Drafting A China Contract, But With Whom?

Determining what makes sense in any given situation usually requires a combination of common sense and due diligence.

Whenever one of our China lawyers drafts an agreement for a client doing business in China, one of the first things we ask is the identity of the Chinese counterparty. This is a complicated question.

The typical Chinese company is composed of multiple entities, with a complicated ownership structure. One entity may run the factory, another entity may run the office, and a third entity may serve as a holding company — and is probably based in Hong Kong or Taiwan. And every single person on the Chinese side ignores corporate formalities and behaves as if all the entities are interchangeable.

But the entities are not interchangeable, and the party with whom you contract matters. How it matters depends on your goals and the Chinese side’s corporate structure.

One basic rule is that the counterparty should have financial resources. It is a bad idea to sign an agreement with a counterparty that is effectively judgment-proof. But many holding companies, especially those in Taiwan and Hong Kong, conduct no business other than receiving payments, and their bank accounts are emptied every few days.

Another rule is that the counterparty should be the entity that you pay. In the face of a stack of wire transfer receipts and a signed contract, it’s hard to argue that a business relationship doesn’t exist. This rule is considerably less compelling, however, when the Chinese side insists that payments be made to its holding company.

You also should want your counterparty to be the entity most likely to steal your IP — the factory. But the factory may be an otherwise impractical choice if it has neither financial resources nor English-speaking personnel. Not only that, but many times the Chinese side does not want you to pay the factory based in China because that will mean it will need to pay taxes in China.

Sponsored

Similarly, you will need to consider dispute resolution, especially if the holding company is a Hong Kong or Taiwan entity. Where do you want to litigate (or arbitrate)? And where do you need to enforce the judgment? Generally, when it comes to the quality and the cost of both litigation and arbitration, Hong Kong is the most expensive and the best, Mainland China is the cheapest and the worst, and Taiwan is in the middle on both counts.

Regardless of the named counterparty, your contract should reflect the reality of your relationship with the Chinese side. If the factory handles your manufacturing and the shipping of your completed products, the office handles communication and orders, and the holding company handles all payments, then the contract should make that clear. The ideal situation, of course, would be for one Chinese entity to handle everything. But reality rarely matches the ideal.

Determining what makes sense in any given situation usually requires a combination of common sense and due diligence. And, increasingly, common sense when conducting due diligence.


Dan Harris is a founding member of Harris Moure, an international law firm with lawyers in Seattle, Chicago, Beijing, and Qingdao. He is also a co-editor of the China Law Blog. You can reach him by email at firm@harrismoure.com.

Sponsored