In several recent posts (see here and here), I have stressed that written contracts are the key to the next wave of doing business in China. I mentioned that relying on written contracts now makes sense in China because of the major improvements in the legal system that have been implemented in China over the past decade. These improvements have come about because Chinese business people have found that they need written contracts to make business work in China. In the old days, business people relied on the Party to resolve disputes. The Party is now engaged in other matters, so business people are forced to rely on the court system. Foreign business people can now take advantage of this purely domestic trend.

The fact is, however, that no contract is worth anything if it cannot be enforced. Foreign companies, however, generally ignore the question of enforcement. In our experience, foreigners from all over the world routinely insist on contract provisions that effectively render their contracts unenforceable in China. That is, by their own efforts they make their contracts worthless, much to the amusement of the Chinese side of the business transaction.

There are three rules for making a contract effectively enforceable in China:

1.   Enforcement is in China through litigation in the Chinese court system.

2.   Governing law is Chinese law.

3.   Governing language is Chinese language.

I seldom see contracts drafted by foreign lawyers that follow these three simple rules. The typical contract that we regularly see drafted by US attorneys provides that governing law is the law of the home state of the US party (our last two were Iowa and Alabama), that the governing language is English and that enforcement is exclusively in the state court of the home state.

Why is this a disaster? The reason is simple. This type of contract violates rule number one, so we do not even need to discuss the other two rules. Chinese courts will not enforce US court judgments. Thus, any judgment obtained in a US court cannot be enforced in China. If the Chinese party has no assets located in the United States, the judgment is effectively worthless. For more on this, check out the following:

Some attorneys have figured out this issue on court judgments and will provide for arbitration in the US These attorneys argue that China is a signatory to the New York Convention on the Enforcement of Arbitral Awards. Accordingly, the Chinese courts are obligated to force US arbitration awards. However, on the ground this simply is not true. The fact is that US arbitration awards are virtually worthless in China. There are several reasons for this:

  • China is one of group of Asian countries (Indonesia is another) that have strong cultural aversions to enforcing foreign arbitration awards. The courts will therefore find any reason they can to avoid enforcing a foreign arbitration award. This is especially true at the local court level. In certain types of cases there is some chance of prevailing on appeal. This is uncertain and the time delay can be so long that the whole process makes little sense. Oftentimes, rather than issue a ruling saying that they will not enforce the foreign arbitration award, the Chinese court will simply issue no ruling at all.
  • In many cases, the Chinese party will not participate in the foreign arbitration process, making any arbitration award a default award. Chinese courts are averse to enforcing default awards and the likelihood that they will enforce a foreign default from an arbitration tribunal is very low.
  • Stated quite simply, Chinese courts do not generally take orders from foreign arbitrators. Many arbitrations concern intellectual property or company management disputes that require some form of injunctive relief. Chinese courts apparently view it is an affront to Chinese sovereignty to be told what to do by a foreign arbitrator and they invariably ignore such orders from an arbitrator.

What this means is that China is a modern country with a reasonably good legal system; the World Bank recently ranked China 19th worldwide in contract enforcement. If you enter into a contract with a Chinese entity, you should plan to settle any contract disputes by legal action taken in China. The attempt to litigate or arbitrate outside of China is a mistake that must be avoided.

Though I sometimes see contracts that follow rule one and provide for litigation in China, those contracts far too often violate rules two and three by providing that the governing law is the law of the home of the foreign party and that the governing language is English. They justify doing this by noting that Chinese law provides that contracting parties are free to choose the law that will govern their contract so long as that law has some relation to the transaction and that the parties are free to choose the language to govern their contract.

These statements are technically true in that Chinese civil law drafters are big believers in party autonomy and the laws allow business people to make whatever decision they want in these areas. However, in the practical world of litigation, these two simple decisions usually render a written contract unenforceable.

Why? Effective litigation in China requires quick and decisive action. In particular, Chinese litigation procedure allows for preliminary seizure of assets and other pre-judgment relief that can be remarkably effective in quickly resolving issues. Use of Chinese arbitration rather than litigation prevents the plaintiff from taking advantage of this preliminary relief.  So litigation rather than arbitration is always preferable. However, with the court system, contracts that provide for foreign law and a foreign language lead to endless delay that makes litigation essentially futile.

Take the governing law issue first. Under the Chinese system, the court will require the parties to prove what is the foreign law on any issue that is important for a decision.  Thus, before any proceedings begin, the court will require the plaintiff to prove all important aspects of foreign law. Proving the law on these points is time consuming and expensive. The same applies to a foreign language. When confronted with a foreign language contract, the court will engage its own translator. Often this translator is barely competent. On important points of translation, both parties will often disagree with the translator, leaving the judge in the hopeless position of having to choose between three competing translations of a language he or she probably does not know.

As you can imagine, a clever defense attorney in this situation can devise an almost infinite number of objections to any statement of foreign law or any translation from a foreign language into Chinese.  Usually, the judge is not motivated to end these disputes, so the potential for delay is almost limitless. Even if the court gets to the point of making a decision, any chance of making use of preliminary relief is lost, rendering the litigation ineffective.

Use written contracts in China to follow the current trend. Follow the above three rules to make them enforceable.