China: When In China, Watch Your Back … -To-Back!

Last Updated: 24 May 2006
Article by Nicholas Brown

The incremental globalization of commercial law is a trend that few in this area have still to notice. As relentless as that trend may be, it still lags far behind developments in international trade. This discrepancy is the source of legal risk and is particularly acute in the export of advanced manufactured goods into China.

Understandably, Chinese buyers prefer the sense of familiarity associated with their own system of legal rules and processes and they will often push for a Chinese Law contract. Whilst commercial lawyers advising in Chinese projects are getting used to Chinese Law and arbitral procedure; nevertheless, the differences between Chinese business law and English business law are too many and substantial to be simply glossed over or, worse still, ignored.

These seemingly academic reflections on this area of comparative law assume practical importance in the high end manufactured goods export sector, where substantial elements of the constituent goods and/or services originate from outside of China. Why is this so? The answer is simple: Subcontract step-down. With the commercial focus these days still so much on price, resulting in already competitive margins having to be stretched ever thinner across profit, overheads and contingencies, there is seldom any substantial margin for risk. What limited margin exists is best applied to risk that are non-delegable or insurable.

The more astute see the key role that stepping down plays in project risk management. We see it attempted a lot. But how often is it done well across international trade transactions? Whilst a precise use of the language of the step down mechanisms will ever be at the heart of an effective risk management strategy, an integrated approach to governing law and dispute resolution procedures is also important. Where different legal regimes govern the various web of contracts across the supply chain this can lead to quite unintended and unfortunate results.

To take a few examples, the PRC Contract Law does not require a contracting party to assume responsibility for deleterious events that are unforeseeable, unavoidable and insurmountable. English Law, on the other hand, except in extreme cases, fixes responsibility upon the party carrying the obligation notwithstanding that performance of that obligation has been rendered much more difficult by an event of force majeure. In the event of unforeseeable, unavoidable and insurmountable non-granting of a government approval, under the PRC Contract Law, the Chinese buyer may secure a release from his obligation to go through with the project; at least so long as the approval is withheld. English Law is less forgiving: the subcontractor is not, as a matter of law, taken to have assumed this risk and, absent suitable contractual protection, may insist on the contract proceeding and payment being made. If the exporter is unaware of the PRC Contract Law approach to force majeure then he will not see the mismatch. Consequently, where the obligations of the Chinese buyer (underpinning the exporter's own obligations to subcontractors) are suspended, the exporter will remain saddled with English Law contractual obligations downstream.

Another incidence of mismatch arises in relation to subcontract payment guarantees. Whilst English Law contains no special rules as to legal capacity in relation to who may assume an obligation by way of guarantee or indemnity for the debts of another, the position under Chinese Law is different. The Guarantee Law of the PRC explicitly prevents State organs, certain public institutions and certain functional departments of state enterprises from assuming these commitments. In similar vein, the Rules on Foreign Exchange Guarantee by Resident Institutions in China requires the approval from the State Administration of Exchange Control and its branch offices of such undertakings. Sound flow-through of buyer insolvency risk will recognise and deal with these limitations.

In the area of dispute resolution the scope for mismatch is of no less concern. In most commercial contracts and in almost all investment contracts between the Chinese and foreign parties, arbitration is king. The Chinese party will very often ask for an arbitration clause requiring the submission of all disputes arising from or in connection with the contract to be submitted to the China International Economic and Trade Arbitration Commission (CIETAC) for final and binding arbitration in accordance with the existing rules of arbitration. This, of itself, is no bad thing. CIETAC offers a relatively high quality dispute resolution process, enhanced just this year by new rules. Nonetheless, however good that process may be, unless the contractor effectively embeds the CIETAC process into his downstream subcontracts, the inefficiency and risk of multifarious proceedings under different regimes will be no less troublesome.

Unlike many institutional rules, the CIETAC rules do enable the appointment of a single tribunal to conduct separate but related arbitration proceedings in tandem. But offshore subcontractors and suppliers will often baulk at the prospect of CIETAC arbitration. As a result, to achieve a consistent dispute resolution scheme, it is worth spending some effort in convincing the Chinese buyer to consider third-party alternatives to CIETAC, such as the ICC Arbitration Rules or the LCIA Arbitration Rules.

These few selected examples of the pitfalls in back-to-back drafting across Chinese and foreign contracts, in the context of present day pricing economics in many export transactions, illustrate the value of having supply chain contractual schemes reviewed by international lawyers experienced in Chinese commercial law.

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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