can lead to problems.

What do you think?

  • twofish

    The Chinese duty to negotiate in good faith comes from German law and the technical term that the Germans have for it is “culpa in contrahendo.” It’s important to point out here that “good faith” means more than mere “lack of fraud.” If there is active fraud involved in a contract negotiation and one party suffers economic losses, there are some equitable remedies such as restitution and promissory estoppel available in common law countries.

    But unlike countries that are based on English law, German law requires that the parties in the negotiation behave toward each other with standard of truthfulness and honesty (the German term is Treu und Glauben) that is more than “mere absence of fraud.” English law does not have the duty of good faith in contracts. American law, curiously, has adopted bits of German law in the Uniform Commercial Code thanks to Karl Llewellyn. UCC 1-203 imposes a duty of good faith in performance of contracts and is copied pretty directly from German law (as is the concept of a commercial code). American law requires that parts to a contract act with “good faith” while a contract is being carried out, but not during negotiations.

    You can also put in an explicit duty to negotiate in good faith in an English contract or disclaim such a duty in a German MOU. The rules are for what happens if no one explicitly says anything.

    England itself is increasingly being influenced by German and France through the EU so bits of “good faith” are (very, very slowly) making its way into English law. Curiously this isn’t true with Hong Kong. The commercial law of Hong Kong is the law as it existed in England as of 11:59 p.m. on June 31, 1997 and since then there have been some changes in English contract law that haven’t been reflected in HK law, and while there is EU pressure to standardize English and German contract law, there aren’t those pressures in Hong Kong.

    One difference between how German law looks at contracts and how English law looks at contracts is that German law views contracts as part of the relationship between two legal actors, whereas common law tends to view the contract as having existence independent of the two parties. One curious thing is that contracts involving financial derivatives are done in common law areas because it’s very difficult to transfer a contract to party C if it’s seen as part of the relationship between A and B.