China: Legal Issues in Contracts for Sale of Large-sized Complete Set Equipment （Part I of II)

As the third-largest trading nation in the world, China's import and export volume increases significantly year by year, among which, certain percentage of transactions relates to import and export of large-sized complete set equipment. Compared with common commodity trading, large-sized complete set equipment trading are much more complicated, involving commercial, technical, legal and financial issues relating to not only commodity trade but also intellectual property protection and services. In addition, large-sized complete set equipment are normally expensive amounting to tens and even hundreds of millions of dollars and such equipment can be crucial for the production and business operation of an enterprise. Thus, any disputes if not resolved successfully may lead serious consequences.

I. Contract Structure

The sale of large-sized complete set equipment is a hybrid category of trade covering transactions in goods, technology and services. The transactions include not only combining many types of complicated machinery, but also tracking patents, other forms of intellectual property, materials, and labor. Therefore, the transaction generally cannot be covered by a single contract. Instead, the documents that can cover the whole transaction usually consist of a principal contract, several accessory contracts, and numerous appendixes.

The principal contract stipulates the major terms and conditions of the transaction and the main rights and obligations of both parties. Generally, it includes clauses regarding equipment model, performance, price, payment methods, transportation, packing, delivery and acceptance, quality guarantees, liability for breach of contract, force majeure, dispute resolution, and governing law. In contrast with a contract for a sale of goods, almost all such clauses must be interpreted in line with the accessory contracts and the appendixes.

Similar to common contracts for the sale of equipment, the primary appendixes usually set out the performance, specifications and technical indices of the concerned equipment. Such technical appendixes are essentially an elaboration of the seller's obligations of quality guarantee. The technical standards or indices stipulated in such appendixes are the crucial criteria to determine whether the quality of the delivered equipment complies with the requirements stated in the contract and whether the seller's performance is in breach of contract.

However, at the drafting stage, parties often attach great importance to the main terms of the principal contract such as payment, delivery, and acceptance, and fail to give enough attention to the technical appendixes. Especially when the equipment comprises a number of individual parts and the technical indices of the individual parts are massive and complicated, the parties may not carefully examine the technical indices one by one. Such omissions may lead to vague contract terms or conflicting terms among the appendixes and the principal contract are used. If the parties fail to carefully examine and define the terms in the technical appendixes when concluding the contract, it may potentially cause complications at the stage of post-delivery inspection. For example, if the specifications for equipment components in the technical appendixes are unclear, a seller might set a high price in the contract based on expensive large-size accessories but deliver the cheapest small-size accessories which are more suitable for the buyer's purpose. The buyer, although having paid excessively, cannot raise any objections during the inspection due to the absence of a criterion for such specifications. In such case the seller does not bear any liability for breach of the promise or guarantee about the equipment performance.

Usually large-sized complete set equipment are tailored and customized to the buyer's specific requirements. The seller sometimes manufactures the equipment based on the blueprint and technical indices provided by the buyer. At times the seller may also be engaged in designing and manufacturing the equipment. At other times the seller may manufacture the equipment based on the designs of a third party appointed by the buyer. Under these circumstances, the technical appendixes will contain the blueprint and the design methods provided or confirmed by the buyer, or list the buyer's production scale, the final product specifications and the productivity requirements. If the equipment manufactured through the above process fails to function, fails to produce acceptable products, or fails to satisfy the productivity required by the buyer, such failures might be the result of design defects.

The explicit agreement in the contract and its appendixes and the interpretations of the relevant clauses form the primary basis to determine whether there are design defects, whether the equipment manufacturing complies with the design, and which party shall be responsible for the equipment's malfunction. If the parties fail to agree upon the design defects and the consequent liabilities for breach of contract or such agreements are unclear, it will be complicated and difficult to allocate liability between the parties.

A complete set of large-size equipment is usually an independent system and requires a foundation project to provide space, power, and raw materials for the operation. Therefore, the construction requirements for the foundation project are often covered by one of the technical appendixes.

Because the equipment operation takes place at the buyer's plant, in most cases, the foundation project is constructed by the buyer or an entrusted third party, while the seller is responsible for providing the relevant parameters, such as the size of a platform where the equipment is positioned, the connection for water and electricity, and pressure level requirements. In practice, if the equipment malfunctions or fails to meet the performance criteria agreed in the contract, which often leads to disputes, one of the seller's common defenses is that the foundation project fails to meet the stipulated standards, such as unstable electric pressure, impurity of water, etc. If the Indices of the foundation project are not expressly agreed in the contract, it is more difficult to determine whether there are defects in the equipment and which party shall assume liability for such defects.

In addition, the construction progress of the foundation project directly affects both parties' essential rights and obligations such as the delivery and acceptance of the equipment and the starting date of the warranty period or claim period. If the foundation project is not completed on schedule, the buyer will incur significant losses. In such case, if the foundation project is entrusted to a third party and the consequent losses incurred by the buyer exceed the reasonable amount the third party is expected to foresee during the construction, the third party shall not bear liability for the excessive amount. However, it is obviously unfair to demand the non-defaulting buyer to bear the excessive amount. Therefore, in these circumstances, if the parties have not agreed on the liabilities, the dispute focuses on the extent to which the third party shall indemnify the buyer against the losses resulting from the construction delay.

Since the transactions involve huge amount of funds, numerous delivery batches, and long periods of delivery time, payment is usually made in installments instead of one-off payment. To minimize risk, the sellers therefore often require the buyer to provide proof of credit, bank demand guarantees or other forms of security, which can align with the installment payments and also ensure the payments will be made on schedule. On the other hand, to ensure the seller's performance of the contract obligations, the buyer may also require the seller to provide necessary security in the form of a standby letter of credit or bank demand guarantee. If the parties provide a performance guarantee, the relevant credit documents and security contracts will become part of the appendixes or part of the principal contract. When the principal contract is signed, in most cases, the format of a standby letter of credit and/or bank demand guarantee will be listed in an appendix to the principal contract.

Although international rules such as the ISP98¹and URDG² have been widely adopted, due to different financial systems, legal rules and practices among various countries, one party's security format may not be accepted by the other party's bank. In some cases, the security will not take effect before being approved or registered. Absent the parties' rigorous review of the contract, during the performance of the contract, the parties' security interests may become difficult to realize, and losses may be incurred by the secured party. As to the party providing security, it will be deemed a default if the party providing security fails to provide a valid bank demand guarantee in the format listed in the contract appendix. As to the secured party, if the demand guarantee provided by the other party is rejected in the secured party's home country because of the non-conforming format, the secured party will have to pay extra costs and overcome more obstacles in order to enforce its security interest. Therefore, in finalizing a contract, in order to avoid future disputes, the parties should consult their local banks and relevant authorities, request approval of the format and validity of demand guarantees, and discuss with each other and agree upon a final format mutually acceptable to either party.

The operation of large-sized complete set equipment typically requires specific technical personnel. Therefore, contracts for service (i.e. labor output) and for the training of technical personnel are usually attached as appendixes to the sale contracts. Moreover, the equipment may involve patent, trademark, Know-How and other valuable intellectual property rights, so intellectual property licensing contracts and confidentiality agreements are also usually attached as appendixes.

Such appendixes are directly related to the daily use and operation of the equipment and dictate whether the transaction can be successfully consummated. Therefore, the parties shall carefully review such appendixes to determine whether they are clear and adequate enough to allow performance.

Editor's Note: Part II of Legal Issues in Contracts for Sale of Large-sized Complete Set Equipment will be published in the next issue of China Bulletin.

Footnotes

¹ The International Standby Practices , No.590 publication by the International Chamber of Commerce, took into effect on January 1, 1999.
²The Uniform Rules for Demand Guarantees , is No.458 publication by the International Chamber of Commerce.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.