Memoranda of Understanding

We have a number of times written on the problems that can arise from using memoranda of understanding (MOUs) with Chinese companies. See the following for some of those posts:

Mostly we have talked about how Chinese company (and to a large extent Chinese law and courts) are much quicker to view an MOU as the contract itself than are American companies and American courts. Because of that, we warned of the dangers in using an MOU.

Since we did these posts though, we have received a number of emails from readers saying essentially that they are having trouble completely eschewing MOUs in their China business and asking us what they should do. Also since that time, our China lawyers have probably done around a deal a month that involved an MOU. In other words, like them or not, MOUs are a fact of life when it comes to doing business with China.

That being the case, in this post we address why MOUs so common to China business and how you can and should handle them, short of just saying “no” and walking away.

MOUs are common with China business for the simple reason that Chinese companies love them. But why do Chinese companies love them? In our experience, we see them used typically to achieve the following two things:

  1. To memorialize in writing the existing state of the agreement before the underlings at the Chinese company pass it on to their boss or bosses for approval. We frequently see this at large Chinese companies, particularly SOEs.
  2. To memorialize in writing the existing state of the agreement and then to use that written document as a starting point for additional negotiations intended to favor the Chinese company only.

If you are negotiating with a Chinese company that insists on an MOU, you should try to discern the reason the MOU is so important and if it is for reason number two above, you should make clear that once the MOU is signed, you will not be in a position to re-negotiate critical terms and you should stick by that statement.

Let’s face it, China MOUs are sometimes necessary for getting the deal done and an MOU that gets a good deal done is a positive/pro. On the flip side, they can be used to lull foreign companies into going beyond where they wanted to go on their deal and as we have previously written, to create a binding agreement without the foreign company realizing that.

Those are the pros and cons of MOUs with China.

What do you think?

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?