China Product Defects, Lawsuits, Hostage Taking and Exit Ban: Please, Please, Please Read This!

As most of you already know, getting defective products from China manufacturers is almost always a possibility. In many cases, foreign buyers frustrated by bad product simply refuse to pay their Chinese factory. Often the unpaid amount is substantial. The foreign buyer then moves on to a new factory. This new factory is often located in the same general region as the former factory. The Chinese factory virtually never files a lawsuit in this situation. So the foreign buyer then starts believing it is off the hook. But in China, matters like this are almost never that simple.

Most factories in China work with a network of subcontractors. So an unpaid invoice to a single factory usually will impact a large number of smaller businesses. Sometimes even an entire village will be impacted by one failure to pay. When the nonpayment is in a significant amount, the failure to pay can mean the salaries of many (sometimes most) of the local residents do not get paid. This leads to social unrest, which is a major concern of the local authorities, who then seek to work with the factory to try to secure payment. The legal issues (like the defective product) are not of concern. The factory and the local authorities will simply seek funds required to calm down the local unrest. These matters are not usually viewed as a business dispute and the court system is seldom used to try to resolve it. The factory never tells anyone the reason for non-payment was defective product; it instead almost always blames nonpayment on an unjustified default by the foreign buyer.

So long as the foreign buyer remains outside of China, there is little the factory and the local authorities can or will do. However, if the foreign buyer or an employee of a foreign buyer travels in China, the risk of some form of non-court or openly illegal action being taken against the foreign buyer is high. For this reason, we advise our clients to take great care when traveling in China if there is any dispute about their having failed to make a payment of a substantial claim to a Chinese factory. This is particularly important when the factory is a major employer in a specific district. The risk level rises exponentially if the foreign buyer travels in any area close to the district where the factory is located.

So what can happen?

a. Hostage taking. The Chinese side will arrange a meeting to take place at the factory or in a hotel that cooperates with the factory. The factory staff will obtain the passport of the foreign buyer. After the passport is obtained (stolen or taken by force), the factory holds the buyer captive either in a factory dormitory or in the cooperating hotel. The Chinese call this a “soft kidnapping” because no physical threats are made. The factory simply states: we won’t let you leave until after you pay the bill. If the police are contacted, the police will usually say: “It’s none of our business. You should pay the bill.” If the local authorities are contacted, they will usually say “It’s none of our business. You should pay the bill.” Resolving the matter without making payment is nearly impossible.

b. Exit ban. Because of the potential for social unrest, the Chinese authorities usually will work to assist the Chinese factory in getting paid. One way they do this is through an exit ban. The foreign buyer is permitted to enter China, but when the buyer seeks to exit China, permission will be refused. The foreign buyer is told: “You will not be permitted to leave until after you have resolved your payment dispute with the factory.” Exit bans are only approved at the national level and a factory that makes a false claim will be penalized. This is why hostage taking is more common.

So what is to be done?

The easy way to resolve the matter is to pay the entire claim in full. In the alternative, the foreign buyer can avoid being taken hostage or an exit ban by staying out of China. Often neither of these solutions is practical.

So what happens most often is that a partial payment is made pursuant to a settlement of claims agreement. For a settlement to work well, the basic rules are as follows:

1. The agreement must be in Chinese and enforceable in China. Chinese authorities typically ignore English language agreements enforceable outside of China.
2. It is normal to include in such an agreement standard settlement language: the creditor takes payment in full settlement of all claims; the creditor agrees not to file a legal action anywhere in the world; the creditor agrees to maintain confidentiality; the creditor agrees not to contact any PRC government authority.

If you have a settlement agreement that meets these above rules the local police and the exit authorities will normally take the side of the foreign buyer and you should be safe from being held hostage or blocked from leaving China. If the payment settlement agreement does not comply with the above rules, it is a waste of time and paper and money.

In general, in the case where there is payment in full or the case of a partial payment under an enforceable written settlement agreement, the risks I write about above will be resolved. I have never experienced an instance where a Chinese entity took anyone hostage or pressed for an exit ban after getting paid and signing an enforceable written settlement agreement. For this reason, even though our China lawyers we have drafted dozens of these settlement agreements, none of us have any experience in having to provide one of these settlement agreements to PRC authorities to try to convince them to free a hostage or lift an exit ban after a formal settlement has been reached.

But on the flip side we also have a lot of experience with companies that have either made a partial payment to their Chinese factory without getting a written settlement agreement or getting a written settlement agreement that does not comply with the two rules set forth above. Our experience in these situations has been uniformly bad and in most instances our clients have had to pay the full amount allegedly owed (and fast) to resolve their crisis situation.

Even in those cases where the reason for non-payment is because of product defects, no authority in the PRC will accept a simple claim from the buyer on this issue. The only way to be sure the PRC authorities will take any notice of the defect claim is by the buyer filing a lawsuit in its home country or (even better) in China making a claim for the defect. Anything short of that will simply be ignored. You can show the Chinese authorities a pile of emails 10 centimeters thick and they will be ignored. You can show them an inspection report and that will be ignored. The only thing they will get their attention is a formal lawsuit with service pursuant to the Hague Convention brought by you against your China supplier. We have done many kidnapping negotiations where our buyer-clients believed they could make the claim that nothing was owed due to defect. This claim never works. The police just laugh and walk away. The local government officials just hang up the phone. On the other hand, presenting evidence of formal legal proceedings where service was properly provided has always worked.

As they say on the cop shows, “Let’s be careful out there.”

For more on dealing with defective products from China check out the following:

• China Hostage Situations With a New Twist
• Maybe Owe Money To China? Don’t Go There.
• China Sinosure: What You NEED to Know
• Owe Money to China? Meet Sinosure, Leviton Law Firm, and Brown & Joseph

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.