China Contracts, But with Whom?

One of the most important things to do before entering into a contract with a Chinese company is to make sure you are contracting with the right company. The right company is usually the company with sufficient financial resources to cover you if and when things go bad. On one level this sounds incredibly obvious, but foreign companies get this wrong all the time.

This seemingly simple principle is often overlooked because many buyers of products manufactured in China contract with third-party sourcing companies unaffiliated with the Chinese company that actually owns the factory making the product. So when a product defect is uncovered, the buyer will only have legal recourse against the sourcing company with whom it contracted and not the actual Chinese manufacturer. The same thing is true when foreign companies contract with Chinese companies for services.

Oftentimes the foreign company will contract with the Chinese company’s parent or holding company in Hong Kong, Taiwan or Singapore that typically does not have assets beyond a few computers and a market-rate office lease.

Before contracting with anyone, you should do your due diligence and make sure the party you are paying is not a shell entity or a sourcing company with little or no assets.

The following are just some of the instances where companies have gotten into big trouble for not abiding by the rules above:

1. Mexican company pays Chinese company nearly a million dollars to produce a toy line for it. Chinese company never produces a single toy. Mexican company hires our firm to explore options for pursuing the Chinese toy manufacturer. We look at the Chinese language official version of the contract and determine that the signing party is a completely different entity than the Chinese toy manufacturer with which our client believed it had contracted. A few hours of research reveals that the company with which our client contracted was a one person “sourcing consultant” who operated out of a $300 a month single person office. Not good.

2. Many years ago, an American company called us after just having learned that its two million dollar order of Christmas tree lights would not be delivered to the United States until December. We called “their” Chinese factory and it told us they had no idea who our client even was. It turned out our client had unknowingly been using a sourcing agent (we figured it out by looking at some other Chinese language documents) and so it had no contractual relationship with the factory that was making its lights. At that point, all it could do was to beg its factory and its agent to do whatever he could to get the factory to speed up the order. There was no point in suing the agent because he was one guy in a small office with an old computer (we investigated). To make a long story short, the Chinese factory was deliberately holding back on the order because it was owed money by the sourcing agent and our client had to pay the factory a lot of additional money to do an end-run around the sourcing agent and get its lights in time for Christmas.

3. American company gets bad product from its Chinese clothing manufacturer and so refuses to pay the remaining $500,000 or so for the shipment. American company then gets sued in China and retains us to assist. Turns out that the lawsuit in China has been brought by a Chinese sourcing agent whose contract with our client makes clear that he gets paid for brokering each transaction, whether or not the transaction goes well or not. In other words, there would have been a very good chance that this sourcing person would have prevailed against our client because he had fulfilled all requirements of his deal with our client, and the fact that some third party manufacturer had provided bad product was irrelevant. Our client ended up settling

4. American company contracts with a Hong Kong company to do coding for a new software product. Two years and hundreds of thousands of dollars later, the 11-person team in China that was doing the coding basically disappears with the software. The Hong Kong company turns out to have had only a tangential connection with the 11 people in China and the American company chooses to shut down its business entirely.

We could go on and on.

The key to avoid these sorts of problems is to know your counter-party. The way to do that is to get the Chinese name of the party with which you will be contracting and then do your due diligence on that company. Generally (though not 100% of the time), the best party with which to contract will be the company that owns the factory that will be making your product or with the company that will be providing you with the service. For more on China contracts, check out Drafting China Contracts That Work.

Just get it right.

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.