China: Owner Tips for Managing Construction Projects in China

Last Updated: 9 August 2011
Article by Meg Utterback and Holly Blackwell

Whether you are building a manufacturing plant, a petrochemical plant or just fitting out an office, local rules and local authorities can play a significant role in your project. Local regulations and practice varies widely, from designer and contractor qualifications to requirements for building completion. Finding the right contractors for design and construction can make the difference in completing on time and on budget.

Here are some tips to avoid common pitfalls:

1. Ensure the designer and contractor are licensed to undertake the scope and scale of the project

A significant pitfall to avoid when engaging in a construction project in China is to ensure the design firm and contractor are qualified for the project. PRC law strictly regulates entities which undertake domestic construction projects. Before engaging in design and construction activities, an entity must be sufficiently licensed. The services to be provided must not exceed the scope of the license.

For conceptual design, PRC law allows an onshore unlicensed entity to undertake limited conceptual design and project management consulting activities. The unlicensed entity may likely provide conceptual drawings, review third party drawings, and engage in limited management consulting. It may not develop or stamp engineering or construction drawings. Unlicensed foreign designers and PRC designers without local qualification are often reliant on local design institutes (LDI) to prepare the construction drawings. As a general rule, you should assume that you as the owner will need an agreement with the LDI that gets filed with the local authorities.

For construction contracts, all parties to the agreement and which provide construction works must be qualified to undertake the project. There are no exceptions for an unlicensed contractor to collaborate with a local contractor for construction works. The scope of the project is limited to that which the lowest-ranked contractor may undertake. Both parties are jointly and severally liable for the work performed under the agreement.

Before commencing any project, an owner should request that the design firm or contractor provide a copy of its qualifications. This obligation may also be included in the agreement. An owner should require a contractor or designer to represent and warrant that it possesses all required licenses, qualifications, and permits to undertake the project.

2. Understand the risks of license borrowing

Though license borrowing may be common practice in China, it is not legal. It is critical for all parties involved—i.e., owners, designers, and contractors—to understand the nature of the risks involved with engaging in this practice. PRC Construction Law expressly prohibits a designer or contractor from agreeing to undertake a project beyond its qualifications. The law goes further to expressly prohibit an entity from undertaking a project in the name of another. It also prohibits a licensed entity from authorizing another contractor or designer to use its license to undertake a project.

The consequences for license borrowing, if enforced, can be severe. An entity which lends or borrows a license may be subject to fines. For the Owner the risk lies in not getting project approval and occupancy and losing the ability to recover in the event of an insurance claim.

3. Understand restrictions on subcontracting

Though subcontracting is permitted, PRC law imposes rigid restrictions on subcontracting works for projects in China. Under PRC law, the contractor must complete the primary building structure. Though what constitutes the primary building structure is not defined, this likely means the contractor must complete at a minimum the shell of the building. Additional works, such as fit-out works, heating, air-conditioning, and ventilation systems, electrical and mechanical systems, and even the foundation, are generally assumed to be beyond the primary building structure and may be subcontracted to a qualified contractor. PRC law expressly prohibits a subcontractor from subcontracting the works to another contractor.

4. Carefully review insurance policies to ensure coverage for contractual and statutory liabilities

In China, most professional liability indemnity ("PLI") insurance for design (including conceptual and construction design) and Contractor's All Risk ("CAR") insurance is project-specific. Under the PRC Construction Law, general liability for construction defects (which include but are not limited to structural defects) continues for the "reasonable life" of the building or part thereof. This period is also the minimum period a contractor must warrant the principle building structure. (A contractor must also warrant other works such as HVAC systems, mechanical and electrical systems, and equipment installation, which have shorter minimum warranty periods).

Under PRC law, employers, including design and construction companies, must contribute to a state-run social insurance fund for work-related injuries. Generally, the minimum contribution an employer must pay is based on the average annual salaries of its employees. If an employee is injured, compensation is paid by the government. The amount of compensation is based on the degree of injury sustained. PRC law also encourages (but no longer requires) construction companies to purchase commercial policies for personal injuries suffered by employees engaged in dangerous operations. Coverage for work-related injuries may in fact be included in the PLI or CAR policies obtained for other risks. Check the insurance coverage and be sure the contractor's mandatory insurance is paid to date of contracting.

5. Ensure the project is legally complete before taking over

PRC law prohibits an owner or tenant from taking over a building for use before legal completion of the project. Before an owner may take over a building, it must first obtain a "Certificate of Final Acceptance" which is issued by local MOHURD. The process for final acceptance is detailed and varies by locality. It involves obtaining various approvals, reports, and inspections which must then be submitted for final acceptance of the project. Key approvals for final acceptance include: (1) Urban and Rural Planning, (2) Firefighting (Public Security Bureau), and (3) Environmental Protection Bureau. Local requirements vary and should be confirmed in light of the nature of the project.

An owner who takes over before final acceptance may be subject to administrative fines. Any lease agreement between an owner and a tenant may also be deemed invalid. An owner or tenant who takes over before final acceptance may also assume liability of building defects. An owner may assume some liability for defects which would have otherwise been borne by the contractor. In the case of a fit-out, the tenant may also incur costs for repairs which affect the progress of the fit-out (e.g., re-constructing interior works due to owner repairs).

6. Know the relationship between your payment terms and the permits

Every construction dispute we have managed in China involved the contractor withholding as-builts and delaying obtaining permits pending payment. At the end of a project, the strongest leverage the contractor has is precluding successful occupancy of the building. While such refusal and delay obviously equates to liquidated damages, the contractor knows that ultimately the owner wants the project and not the money.

7. Resolve disputes with all stakeholders

Given the frequency in China of less than transparent contractual arrangements and obligations, make sure that any resolution or law suit involves the necessary parties. Often owners assume that contractors have resolved all claims with subcontractors when the contractor accepts final payment at the close-out of the project. Often when the project has been riddled with disputes, third party claims may still be outstanding at the close of the project. Even a full release and representation and warranty from the contractor may not be sufficient to preclude suit against the owner by an unpaid supplier or subcontractor. Indemnity terms in China can be challenging to enforce so avoid the issue up front.

8. Perform local due diligence

Know with whom you are contracting. Request copies of business licenses and design and construction qualifications. The business license will provide information about the company's registered capital, its legal representative, and the scope of business activities it may undertake (which must include the services performed for the project). The business license should be confirmed with the local branch of the Administration of Industry and Commerce. The design or construction qualification will provide the scale of the project the designer or contractor may undertake (i.e., the class of the license) and the scope of construction activities it is licensed to perform. This too should be confirmed with the local MOHURD.

Failure to understand the local requirements can derail project schedules, blow project budgets, and increase the likelihood of disputes and subsequent litigation after the project is complete. Anticipating pitfalls and engaging in due diligence before taking on the project can reduce risk, lead to a smoother project, and reserve available resources to address unavoidable problems which inevitably arise.

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.

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