Avoiding Legal Disputes in China
By Jian Zhang
The most effective way to build a successful China business, protect your company’s reputation, revenues, markets and customer relationships is to avoid disputes by negotiating and signing clear and balanced purchase contracts.
Investing time and expertise up front to create a good contract is one of the most important revenue-generating tools to avoid liabilities, future trade disputes, uncollected accounts receivables, reputation-damaging publicity, and claims of breach of contract or poor quality control. Failure to invest up front in practical street-smart advice is “penny wise and pound foolish.”
Here are a few basic principles to apply to protect your business:
- Ensure contracts are clear about all the major terms and conditions without any room for different interpretations.
- Ensure contracts are clear about the responsibilities and obligations of all parties without any room for different interpretations.
- Ensure contracts reflect the realities as understood by all parties without any room for different interpretations.
- Ensure that all payment, legal title transfer, and delivery terms are reasonable and stated clearly.
- Ensure that the contract is enforceable against all the real parties in interest and provide for practical and efficient dispute resolution mechanisms.
- Build in practical communication mechanisms to identify and solve problems before embarking in costly litigation/arbitration.
Based on more than 50 years of cumulative China experience, we share here the best practices that should be included in the basic form contract for every company, before tailoring for specific situations. These should be useful to help protect a business in an increasingly complicated and competitive trade, investment and business environment.
- Sign a Non-Disclosure Agreement Before Starting Discussions
A non-disclosure agreement signed at the beginning of discussions prevents unlawful use of trade secrets and/or confidential information (for example, sales, design or customer information) by other parties.
- Sign with the Legal Representative
Request that the purchase contract be signed by the authorized legal representative in the company’s current official registry. If the person signing the contract is not the legal representative, the other party may claim to not to be bound by the contract and refuse to abide by some or all of its terms.
- Discuss Demand Forecasts
Demand forecasts should be explicitly binding. Ensure that forecasts are binding only for a short term, and retain explicit rights to modify the forecasts to allow future flexibility.
- Determine Whether Orders Can be Canceled, Rescheduled, or Modified
By default, orders are binding and cannot be modified or canceled without liability unless explicitly stated. To allow flexibility and fairness to both parties, set specific bounds (dates/volumes) for when orders can be canceled, rescheduled or modified.
- State Explicit Payment Terms and Penalties for Delayed Payment
The contract must clearly state the payment terms. For example, it is better to ask for payment “10 days after shipment,” instead of “on receipt of products.” The contract should clearly define a lump sum, a daily/weekly/monthly penalty, and/or an interest charge in the event of delayed payment. As with other penalties, a fixed figure must be agreed on in advance.
- Determine When to Transfer Title of the Goods
As a buyer, make sure that title to the goods is transferred upon shipment. If the seller transfers goods to you, but files for bankruptcy before you pay for them, the goods will be considered part of the seller’s assets and liquidated. As a seller, title to goods should be transferred upon payment. If you transfer title to the goods before payment and the buyer then files for bankruptcy protection, the goods will be considered part of the buyer’s assets, and will consequently be liquidated.
- Payment After Acceptance
The contract should ask for payment within a reasonable period after the products have passed acceptance tests. This ensures that defective products are not bought and safeguards against later refund disputes.
- Have the Right to Audit
As a buyer, incorporate a clause that permits audits of the seller’s financial data and visits to the seller’s factory (with prior notice) to guarantee that the seller is not unlawfully manufacturing the same products for other uses.
- Most Favorable Price
A most favorable price term should be incorporated into the contract to ensure that other buyers will not be able to make an equivalent purchase for the same goods for a lower price in the future.
- Define Clear Quality Control Mechanisms and Specifications
Ensure the contract provides clear, detailed and previously agreed upon quality specifications, as well as a description of the inspection process (who will inspect the product, when and how). The seller should provide sample products for reference and records. Make sure an independent and local third party conducts quality control inspections during production or before shipping the goods to the buyer. State that the results of these inspections are binding. It is common practice for the buyer to select and pay for this service provider.
- Clearly State Warranties
The objective of spending time and energy drafting a contract is to minimize your liability in all transactions. Reasonably state everything you need in the warranty clause, and do not simply rely on your insurance policies.
- Sufficient Indemnifications
Claim sufficient indemnifications in order to cover your potential losses in any future disputes, including the attorney fees you may be required to spend.
- Define Clear Mechanisms to Handle Returns
Specify deadlines to report product defects and returns (e.g. 10 days after shipping). Ensure the term “defect” is clearly defined and understood by both parties. Document customer complaints and require products to be inspected by you or a mutually agreed upon third party to be deemed defective. Have clear deadlines and procedures to reduce misunderstandings and pass liability to the other party if they fail to adhere to the established system.
- Right to Offset
As a buyer, make sure you have the right to offset any amount owed by the seller against product payments. This must be clearly stated as the right is not usually granted.
- No Right to Outsource
As a buyer, make sure the seller is forbidden from outsourcing the function of manufacturing and/or supplying to a third party to ensure the quality of the products unless prior written consent is given.
- State Termination Rights
State very clearly the circumstances under which the contract can be terminated. These usually include mutual consent and breach of specific clauses by one of the parties.
- Select the Governing Law That Better Protects Your Rights
Remember that any jurisdiction can be used if both parties agree. Even though your first impulse may be to use your own jurisdiction, you should explore other options with your lawyer on a case-by-case basis. In some cases, choosing the other party’s jurisdiction may facilitate seizure of assets in a dispute.
- Prepare a Standard Contract in Advance
As Louis Pasteur said: “Chance favors the prepared mind.” The best way to protect your interests is to develop your own template contract with the assistance of an experienced commercial lawyer and use it as a baseline during negotiations.
- Sign with a Real Party in Interest
Ensure the other party has assets for future enforcement if a dispute arises. Remember that contracts are only binding for signing entities, regardless of who actually receives the product. “Paper companies” often have no assets, which defeats the purpose of signing a contract in the first place if there are no assets to enforce against.
Always request to sign the contract with the global or regional headquarters. Be very suspicious if one party suggests using an offshore entity. It is always advisable to conduct a background check to ensure the signing entity has a track record of successful sales and assets (real estate, production facilities, bank accounts, etc.) that can be seized in a dispute.
Never sign a contract with a representative office unless the real party in interest is legally responsible for payment of orders placed in their name by the representative office.
- State Explicitly Any Geographic Limitations for Distribution
If product distribution is to be limited to a specific geographic area, this should be negotiated beforehand and stated clearly in the contract. Any penalties for breaching this restriction must also be stated as a fixed amount, which should also be negotiated in advance.
- State Explicitly When Prices Can Be Negotiated
This is particularly important in industries where prices for key components or commodities increase/fluctuate seasonally, or depend on global/local supplies.
If breakbulk and project cargo handlers have failed to follow the best practices above, and face a potential dispute situation, what can be done? A company will need to undertake a timely review of key documents, evaluate business and legal options, and then make recommendations and a pragmatic assessment of the next best steps to take.
Jian Zhang is a partner at Pamir Law Group. He is a UK educated, China-licensed lawyer based in Shanghai with more than 20 years’ experience advising diverse clients on cross-border business and dispute resolution matters. For more information contact Zhang at firstname.lastname@example.org.
Photo credit: Shutterstock
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