A Workshop on China

Earlier this year, a major Russian company received an order for a large batch of polyester garments. To fill the order, the company decided to use a supplier in China found on Alibaba.com, a standard search engine in cases like this. The product specifications were exactly what the Russian company wanted, and the photographs of the goods posted online were even more impressive.

After a short e-mail negotiation regarding technical details, a contract was signed with the Chinese supplier. Here the Russian customer, who had worked with Chinese businesses for nearly seven years, had enough experience and knowledge to refuse to deal with a pro forma invoice, which Chinese partners often produce instead of a contract. As usual, a 30% prepayment was made, and production was set to begin.

However, something went wrong in the well-established system. When the Russian importer asked for a certificate of quality for the thread, the Chinese supplier became evasive and would not send the documents. In fact, the supplier started asking if they could get the entire payment in advance, despite the fact that the contract clearly listed delivery under CIF terms (Cost, Insurance and Freight), which meant the payment would happen only after delivery of cargo.

After a brief argument, the Chinese explained they did not want to take any chances – they had heard that the Russians were broke because of Western sanctions. The Russians decided to request samples of the finished product, which only offended the Chinese more. “Why don’t you trust us?” wrote the Chinese supplier in an email. “Here are pictures of spools of thread and the spools packed in boxes. What more do you want?”

This rebuke only served to make the Russians nervous – the company decided to pay a visit to the factory in China to inspect the production line in person. The Chinese supplier had no objections and expressed readiness to roll out the red carpet. However, on the day they were supposed to depart for China, the Russian delegation received a text message, in which the Chinese reported the following: an exhibition was opening in the United States, and the entire management team was on a plane to America. Thus, they could not receive the Russian delegation. “We are very sorry,” the message finished, “but rice and vodka are canceled until better days.”

Threats of litigation and a reminder that their reputation would be destroyed only irritated the Chinese partners more. Further letters and additional pressure received the same – albeit increasingly infrequent – reply: “Payment upfront!”

During the six months of negotiation attempts, the Russian ruble experienced a strong devaluation. Eventually, the economic benefits of acquiring the product in China waned to the point that it became more profitable to buy the thread in India.

The cost of hiring local lawyers for litigation or arbitration in China was comparable to the initial prepayment, but wouldn’t guarantee results – as is common in such cases. It would also be impossible to enforce any decision made in a Russian arbitration court in China. In the end, the money that the Russian company had paid was irretrievably lost.

This true story perfectly illustrates the difficulties that foreign companies can face when dealing with Chinese suppliers. It is all the more interesting if we bear in mind that the Russian client was no newcomer to the Chinese market – the company had worked with Chinese companies for seven years, and imports up to 90% of its product line from China. So what did they fail to take into account, and what should they have done in order to avoid unjustified losses?

Starting at Alibaba

Using a search engine like Alibaba.com or another similar resource to find a Chinese supplier, like in the above example, is common practice when a company does a ‘cold’ search. However, it carries obvious and intrinsic risks – company information may be incomplete, inaccurate, or pure marketing. For example, a description like ‘Gold supplier for seven years’ does not mean that the search engine has verified the reliability of the company. All it means is that the company has paid Alibaba an annual fee of about $2,500 for the last seven years for the right to appear at the top of query results. However, you can get some useful information about the company even after this first search. For instance, when joining the Alibaba.com ‘club,’ the supplier must submit a certificate of registration as a legal entity, and although an unscrupulous supplier might use another company’s certificate, it must still contain basic information about the company that will be published on the website.

Screening the supplier online is only the first stage of the selection process, and should be followed by a second stage. The Chinese company should be asked to provide copies of three documents in electronic form:

Certificate of registration of legal entities. This is the main document a Chinese company must have, which reflects any changes in the status of the company, should they occur. Information listed here includes:

• Registration number. It can be used to look up the company in an open register of legal entities.
  
• Company name. It is important to remember that the majority of Chinese companies (except joint ventures and some enterprises with foreign capital, which are rare) are officially referred to only in Chinese. This means that the name of the company written in Latin script is little more than a pseudonym used for foreign trade activities – it can easily be hid behind or used to avoid legal liability.
  
• Registered address. According to the rules, a representative company office must be physically located here. Using a P.O. Box or a virtual address is not acceptable in China.
  
• Name of CEO/General Manager (legal representative). Only this person has the right to sign legally binding documents and act on behalf of the company without a power of attorney. In addition to the unlimited powers to manage the company, this person usually makes the most significant decisions, which often impact the success and conditions of the transaction - in particular, the price of the products and any discounts.
  
• Registered capital. This is important for two reasons when dealing with Chinese legal entities. First of all, shareholder liability for debts and obligations is limited by the size of the registered capital. Hence, if you sign a $1 million dollar contract with a company whose authorized capital is estimated at $30,000, your risks will be greater. Second, this amount should be sufficient to carry out the company’s statutory activities. For example, an enterprise with registered capital of $30,000 is a trader, not a manufacturer. However, since 2014, Chinese companies are unfortunately not required to declare their registered capital.
  
• Type of business entity. Most often, it will be a limited liability company (LLC). However, individual entrepreneurs have become more common recently. Unlike an LLC, an individual entrepreneur’s liability does not amount to their registered capital, but to the value of their entire property. At the same time, an individual entrepreneur is very limited in their activities. In particular, they have no right to engage in foreign trade activities, charge VAT, or return it when exporting. It is very rare that a manufacturer would register as an individual entrepreneur, unless it involved a makeshift production in someone’s garage.
  
• Scope of permitted activities. Chinese companies have a limited legal capacity. They cannot carry out trade and manufacturing at the same time, except for the goods produced at the company’s facilities. This section must contain the exact list of goods that the company works with and what it can do with them: only sell and export, or produce and process as well. Despite the fact that all Chinese companies declare themselves manufacturers, trading companies have a reason to hide the fact that they are traders – every customer knows that it is cheaper and safer to buy the goods directly from the manufacturer. As a result, it is extremely difficult to get a certificate of registration from companies that are hiding something, which should immediately set off alarm bells.
  
• Company founders (shareholders). Traditionally, the ‘main’ shareholder becomes the company’s legal representative (CEO/General Manager). In other words, it is the person or organization that owns the largest number of shares. Sometimes, knowing all the shareholders (if there are several) allows you to pit their ambitions against each other to your advantage.
  
• Annual audit stamp. The tax authority puts its own stamp and date on the certificate (in one of the small squares located on the right side of the certificate) every year, but no later than April. If the stamp for the current period is not present in May, this is serious cause to rethink your choice of partner.

Import and export license. If your potential Chinese partner does not have this document, then your dealings will involve an intermediary. This will inevitably affect the price as well as lead to increased quality risks because the trader is always interested in reducing the cost of delivered goods. Also, the commercial intermediaries are limited to one particular transaction, so talks about a long-term relationship are useless. In contrast to the intermediary, the manufacturer, especially if you can reach the head of the company, would consider the contract as a whole. When determining the price of delivery, the manufacturer would base it on the cost of the goods, taking into account factors like the order quantity and frequency, and even personal sympathies.

Whatever the case, working with suppliers in China without a contract is not only illegal, but also not profitable. The first reason is the risks that arise every time a verbal agreement is not supported on paper. In Chinese tradition, the spoken word is not just a ‘sparrow,’ as the Russians say, flying along and impossible to catch, but an ephemeral thing that may not exist at all

International Quality Certificate. This document, issued by the certifying body, states that the product produced by the specified factory complies with international standards in general, and European quality standards in particular. This is a certain guarantee that the goods will not be ‘made of Styrofoam.’ Many local Chinese companies that do not export products do not have this certificate. It is better not to get involved with those suppliers.

Additionally, it is important to pay attention to the validity date on the certificate and whether it was issued for your product. If there are no certificates, then it is highly likely the company produces products of the lowest quality.

In some cases, the clearance of goods requires additional documents, which must also be requested from the supplier. It would be impossible to pass the customs control of the importing country without them.

“Any contract is nothing more
than a piece of paper” (Mao Zedong)

The Russian company in our example was right to draw up a contract that tried to account for its interests and minimize its risks. But the Russians did it based on their own understanding and without paying proper attention to the provisions of Chinese contract law and existing business practices.

First of all, it should be borne in mind that a contract is not so much a way to fix an agreement with a counterpart on paper (it is actually enough to simply sign a protocol of intent). The main purpose of this document is to be filed in court or arbitration. In other words, a contract is primarily of legal value, and without taking into account the provisions of applicable law, it becomes ‘nothing more than a piece of paper.’

Secondly, if your Chinese partners sign the contract ‘sight unseen,’ without a single comment, it signifies that they are diligent students of Chairman Mao. The content of the document does not interest them because they do not believe that you can do anything to them, and they have grounds to think that.

Whatever the case, working with suppliers in China without a contract is not only illegal, but also not profitable. The first reason is the risks that arise every time a verbal agreement is not supported on paper. In Chinese tradition, the spoken word is not just a ‘sparrow,’ as the Russians say, flying along and impossible to catch, but an ephemeral thing that may not exist at all. It’s no coincidence that a typical Chinese agreement contains items like: “Upon the signing of this contract, all previous agreements and correspondence between the parties shall become invalid.” In other words, prior contracts are null and void in the legal sense, and all provisions in the newly signed document are extremely important.

Therefore, this document should be approached with the greatest care. Here are a few points that require special attention and need to be spelled out very carefully:

Terms of delivery. As a general rule, they are defined in Incoterms 2000 – EXW, FOB, CIF – something that all participants in foreign economic activity are familiar with. The Chinese side may not know or pretend not to know what they mean, which is why writing ‘FOB Shanghai’ in the contract may not be enough. A complete definition is preferable: “A condition of delivery is FOB Shanghai, which includes the cost of the product, its packaging and labeling, customs clearance in China, as well as delivery and loading onto the means of transportation.”

Specification. The exact product you are buying should be described in as detailed a manner as possible – what the product is made of, its size, product options, and so on. You cannot just write, ‘metal pan 30 cm in diameter.’ If you do, it will be no surprise if you get a bent aluminum bowl instead of the Teflon-coated stainless steel frying pan you were expecting.

Terms of delivery and payment terms. In China, nothing is done in a hurry (which does not imply quality), so 9 times out of 10 it will be impossible to stay within the exact time frame. You must be prepared for this, especially if your product is seasonal or perishable. Nevertheless, the time frame and the terms of payment must be specified clearly and unequivocally. It is highly advised to ensure that the final settlement is made only after the initial assessment of product quality, when the shipment arrives to your warehouse. You can do this, for example, by including this requirement in the ‘Acceptance criteria and quality of goods’ section. In general, the option of inspecting the goods prior to their leaving the factory gates is directly spelled out in the Contract Law of China. In other words, you have the right (if specified in the contract, of course) to send your representative to the company to assess the quality and check the contents of the lot, and only then carry out the final settlement.

Supporting documents. The contract should have a final list of all documents required for customs clearance, technical needs, and other requirements, indicating the number of copies of the originals and other details. One must bear in mind that the Chinese supplier will never do anything beyond the scope of what is written in the contract.

Weight and composition of the cargo. A typical problem is for the weight of the container and composition of the cargo to be listed incorrectly (or unspecified), which leads to delays at the border, cargo inspections, and even penalties. Incorrect labeling – absence of labels on the product, a simple oversight by the Chinese supplier – may lead to similar difficulties during customs clearance.

Sanctions and claims. As a rule, this point generates the most vigorous opposition from the Chinese counterpart, which is why it must be spelled out as clearly and in as much detail as possible. You must specify the quality, characteristics, and features of the product (material, weight, color, size). It is a good idea to have a mutually approved sample that will be used as a standard when receiving the entire shipment. Be sure to specify the entire range of conditions for the possible claim, as well as the time frame and at whose expense the return or replacement of the product is to be carried out.

Settlement of disputes. In most cases, it is impossible to force a dishonest Chinese partner to accept the decision of an international or Russian arbitration court, even if its fault is clear and has been proven. Therefore, specifying foreign or even Hong Kong-based arbitration as the final authority is very shortsighted. A better way is to include an item in the contract stating that any disputes are to be settled by the China International Economic and Trade Arbitration Commission (CIETAC). This organization, operating in China since the mid-1950s, enjoys a well-deserved reputation among foreign companies working as being the most objective.

Sacrificing the Queen

The contract in our example had almost every possible mistake in it: there was no version of the contract in Chinese; the name of the Chinese company was listed in English; the contract had the seal of a Hong Kong company on every page, and was unsigned; the arbitration clause mentioned a court of arbitration under Russian jurisdiction, whose decisions cannot be automatically enforced in China; and the prepayment was transferred to a single individual in Hong Kong.

In this situation, it is not even clear to which jurisdiction the dispute belongs, Hong Kong or China. Therefore, initiating legal proceedings to resolve the dispute would likely be useless.

Nevertheless, it is possible to argue and defend your position with your Chinese counterparts, although, objectively speaking, it is not easy. It is not so much that people from the East have a different mentality, a language barrier, or possess exceptional legal skills; direct confrontation runs contrary to their long-term business practices, and also to Chinese laws. In a long-winded and detailed manner, they spell out the conciliation procedures, which must precede any legal or arbitral proceedings. Generally, most disputes in China, especially in the area of civil law, are resolved at the negotiation table. This is especially true for foreigners living somewhere outside the ‘Heartland.’ From the start, an outsider is treated as a ‘barbarian’ to whom ‘regular’ norms of morality do not apply – or if they do, then only to a limited extent. It is worth remembering that when it comes to negotiations, just as it does to any other affairs, the Chinese have certain strategies. They approach each transaction like a game of chess, trying to seize the initiative and take advantage of any ‘blunder’ on the part of their ‘opponent.’ In our example, the Russian customer made numerous mistakes. The Chinese were fully in control of the game, and even the Queen (prepayment) was lost from the outset. When you are clearly in a losing position, it is unwise to start posturing and threatening the Chinese with a Russian arbitration court or the loss of reputation. This will only invite a snide grin and hasten the situation towards the point of no return, when the inevitable defeat will become a reality.

What is one to do in this case then? The only chance to get out of this situation is to go back to the negotiation table. The Russian company will have to do this on Chinese territory, no matter how weak its current position. In other words, go and ‘confess your sins.’ The challenge then would be to ensure that the transaction is completed with minimal losses and get the ordered products, sooner or later. Arrange a meeting, check the quantity and quality of the products, and make sure they are shipped – if the Chinese feel generous, that is. And, of course, learn from your mistakes in order to avoid them in the future.