In this third part* of our Guidelines for business in China we will analyze and describe those provisions or clauses which ideally should be present in a contract when doing negotiating a deal with a Chinese business partner.

Overall, when drafting contracts, the two parties should focus on the basics and eliminate unnecessary details. Standard common-law agreements should be avoided, in favour of simple and straight contracts.

As a matter of fact, generally speaking, contracts in China are better fit and more effective when they are simple, clear and precise. It is advised to clearly state obligations – who shall do what, when, and how much/many – and thus minimise risks of doubts or misinterpretation. Penalties for a breach shall be included (they might be subject to moderation by the court), as well as clear deadlines and way-out/termination clauses.

It is noteworthy that Purchase Orders are acceptable in lieu of contracts, but shall have clear details. These must be original, printed out in paper version and chopped with the official chop of the contracting party.

A summary of those main provisions which ideally must be present in the contract would be as follows:

1. Contracting parties

It is important to determine exactly which parties are entering into a contractual relationship.

In the case of Chinese companies, their official Chinese name rather than its unofficial translation in English must be included in the contract, together with other identifiers such as the registered address and legal representative, which can be found on the business licence and verified online.

It is not uncommon for Chinese companies to prefer that the contract is not signed in their name, but in the name of an offshore affiliate (a company belonging to the same group or cooperating company) – for example, a Hong Kong trading company.

That is because, due to foreign exchange restrictions that continue to prevail in China, it is easier for payments to be made from or to an offshore company. This, however, puts the foreign counterpart at risk. If the Chinese company fails to meet its obligations under the contract, then any legal action will have to be taken against the offshore company.

However, that offshore company may have no assets to enforce against, while the Chinese company with assets can walk away. Therefore, it is best to deal directly with the company that is the actual buyer.

2. Product description clause

After several rounds of discussions and negotiations (usually via email), parties often believe that they agreed on the exact product to be sold. However, it is a mistake not to include into the contract a very detailed description of the product, including any quality requirements.

In case of a dispute, this will give a clear standard against which the court or arbitration tribunal can measure performance. Moreover, it will ensure that parties' expectations are clear on how obligations will be performed.

If a product is difficult to describe, then one approach is to work with a "golden sample," i.e. one product that both parties confirm as the sample for further production. Pictures and test reports may be attached to a contract to further support what has been agreed.

The description to be included in the contract must take into account the frequency of the sales and the scenario in which the parties will perform their obligations. Hence, the wording and regulation stated in the contract should not be the same for a one-off sale as for a regular provision of goods to the buyer.

For a one-off sales contract, a product description clause might be composed by a simple table describing the product, quantity, specifications, etc...

For regular sales contracts, product description clauses might vary depending on the form and periodicity agreed by the parties.

If a product comes with after-sales services, then this should be specific as well. In short, the full scope of deliverables by one party to the other party should be included in the contract, in as much detail as possible.

3. Purchasing process provisions

It is essential to include a detailed description of how the products shall be ordered (including their price, type, quantity, etc.), and when such an order will be considered as accepted by the seller.

In a one-off sale this will not represent much trouble, as the above details will be easily described. However, if sales are expected to be performed on a permanent basis or from time to time, then a clear description of the process is highly advised to be agreed.

4. Payment terms

One of the key commercial terms of a sales contract is the term on payment, i.e. how and when the payment should be made. The most common methods include:

  • Payment upon delivery:

From the buyer's perspective (in this case the Chinese party), the best option is to agree to make the payment a certain number of days after delivery. Larger buyers are generally able to impose such a term on the seller, especially where the deal is expected to be recurring. On the other hand, this arrangement does present a considerable risk to the seller: if the buyer does not pay, then the only option will be to file a claim against this buyer.

  • Advance payments:

A method which is much more favourable to the seller (foreign party), is to agree to a partial advance payment, with the remainder to be paid through progress payments and/or upon shipment, for example against the bill of lading.

This kind of method provides highest security to the seller, but for the buyer it presents a risk: if, upon delivery, the goods are found to be incompliant with the agreed conditions, then it will be up to the buyer to try to get his money back. If a Chinese company is the buyer, it may, for example, insist on one of the above solutions:

§ Part of the payment is delayed until the goods have been received and inspected;

§ The goods are inspected by the buyer or its representative before they are shipped.

If the goods need to be installed by the seller, then it is common to link the payments to such installation. Moreover, for certain kinds of goods, it is usual to leave a final payment until much later – as a guarantee that the goods will work properly.

  • Letters of credit:

Another option is to work with letters of credit, which are used extensively when selling into China, and tend to be the preferred method of payment for larger transactions. On the other hand, many smaller Chinese companies may not be familiar with letters of credit, and/or will have to incur additional expenses to convince their bank to support them. Regardless, the foreign seller should insist on letters of credit from well-established banks in China or the Chinese branch of a well-established American, Asian or European bank.

In addition, it is advised to define as clearly as possible what exactly the agreed price includes. In particular, whether taxes and customs duties are included.

In this regard, reference can also be made to INCOTERMS, which are accepted in China. They determine the obligations of the parties, such as which party takes charge of delivery, takes the risk for the goods during transportation, is responsible for arranging (and paying for) freight and insurance, etc.

5. Delivery clause

Description of how the delivery of the goods will be carried out, including the process, periods and liabilities, must be as detailed as possible. The transmission of risks and use of INCOTERMS should be especially mentioned.

Particularly useful is a retention-of-ownership clause. Chinese law establishes that ownership of goods is transferred upon delivery, unless otherwise agreed between the parties. Hence, the parties can agree that ownership passes only upon payment of goods. This has an impact, particularly, in case the Chinese purchaser goes bankrupt – since the goods, still owned by the foreign seller, will not be part of the purchaser's assets to be liquidated.

In a one-off sale, the term agreed for the delivery of the product as well as the INCOTERM must be specified. This will govern the allocation of responsibilities in case of any loss, damage or breach of the conditions agreed. Quality control procedure

By regulating a quality control procedure, for instance by adding an obligation to inspect the goods upon delivery, it is possible to minimise the potential eventuality of the business partner raising ungrounded complaints over the quality of the products delivered, or even using such argument as a countermeasure in a dispute over a potential breach of the buyer.

6. Warranty, liabilities and penalties

Chinese laws sometimes have mandatory terms on potential warranties and liabilities, depending on the specific product that is being sold and purchased, while restrictions may also apply to possible penalties in case of non-delivery.

For instance, Chinese law allows penalties only in form of liquidated damages. This means that the parties can agree on a fixed amount of damages in case of breach. However, a Chinese court or arbitration tribunal may adjust the final amount, based on the actual damages suffered by the non-breaching party.

Hence, it is always a good idea to clarify specifically what warranties are given with a product and for how long, and what liabilities may arise if one of the parties fails in its performance. For example, does the seller have the obligation to replace unqualified products, and within what time period? And what kind of damages should the purchaser be able to claim if the seller breaches the contract?

It is thus important to be strategic in determining the amount of liquidated damages specified in a contract. If too low, this can impact the ability to obtain compensation for losses, but if too high, it may be more easily challenged by a court or tribunal.

7. Term and termination

For a one-off transaction contract, including a specific term is not essential: the parties will agree that the contract becomes effective upon signing, and will conclude after the parties have performed all their obligations.

Many contracts, however, are signed as framework contracts, under which parties may continuously issue new purchase orders. In that case, the contract establishes the general terms of the relationship and will remain in force in perpetuity until it expires under an agreed term, or one of the parties initiates termination. Hence, in such cases, establishing a logical term is often not difficult: parties may, for example, agree to a one-year term, with automatic renewal unless one of the parties notifies the other party of its intention not to renew.

However, the conditions for early termination are usually more complex, in particular if the contract establishes a fixed price for a product at which the seller must sell, and/or the purchaser must purchase (e.g., for a certain volume). Common termination clauses relate to one of the parties going bankrupt or entering into liquidation, but they could also be linked to market developments (e.g., the price of raw materials) or even be fully discretionary (each of the parties may initiate termination without any reason, usually with some advance notice).

*The second part of the third section will be published next week. Stay tuned to read about:

  1. Confidentiality and IP rights protection
  2. Language
  3. Contract validity and effectiveness
  4. Choice of law
  5. Dispute settlement

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.