China: Effective Enforcement of Contract Rights in Chinese Sourcing Contracts

Originally published 12 February 2010

Keywords: China, contract rights, contractual enforcement, contract structure, international commerce standards, disputes

Effective enforcement of contract rights is on virtually every customer's short list of concerns when considering sourcing goods or services from providers in China. As China builds on its position as a manufacturing powerhouse and drives to become a global player in the services industry, its ability to assure customers that they can effectively enforce contract rights in Chinese sourcing agreements stands as a key challenge to its success.¹

In considering the issue of contractual enforcement, focus often tends toward dispute resolution mechanisms that can be utilized either to compel performance in the face of actual or threatened nonperformance or to address damages or other remedies for failed performance. Emphasis tends to be placed on traditional means of dispute resolution, including mediation, arbitration, litigation and injunctive relief, and on satisfaction of awards and judgments. While the availability and effectiveness of such dispute resolution forms a critical component of contract enforcement, however, actual dispute resolution alone is far too narrow a focus for evaluating the effectiveness of contract enforcement.

Effective contract enforcement should be viewed on a broader systematic basis, as part of the overall contractual arrangement and its context. This perspective encompasses the contract's legal environment, including the availability of traditional dispute-resolution mechanisms, but also includes contract-specific considerations, such as the structure of performance established under the contract. Further, it must take into account extra-contractual considerations, such as the broader relationship between the parties and the market visibility and reputation of the provider.

This article identifies some of the important issues facing customers as they assess effective enforcement of sourcing contracts with Chinese providers. The objective of this discussion is to assist prospective customers in evaluating the viability of sourcing arrangements with Chinese providers.

Inventory of Considerations – Acceptance of Relatively Few Absolutes

When a customer evaluates the viability of a sourcing opportunity, it inevitably balances the criticality of specific contract compliance with the reality of actual contractual performance. In jurisdictions with reasonable predictability and assurance of contract enforcement, the evaluation can often be relatively straightforward, although it is never completely without risk. An assessment conducted in this context is ultimately aimed at determining whether a particular product or service sourcing arrangement meets the customer's acceptable risk profile. An analysis of this nature is a challenge in any market environment, but particularly so in the rapidly evolving market of Chinese providers.

Enforcement mechanisms available for a sourcing contract can be divided into two major groupings. The first relates to the structural and operational factors established both by contract and by extra-contractual environmental considerations. These factors focus primarily on operational safeguards and mechanisms that provide practical protections in order to assure performance and, to a lesser extent, on actual enforcement.

The second category comprises more conventional enforcement mechanisms. In China, as in any commercial jurisdiction, these mechanisms include all of the traditional dispute-resolution devices (such as alternative dispute resolution and litigation) and related considerations (such as choice of law, procedures and forum). It is with this second category of enforcement mechanisms that China offers particular challenges, graphically illustrated by the fact that it has only recently formally embraced the concept of rule-of-law.

China is seeking to create a business-friendly environment characterized by predictable legal enforcement of contract rights. The People's Republic has made significant strides in its development of a national business atmosphere in which contract enforcement is reliable and consistent with international commercial standards and practices. Nonetheless, the establishment of effective, predictable enforcement mechanisms represents a relatively new endeavor in the PRC.

Businesses operating in today's China, then, may be less certain that contractual agreements will be supported by effective legal enforcement as compared, for example, to national jurisdictions with long histories of commercial practice. This reality means that the first grouping of enforcement mechanisms described above — emphasizing contract structures and operational arrangements — has heightened significance for sourcings from China.

Contract Structure and Operational Arrangements to Avoid Disputes

Some of the most effective contract enforcement techniques in sourcing transactions have been dispute avoidance strategies that are embodied in the scope, structure and operation of the sourcing relationship. Savvy buyers of products and services have long worked to scope and structure their sourcing arrangements to avoid or minimize the likelihood of disputes and to eliminate high-risk situations because no matter how sophisticated and established the dispute resolution environment, actual dispute resolution activities are ultimately distracting, costly and non-productive.

Proactive approaches and arrangements designed to avoid problems in the first place generally provide a superior alternative to dispute resolution strategies. These may include:

• payment schedules tied to actual delivery and acceptance by the buyer;
• strategic scoping of the sourcing agreement to ensure that the customer retains control of the overall production/performance process (e.g., limit sourcing to discrete components or phases or utilize multi-supplier arrangements);
• careful due diligence in supplier selection and monitoring (e.g., to ensure that the supplier is motivated to preserve and protect its reputation and the integrity of its operation);
• effective customer-side audit and other quality controls, including inspection and reporting; and
• effective and legitimate utilization of business incentives (e.g., retention or expansion of business).

Proactive dispute-avoidance measures, developed and tested over time as regular good practice in any sourcing transaction, are readily applicable. They take on added importance when sourcing in China, where the options and mechanisms of dispute resolution may be less developed and certain.

Dispute Resolution Considerations in China

Despite best efforts to scope, structure and operate sourcing relationships to avoid the need for active dispute resolution mechanisms, buyer-supplier disputes requiring formalized resolution processes can and do happen. In the case of Chinese providers, all of the basic dispute resolution options are available in the PRC. In some cases, however, these options present unique requirements and considerations.

Effective dispute-resolution strategies, ranging from structured issue escalation within the contracting parties to mediation and even arbitration, are available in China and are typically well-suited to address issues with Chinese suppliers. Prospective sourcing customers should be aware that from a cultural perspective, informal dispute resolution tends to be more consistent with important elements of Chinese culture and tradition, including Confucian ethics and the characteristic desire for harmony.

Consequently, in sourcing arrangements with Chinese providers, there is a marked preference to resolve disputes through alternative dispute resolution efforts, rather than through litigation. In fact, public litigation has historically carried a connotation of criminal proceedings in China and may be viewed as humiliating to the parties involved.

Cultural realities and other considerations explain why larger sourcing arrangements with Chinese suppliers very often include well-structured but informal dispute-escalation procedures. For example, parties may be contractually obligated to address and escalate issues within their respective management groups in order to avoid or resolve disputes without litigation. Other, more formal mediation arrangements that are legally supportable while still maintaining sensitivity to Chinese cultural and social norms may also be incorporated into sourcing contracts.

Nonetheless, resort to formal dispute resolution proceedings may be inevitable, and a buyer sourcing from a Chinese supplier must account for this possibility. In this regard, both litigation and arbitration are available methods of dispute resolution with Chinese suppliers but each carries important considerations and qualifications.

Subject to certain important limitations, a sourcing contract between a Chinese provider and a foreign customer may provide that the law of a national jurisdiction other than China will govern the contract and that any disputes under the contract will be resolved through proceedings conducted outside China. In this regard, however, two important limitations must be noted:

• despite a contract's generally valid choice of law, some issues remain subject to Chinese law. These include certain issues concerning intellectual property ownership, labor laws, land ownership, insolvency and enforcement of foreign judgments or awards; and
• courts in China are far more likely to enforce a foreign arbitral award than to uphold the judgment of a foreign court.²

Litigation in China

Since 1979, China has had a judicial system that will hear and resolve commercial disputes. However, beyond the standard concerns of litigation in even more established judicial environments, including inefficiency, cost and time, commercial litigation in China raises a number of significant concerns — many related to the lack of a litigation tradition for resolving commercial disputes and relative infancy of its judicial system.

For a variety of reasons, including concerns with the still-developing judiciary, arbitration is becoming the predominant formal mechanism for resolution of contract disputes in China.  As part of its sweeping enactment of commercial laws over the past 20 years, China enacted a comprehensive arbitration law in 1994 that, in tandem with numerous opinions issued by the Supreme People's Court, has helped to meet international arbitration law standards in terms both of scope and content.³

Practically speaking, three types of arbitration are recognized in China: domestic arbitration, foreign-related arbitration and foreign arbitration. The first two categories of arbitration describe proceedings that are conducted and enforced in China under Chinese laws. The latter category refers to arbitration conducted outside China but enforceable within the country under the New York Convention. The following table describes these distinctions:

For arbitrations taking place in China, procedures that are categorized as "foreign-related" can offer the participating parties broader options, and the designation can be an important consideration. A dispute meeting one of several specific elements can be recognized as "foreign-related" by Chinese courts. These elements include:⁴

• one or both parties in the dispute are foreign persons or are organizations that are domiciled in a foreign country;
• the subject matter of the dispute is located in a foreign country; and
• the facts that establish, change or terminate the contract between the parties occur outside China.

A potentially significant qualification with respect to the dispute characterization issue is the fact that, for this determination, both foreign-invested enterprises (FIEs) and wholly foreign-owned enterprises (WFOEs) are considered Chinese persons because they are Chinese-formed entities. While it is not a prerequisite that a local entity be formed and utilized in sourcing transactions by foreign customers, one or another of these structures is often used as a vehicle for various local operational reasons.

Sourcing transactions in which such Chinese-formed entities are common include shared services captive structures. In such cases, use of an FIE or WFOE structure increases the likelihood that a foreign buyer may find its contractual obligations with Chinese providers governed by Chinese law. As a result, any disputes may be characterized as "domestic."⁵

The consequence of this domestic characterization can be significant. For example, in both a recognized foreign-related arbitration and a foreign arbitration, the court's ability to deny enforcement is far narrower than in a domestic arbitration. In contrast, the People's Court may deny enforcement of a domestic arbitral award if it finds insufficient evidence to enforce, or if it determines that the law (which would necessarily be Chinese law) has been erroneously applied. Neither of these defenses would be available to deny enforcement in a foreign-related arbitration or in a foreign arbitration. Accordingly, there is far less certainty regarding judicial enforcement in the case of Chinese domestic arbitrations, a consideration that may effectively defeat the entire objective of arbitration.

One of the main commissions for conducting foreign-related arbitrations in China is the China International Economic Trade Arbitration Commission (CIETAC), a state-sponsored organization that was formed in 1956. Despite significant modernization of its procedures in recent years, CIETAC proceedings continue to be viewed with some concern by the international business community. These concerns include issues regarding transparency of arbitrator compensation and even the possibility of improper influence and pressure being brought on the arbitrators.

To the extent that a dispute results in an award or judgment, a range of issues arises relative to the enforceability of that award or judgment against a Chinese supplier, irrespective of the forum proceeding or governing law applied. Applications for enforcement of arbitral awards are made to local intermediate Chinese courts. The basis of nonenforcement of otherwise enforceable foreign-related and foreign arbitral awards, however, is limited to procedural violations such as:

• lack of jurisdiction of the arbitration proceeding;
• lack of a valid arbitration agreement; and
• discrepancies in the proceeding, such as the improper appointment of an arbitrator or lack of appropriate notice to a party.

Finally, the most common reason for ultimate nonenforcement of arbitral awards (domestic and foreign-related) is one that is not limited to China:  lack of assets. Such a situation may involve actual bankruptcy or insolvency. Often, however, it includes cases in which the plaintiff or court simply cannot locate assets.

Conclusion

Enforcement of contract rights is a critical consideration in any commercial transaction. As China works to increase its role as a global supplier of products and services, the legal system and practice necessary to ensure efficient and predictable dispute resolution will certainly develop. With this legal evolution, there should come increasingly favorable international perceptions of China's viability as a sourcing environment, and the scale and quantity of sourcing transactions involving Chinese can steadily — and sharply — increase.

In the meantime, companies looking to source from Chinese providers must carefully consider the scope and structure of their contractual arrangements. They must also carefully assess the effectiveness of their arrangements to both avoid and address disputes with sourcing providers. With diligent consideration and planning, however, companies can approach the Chinese market with a level of confidence that will enable them to take advantage of the many and growing opportunities in what is, and promises to remain, one of the most dynamic markets in the world.

Footnotes

1. See "Going to China" in this publication.

2. The PRC is a signatory to the New York Convention, and its courts are therefore obliged to recognize and enforce arbitral awards of other signatory countries, including the United States. On the other hand, the United States and a number of other countries have not signed treaties on recognition and enforcement of foreign judgments. Consequently, Chinese courts have no similar obligation to enforce court judgments of those countries.

3. Beyond issues associated with the infancy of China's judicial system and the inexperience of its judges, principal concerns include the means of judicial appointment and compensation and the overall level of judicial qualification in many parts of the country.

4. These elements were adopted by the Supreme People's Court in defining "foreign-related civil litigation" in a 1992 opinion. No such specific guidance has been given for "foreign-related" arbitration, leaving the matter less certain. Further, under Article 20(7) of the Consultation Draft of the Provisions for Handling of Foreign and Foreign-related Arbitration Cases by the People's Court (31 Dec 2003), there appears to be a likelihood that an agreement between parties for arbitration outside of China may be found void if there is no "foreign element."

5. Article 126 of Contract Law of the People's Republic of China.

Learn more about our Asia offices and Business & Technology Sourcing practice.

Copyright 2010. JSM, Mayer Brown International LLP and/or Mayer Brown LLP. All rights reserved. Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: JSM, a Hong Kong partnership, and its associated entities in Asia; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and Mayer Brown LLP, a limited liability partnership established in the United States. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Please also read the JSM legal publications Disclaimer.