Damage limitation

A written contract is essential for protection of the rights of any foreign party doing business in China – but it’s worthless if not properly enforced. Many foreign business owners and lawyers know little of the specifics of Chinese law and are distrustful of Chinese courts. As such, they often insist that any dispute arising from a contract must be resolved by arbitration or court proceedings conducted outside of China and subject to foreign law.

While these steps are taken to increase the enforceability of the contract, in many cases they have exactly the opposite effect. In fact, these provisions often render the contract practically or legally unenforceable, producing an effect opposite from what was intended.

How does this happen? I can illustrate with three common dispute resolution disasters:

Disaster 1: Exclusive jurisdiction in a foreign court. A Chinese supplier has shipped defective goods to its foreign customer. The claim is undisputed, the contract provides that the sole remedy for enforcement is litigation in the US and the plaintiff is thrilled to obtain a favorable judgment. But joy turns to despair when the plaintiff discovers that the judgment is worthless. If the Chinese party has no assets in the US, the only way to enforce the judgment is to proceed against the assets of the Chinese party in China. However, US judgments are not enforceable in China and so the foreign customer is unable to recover its losses.

Slow death
Disaster 2: Foreign arbitration required. Contrary to the terms of the agreement, a manufacturer of outsourced products in China has been using its foreign customer’s molds to make goods for a competitor. The foreign customer seeks a court order requiring that the molds be immediately returned. However, the court refuses to hear the request because the contract provides that all disputes must be submitted to arbitration in Hong Kong. The Chinese supplier continues to manufacture the infringing product and the foreign party goes out of business before it has the chance to complete the arbitration in Hong Kong.

Disaster 3: Foreign law governs. A foreign party learns that its Chinese partner is improperly using trade secrets in violation of a trade secrecy agreement. Since the damage is immediate and cannot be repaired, the foreign party seeks an order from a Chinese court requiring the Chinese side to terminate the activity immediately, prior to the final resolution of the dispute in the Chinese court. Under Chinese law, such interim relief is available, but the contract provides that US law governs in the case of a dispute. Unfamiliar with the US system, the Chinese court requires that every element of US law must be proved before it will take action – an expensive and time consuming process. As a result, the remedies available under Chinese law to deal with these emergency issues are rendered ineffective and the contract is virtually useless.

These are only three examples of contract enforcement disasters that occur every day in China. The ironic thing is that the disaster is caused by contractual provisions inserted by the foreign party itself.

Playing it smart
Avoiding falling into this trap requires an awareness of what type of enforcement the dispute resolution process will throw up.

If it amounts to nothing more than calculating damages that must be collected in China, then foreign arbitration is a good alternative. China is a party to the New York Convention on the enforcement of arbitration awards and has a good record of enforcing lump sum monetary awards. Litigation, however, should be avoided since China generally does not enforce judgments from foreign courts.

Where the issue requires an order from a Chinese court instructing the Chinese party to act or terminate an action, foreign arbitration tends to be too slow and too expensive. In these cases, access to a PRC court with jurisdiction over the defendant is essential, and potential plaintiffs are therefore well-advised to provide for litigation in China subject to Chinese law. This is true even where the provisions of Chinese law are not favorable or where there is suspicion concerning the impartiality of the Chinese court. While these concerns may be well-founded, there is simply no practical alternative.

It is best to face reality rather than to imagine that foreign proceedings or law will provide some magical form of relief.