A well-designed and enforceable contract dramatically increases the likelihood of a successful commercial exchange in China.
Doing business in China entails significant risks for those unfamiliar with its legal, regulatory, and commercial environment. A well-drafted sales contract and its formation process mitigate such risks by providing clarification to the objective of the commercial exchange, the tone of the relationship, the intent of the counterparties, and enforcement rights of the parties.
Parties should assess the elements of a commercial exchange prior to negotiating and concluding a contract, as well as stages of the transaction and corresponding risks, intellectual property, enforcement, and due diligence.
Stages of the Transaction
The parties should consider how to mitigate risks associated with each stage of the transaction. Clear delineation of each stage will help the parties understand the risks associated with each step of the transaction, by understanding the risks involved in each stage of the transaction, the parties will be able to make choices which minimize risk – e.g., order placement procedure, product liability and inspections duties, payment methods, how evidence should be prepared on an ongoing basis, etc. The delineation of the transaction as a step-by-step process then builds the framework for subsequent negotiations and drafting.
A goods-based commercial transaction may be prompted by the seemingly simple step of an order for goods. However, this initial step alone gives rise to additional questions such as, “when is an order for goods considered to be delivered?”, “How much advance notice is required, and how can a party prove that proper notice was provided?” Considering and then accounting for such questions results in a more fully conceptualized contract.
A commercial exchange exposes trademarks, trade secrets, and other intellectual property to many other parties; consider measures to secure relevant intellectual property prior to entering into a China-based exchange, and even prior to engaging in dialogue.
For example, it is highly advisable to register relevant trademarks as early as possible and certainly well before exposing such trademarks to third parties. China follows a “first-to-file” rule for trademark registrations i.e. the party filing the trademark application first is normally entitled to the exclusive use rights arising from successful registration. The party with an interest in the intellectual property should plan ahead and envision which & how & when the intellectual property may be exposed and what contractual and practical provisions may secure it.
Assessing enforcement at the outset of a commercial exchange may seem premature; nevertheless, a sophisticated party will soberly assess comparative power of the contracting parties, methods to identify assets of the counterparty, comparative advantages between litigation and arbitration, forum selection, choice of law, prevailing contractual language, documentary evidence, and other related issues.
This early focus on enforcement heavily influences the conceptualization, mitigation and acceptance of commercial risks, drafting of contractual terms and conditions, and sequencing and structuring of the underlying commercial exchange.
Parties should conduct due diligence on counterparties before contractual negotiations and, draft. Due diligence in the China context may involve confirming proper registrations, business scope, requisite licenses, seals, and relevant personnel such as the legal representative; it may also involve confirming ownership of assets that may become relevant to enforcement. More sophisticated and nuanced relationships may go further and call for reputational and another dimension of due diligence.
Due diligence is especially relevant in the context of fraud prevention. Many commercial parties seek assistance in the context of being defrauded in a trade transaction. In some cases, the fraud takes the form of intentional fraud, such as a trading company that vanishes after receiving a significant up-front cash payment. In other instances, the fraud is, in fact, not fraud but rather a significant breach of an implied warranty or material contractual obligation but the breach is of such an aggressive and blatant nature that an experienced business person may be hard pressed to articulate the distinction between fraud and breach of contract.
Some specific steps the buyer can take to learn about the seller include:
- Visit the seller’s facilities;
- Obtain several references from the seller; and
- Obtain a copy of the seller’s business license and export license (as well as other mandatory licenses).
Item (iii) can help the buyer to confirm the seller is duly engaged in the underlying transaction; the buyer is likely to engage in further due diligence to confirm the authenticity of the provided materials.
Consider it a flag of caution, if the seller hesitates to provide you with any of the above information,
Negotiation and discussion of key contract terms are not merely important for drafting an effective contract – it can also affect the counterparties’ behavior and treatment towards the commercial relationship.
A foreign party demonstrating a strong awareness of China’s legal, regulatory and business environment during negotiations with strengthening its bargaining position with respect to its Chinese counterparts.
A party’s behavior and attitude towards negotiating the terms of the contract will likely be indicative of its intentions. Sophisticated parties will welcome negotiation as a method to clarify and deepen the ongoing commercial dialogue. A party acting in good faith will closely review the contract and provide insight and feedback on the issues it deems critical.
Drafting the Contract
Clear and precise language is essential to any effective contract; however, the importance of language is especially important in China due to considerations such as bilingual documentation, preferred governing language, and the preferred practice of courts that adhere to literal interpretations of terms and conditions.
The contract should clearly and methodically outline precise steps and obligations comprising the exchange; the more mechanically and linearly the exchange can be outlined, the easier it is to enforce the contract upon breach. There should be no expectation that assumptions made during negotiations will be apparent or enforceable.
Document the Transaction
In the event that the buyer is buying the subject products directly from the seller, the sale agreement will be relatively straightforward. Common sense provisions such as the payment terms, the quality standards, and the delivery terms should all be included. In addition, the buyer will want to specify who will have the obligation to clear the subject products through customs.
A critical term to be included is specific damages if any of the material terms are breached. If there is a breach of a material term, the buyer can rely on this term to directly seek damages instead of first having to prove the damages.
In the event that the seller, manufacturer or exporter are not the same parties, then the sale agreement will be more complex, setting forth which party is obligated to perform which functions and how the transfer of payments will reflect such division of labor. In the event of a dispute, such clarity will mitigate the risk that the various parties are unclear as to who will bear liability.
It is extremely critical to bear in mind, however, that a sales agreement is merely a piece of paper. The buyer must still rely on common sense, be aware of who the seller, manufacturer, and exporter are and closely monitor the transaction.
A properly executed contract prevents the commercial counterpart from raising a technical defense of non-formation in the event of a dispute. In China, written contracts are valid when signed by each counterpart’s legal representative and/or sealed with official company seals. The signature and seal information gathered during the due diligence process must precisely match that in the contract.
Additionally, if the content of the contract is of sufficient importance, parties may consider investing in resource-intensive notarization, which ensures admissibility of the agreement as evidence in court or arbitration.
It is also very valuable to consider how you can monitor the transaction closely throughout the entire process. So, for example, consider how monitoring will ensure payments in full should not be made until the subject products have been inspected by a trusted third party and, immediately after such inspection, are sealed in a shipping container and immediately enter the control of an independent shipping agent and are no longer under the control of the seller.
For smaller buyers, this step, in particular, can present unique challenges given that the scope of the subject transaction may not justify committing the resources necessary for such inspection. Smaller buyers must be creative in finding adequate solutions.
The single most effective tool at a buyer’s disposal is common sense. Assume the transaction was occurring in the buyer’s home country and ask: How would a reasonable buyer behave? For example, would the buyer agree to an up-front cash transfer prior to confirming the quality and quantity of the subject products? Would the buyer agree to additional cash transfers upon request of the seller without insisting upon in writing a set of conditions that the seller has to meet?
In short, the buyer should not behave commercially in a manner inconsistent with how it behaves commercially in its own country, even if the seller insists that “this is how we do it in China,” or “this is the Chinese way”.