Practical Solutions to Business Puzzles

This is part 4 of the reprinting of an article written based on research in 2000 and a trip to China. This part continues the discussion of contract laws in China and the United States. Please consult appropriate advisors. This is especially important when doing business in a foreign jurisdiction. Go here for part 1 of the article.
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Hong Kong’s standards

In Hong Kong, the local court system “provides effective enforcement of contracts, dispute settlements and protection of rights…” (U.S. Department of State - Hong Kong 2000 at 61). Hong Kong’s legal system is considered to be “based on the rule of law and the independence of the judiciary” (Id. at 62). Hong Kong has a reputation for combating corruption and, for the last thirty years, there have not been any reports that corruption was an obstacle to foreign direct investment (Id. at 68-69).

China’s Standards

Although China has engaged in a high profile effort to deal with official corruption and has harsh penalties for individuals convicted of corruption, corruption is widespread in China (U.S. Department of State - China at 78). According to surveys of US firms, corruption was viewed as a hindrance to doing business in China. (Id. at 78).

“Although more than 150 major laws and regulations apply to foreign investment, China’s legal and regulatory system remains characterized by a general lack of transparency and inconsistent enforcement” (U.S. Department of State - China 2000 at 75). Guanxi is prevalent in most judicial proceedings (Johnson 1999 at 723). “[T]he party who has the strongest guanxi with the most individuals will have an edge regardless of the strength of his case” (Id. at 723). Part of the reason for guanxi’s power may relate to the individuals serving as judges in China. In 1999, only 66% of China’s judges had completed college and many did not have any legal background (Rosen, Daniel H. 1999 at 208). In addition, China has spotty or absent enforcement of laws and regulations (Rosen 1999 at 222).

Local officials encourage people to circumvent Chinese law. According to Nicholas Howson, “[i]n every province and major municipality of China, foreign investors are being asked by their Chinese partners or local officials to circumvent China’s published laws and regulations” (Howson, Nicholas 1999 at 8 ). At the meeting with Deloitte Touche Tohmatsu on April 20, 2000, tour participants learned that China’s local government officials are promising foreign investors more than the law allows them to provide in order to attract foreign investment. In speaking with the mayor of a zone in Chan An on April 17, 2000, the tour participants were assured that, if their companies wanted to invest, the mayor would take care of everything. In retrospect, it seems as if the mayor was indicating that they had ways to deal with any “problems” that foreign investors might encounter.

China places strong emphasis on resolving disputes through conciliation and consultation, rather than litigation (U.S. Department of State - China 2000 at 69). When it is necessary to use a formal dispute resolution mechanism, the authorities prefer arbitration through Chinese agencies. Some foreign investors have experienced asset striping by Chinese joint venture partners during the course of dispute resolution and China was unwilling or unable to prevent this (Id. at 69). Even when foreign companies won arbitration or a favorable court decision, the local courts where the venture is situated may choose not to enforce the decision.

The contract laws of China and the United States

There are certain basic standards for contracts in the United States and most of the world. These standards include definitions of who can contract and what is required to have a valid contract. This paper will consider the parties’ capacity to contract, the required elements of a contract, warranty provisions, and breach of contract provisions.

Capacity

Individuals must have sufficient maturity, mental capacity, and authority in the United States or the agreements they sign will be invalid. Individuals signing agreements in the United States on behalf of companies must have actual or apparent authority to do so. How do these requirements compare with the corresponding provisions under Chinese law? China generally defines an adult as someone who is at least 18 years old, although this limit can be lowered to 16 or even 10 years old in some cases. (General Principles 1986, Chapter II, Articles 11-12). Under Article 10 of the Contract Law, the parties must have “appropriate capacity” for civil conduct in order to execute an agreements. Some agreements by individuals with “limited civil capacity” are binding (Contract Law 1999 at Article 12-13). Depending on the situation, an individual may be able to contract if the individual is as young as 16 or even 10 years old. In the United States, any child (regardless of age) as well as mentally incompetent individuals can contract for items required for basic survival. To be enforceable, such agreements normally must relate to food, clothing, or shelter. Consequently, the Chinese law and laws in the United States are very similar regarding the capacity to contract.

In the United States, issues relating to capacity normally relate to whether the individual executing the contract has authority to do so on behalf of a third party or an organization. There are two types of authority, actual authority and apparent authority. The concept of actual authority relates to situations in which the third party or organization has specifically granted the individual authority to speak for the third party or organization. Most of the time, questions relate to apparent authority. Unless the party trying to enforce the agreement knows the person does not have actual authority to enter into the agreement, if a reasonable person would have felt that the person signing the agreement was authorized to do so on behalf of the organization or third party, the organization or third party is bound by the agreement in most cases.(The organization or third party may have a cause of action against the person found to have apparent authority, but this will not eliminate the requirement that it fulfill the agreement.) China appears to have similar concepts (Id. at 48-49).

The difference between Chinese law and the norm in the United States regarding capacity is found in the context of companies and other “legal persons.” A “legal person” is an entity that has capacity for civil rights and civil conduct (General Principles at Article 36). To qualify as a legal person, the organization must be established in accordance with the law; possess the required assets; have its own name, organization, and premises; and be civilly liable independent from any other organization or individual (General Principles at Article 37). According to Z. Alex Zhang, corporations in China must specify the scope of their business and obtain approval for the scope from relevant authorities. In the United States, corporations generally do not have to limit the scope of their businesses to any area. While corporations must file certain documents with government in order to be created, this is primarily an administrative requirement. In the United States, if the paperwork is in the appropriate format and contains the prescribed information, the document must be accepted and filed.

Elements of a contract

Normally, a valid contract in the United States requires offer, acceptance, and consideration. The Contract Law requires that offers be specific, definite, and result in a binding obligation upon acceptance (Contract Law 1999 at Article 14). Chinese law allows offers to be withdrawn or revoked in most cases. It also allows the acceptance requirement to be satisfied by notification or behavior (Id. at Article 22). Each of these provisions is, on its face, similar to the provisions commonly found in the United States. The differences between the laws one generally finds in the United States and the Contract Law relate to the depth with which issues are addressed. Since China uses a code system instead of a common law system like the United States, the Contract Law includes considerable detail relating to each element of a contract.

In the United States, most agreements can be oral. A written agreement is generally required if the contract cannot be performed within one year or the transaction fits into certain categories (such as real estate sales or consumer credit). Likewise, the Contract Law allows oral agreements in most situations (Id. at 10). In both countries, it is generally best to have a written agreement so that there is no question regarding the scope of the agreement and in order to prevent misunderstandings.

Warranties

In the United States, there are two important warranties that courts imply in commercial transactions, unless the parties have waived the warranties. The first warranty is called the “warranty of fitness for particular purpose.” This warranty arises when the seller knows at the time of the contract what the buyer intends to do with an item and that they buyer is relying on the seller’s skill or special knowledge regarding the suitability of the item. The explicit or implied warranty given by the seller in such a situation is that the items are suitable for the uses that the buyer intends. The second warranty is called the “warranty of merchantability.” This warranty means that the items meet the contract specifications, are suitable for the ordinary purpose of such items, are adequately contained, packaged, and labeled, and conform to the information published by the seller (Black’s 1979 at 1423).

China did not explicitly adopt either a warranty of fitness for particular purpose or merchantability. The closest statement in the Contract Law to these warranty provisions is found in Article 62. Article 62 uses industry standards to measure performance when quality provisions are unclear. However, there are at least two risks associated with this approach. First, it provides little guidance to the parties on what is required or acceptable. One of the reasons that contracts rely on the laws of particular states or countries is that laws have been tested so parties know what is required. In specifying jurisdictional law that applies to a particular contract, the parties are able to avoid certain procedural burdens (in case litigation arises) and to obtain certainty about the standards that will be used to judge their performance. However, there is insufficient history for the parties to know what “industry standards” will be applied by Chinese courts. It might be an international industry standard, Chinese industry standards, or even the industry standards of another country. Consequently, the term “industry standards” does not provide the parties with sufficient guidance to identify the source of the standards that will be applied.

Part 5 discusses breach of contract, and contains the conclusion and bibliography for the article.