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

Last Updated: 19 November 2011
Article by Zhang Shouzhi, Zeng Ying King and Liu Xiang

This article continues to discuss Legal Issues in Contracts for Sale of Large-sized Complete Set Equipment. The first part of this article was published on Chinalawinsight on October 2011.

II. Delivery and Acceptance

Because large-sized complete set equipment are often composed of multiple parts, it is customary for the manufacturing and delivery of equipment to occur in conjunction with the assembly sequence. Accordingly, there are multiple deliveries, installations and inspections during the contract performance. The general procedures are as follows:

A. Inspection

The first inspection of the equipment is usually an open-package joint inspection conducted by both parties upon the arrival of the equipment at the destination port. If the package appears intact, yet after inspection the equipment is found damaged, defective, short of quantity or not conforming to the quality standards and specifications, the buyer is entitled to request the seller to repair, replace, or supplement the parts in question or to claim compensation. If problems are found to arise from the transportation, the buyer's claim should be made against the carrier or insurance company. As an extra precaution, the buyer sometimes dispatches staff to do a preliminary inspection at the seller's factory or at the departure port before loading of the equipment.

B. Installation

After the foundation project is finished, if the whole equipment or individual parts that can be independently operated are delivered to the buyer's plant and have met installation requirements, the equipment will be installed and the connection of water, electricity and pressure levels will be tested.

C. Mechanical Test

Installation is followed by mechanical test, which allows the equipment run without a scheduled task to verify if the equipment is capable of running.

D. Commissioning and Performance Test

After completion of the installation and mechanical test, both parties will agree on a period of time for commissioning, which is the most significant procedure before equipment acceptance. During commissioning, the equipment usually runs continuously for a period of time, which may be a week or a month. During such period, the equipment's performance is tested to check whether the equipment is capable of producing qualified products and maintaining the agreed technical parameters and production capacity.

E. Acceptance

After commissioning is finished, if the equipment complies with all the agreed technical indices and productivity, the final Acceptance will be confirmed by the buyer. If the equipment fails to meet the performance indices, pursuant to the contract the buyer can request the seller to make improvements to the delivered equipment at its own cost or pay a proportional penalty. Only when the equipment satisfies the acceptance criteria will the equipment be accepted and the warranty period start running.

F. Warranty Period

The warranty period is usually six or twelve months following the equipment acceptance. If a defect shows up in the warranty period, after both parties jointly investigate and confirm the defect, the seller shall be responsible for supplementing, replacing or repairing the defective part or providing compensation. If the buyer fails to do a timely installation and commissioning after receiving the equipment (and such failure generally results from an unfinished foundation project), the seller could be responsible for an unlimited warranty period. To avoid the above situation, the seller generally requires limits on the warranty period in the contract. For instance, the warranty period is limited to twelve months following acceptance or forty-eight months following the arrival of the equipment at the destination port, whichever is earlier.

G. Keeping Documentary Evidence during Delivery and Acceptance

Due to the complex nature of the large-sized complete set equipment and that of the acceptance procedure, each of the above procedures should be recorded in writing. Inspection records shall be signed by both parties after the joint open-package inspection. A Mechanical Test Completion Certificate shall be issued by the buyer after installation. Technical parameter records shall be signed by both parties during commissioning. And an Acceptance Certificate shall be issued by the buyer if the equipment is accepted. Such documentary evidence forms significant proof if there are future disputes over the quality or performance of the equipment.

It is advisable for the seller to ensure that each procedure is signed and confirmed by the buyer before proceeding to the next stage. Otherwise, it will be difficult to allocate each party's liability if in the future the buyer claims that equipment has defects.On the other hand, the buyer must be cautious with every signature because the signature represents the buyer's confirmation and approval of the equipment at that time and the buyer will face more difficulties raising objections afterwards. Due to the complex nature of the equipment, very small issues arising during installation and commission might result in malfunction of the whole equipment. However, if the buyer clings to every small issue, it will not be possible to put the equipment into operation for a long while. Therefore, in order to ensure efficiency, if the equipment performance parameters slightly deviate from the agreed specifications or there are insignificant discrepancies with the contract but without causing substantial adverse effects to the operation of the equipment, the buyer may sign the acceptance with a note or statement to reserve the right to raise an objection at a later time. In this way, the installation, commissioning and testing can continue, while the buyer also preserves leeway to raise claims against the seller in the future.

III. Payment

As mentioned above, there are usually payments by installments rather than a one-off payment in the sale of large-sized complete set equipment. Many such transactions are accomplished through export credit (including the buyer's credit and seller's credit).

A. Advance Payment or Deposit

Because a set of large-size equipment is expensive and tailored to the specific requirements of the buyer, the seller is generally inclined to ask the buyer to make the advance payment or deposit before manufacturing the equipment to an extent proportional to the contract price, in order to insure itself against possible losses from a buyer's breach of contract. The advance payment or deposit is usually about 10% to 15% of the total contract price. In order to prevent the seller's breach of contract after the seller has received the advance payment or deposit, the buyer usually withholds payment until it has received the seller's bank demand guarantee or standby letter of credit in the amount equal to the advance payment or deposit, provided that such demand guarantee or standby letter of credit takes effect at the same time the buyer make the advance payment or deposit.

B. Interim Payment

At the time of equipment delivery, the seller will typically make a large payment. Such payment plus the advance payment or deposit might account for 85% to 95% of the total contract price. At the delivery or the acceptance, such payment may be made in whole or by installments. For instance, 50% payment may be made when the equipment is manufactured and delivered and another 20% when the equipment is inspected and accepted. Interim payments are often made by a documentary letter of credit.

C. Performance Guarantee

Normally the buyer withholds 5% to 10% of the whole payment as a performance guarantee. The performance guarantee is paid to the seller on the condition that no defects or malfunctions are detected during the warranty period (generally six months to one year after the equipment is accepted). Otherwise the buyer is entitled to deduct the necessary expenses for repairing or replacing the defective part. In order to timely receive full payment, the seller sometimes uses the bank demand guarantee or standby letter of credit as a performance guarantee. When the performance guarantee is paid, the payment is concluded.

D. Payment Guarantee and Payment Conditions

As discussed above, to avoid risks, both parties require each other to provide a certain form of assurance for performance of the contract obligations. Nowadays bank demand guarantees or standby letters of credit are widely adopted. Furthermore, because the buyer might make payment by installments, besides being irrevocable, such letters of guarantee or letters of credit should also be transferrable and divisible.

Under a standby letter of credit or a bank demand guarantee, as long as the beneficiary puts forward its request with no need to attach any reason or evidence, banks shall make the payment in the requested amount. In the event of a dispute, this can be a concern for the party who provides such guarantee. For example, in one case, a buyer was delaying acceptance of the equipment on the grounds that the equipment was not qualified. Although in the seller's mind the equipment was qualified, in order to continue to perform the contract the seller consented to assume some extra-contractual obligations. During the negotiation, the buyer cashed out the letter of guarantee before it was due, which left the seller in a very difficult position.

As for payment, the most controversial issues are what the conditions for payment are and whether such conditions have been met. Because the buyer's payments by installments are closely related to the delivery and acceptance of the equipment, these disputes usually always involve shipment, inspection, acceptance etc. For example, in one case, 55% payment was agreed to be made through an irrevocable letter of credit, provided that the payee submitted all the shipping documents. On the other hand, it was also agreed that the goods were not shipped unless said payment was received. In performing the contract, the seller refused to ship the goods before it received the payment. However, the failure to ship the goods meant that no shipping document would be issued, while the bank could not negotiate without such shipping documents. These contradictory contractual agreements led to a dispute.

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