China contract rules

In recent posts (here and here), we have stressed that written contracts are the key to the next wave of doing business in China. Written contracts make sense in China because of the major improvements in China’s legal system over the past decade. These improvements have occurred because Chinese businesspeople have found 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.

However, no contract is worth anything if it cannot be enforced. In our experience, foreigners from all over the world routinely insist on contract provisions that effectively render their contracts unenforceable in China. By their own efforts they make their contracts worthless, much to the amusement of the Chinese side on their business transaction.

There are three rules for making a contract 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 contracts our China lawyers regularly see drafted by US attorneys provide for exclusive jurisdiction in the state court in the foreign company’s home state with that state’s  governing law applying to the contract and English as the governing language. The contracts we see from our EU contracts are similar.

Why is this a problem? 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 and they also do not enforce the judgments from many EU countries either. 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 Chinese Companies Can Say, “So Sue Me.

Some attorneys have figured out this issue on court judgments and will provide for arbitration in the United States or in Europe. These attorneys argue that China is a signatory to the New York Convention on the Enforcement of Arbitral Awards and so Chinese courts are obligated to force US and EU arbitration awards. This is all true in theory, but false in real life. The fact is US and EU 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 and its 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 it 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 (like courts everywhere) are averse to enforcing default awards and the likelihood they will enforce a foreign default award from an arbitration tribunal is low.
  • 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.

China has a decent 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. Writing your contracts to litigate or arbitrate outside China is a mistake.

Though we sometimes see contracts that provide for litigation in China, those contracts far too often violate rules two and three by providing for some other country’s governing law and/or for the governing contract language to be English. They justify doing this by noting that Chinese law allows contracting parties to choose the law that will govern their contract so long as that law has some relation to the transaction.

These statements are technically true, 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 usually preferable. However, with the court system, contracts that provide for foreign law and a foreign language lead to endless delay that make litigation essentially futile.

Take the governing law issue first. Under the Chinese system, the court will require the parties prove what is the foreign law on any issue relevant 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. Oftentimes they

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 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.