China, International Law

China Demand Letters: Because They Work

Demand letters work in China because they're viewed as more important, unusual, and serious. Why?

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Demand letters have become so commonplace in the United States that they rarely instill much fear into or much action from their recipients. I know of some lawyers who no longer will write such letters, believing that US companies will not seriously discuss settlement until sued.

China is different.

We have a much higher rate of success in China with our demand letters than we do just about anywhere else. We send these letters in Chinese, sometimes under our own law firm letterhead, and sometimes under the letterhead of one of our affiliated Chinese law firms — with their cooperation, of course. Like a demand letter in the United States, we usually conclude these letters by saying that if resolution is not reached within x number of days, we will commence a lawsuit.

Our China lawyers do not know exactly why we tend to have such a high success rate with these letters — nor on one level do we really care. But for whatever reason, in China, where demand letters (they are actually called lawyer’s letters there) are more uncommon and companies are not as joined at the hip to their lawyers as in the United States, these letters are viewed as more important, unusual, and serious.

Two Columbia Law School professors, Benjamin Liebman and Curtis Milhaupt, did a study, entitled, Reputational Sanctions in China’s Securities Market , where they posit that the avoidance of public humiliation is a big behavior inducer in China. And, unlike in the United States where being sued is a legal matter, in China it is humiliating, as per an Economist Magazine article, entitled, Shame fills a vacuum in China’s financial law enforcement.

Over the past 18 years, China has introduced rules against market manipulation, fraud, and insider dealing, but enforcement remains patchy. The China Securities Regulatory Commission seems competent, but overwhelmed. Sometimes it takes years to issue penalties after lengthy investigations — and along the way, cases lose relevance. In the meantime, the exchanges have quietly begun to acquire authority. The power that they wield appears flimsy — the most serious penalty they can levy is a rebuke to firms and individuals through public notices.

But it is remarkably effective in a country with a long history of punishment by humiliation — think of the cangue, a rectangular slab around the neck, in pre-Communist times and dunce caps in the Cultural Revolution. As a result of the culturally relevant and effective method of financial enforcement mechanism, Messrs. Liebman and Milhaupt write that between 2001 and 2006, the exchanges publicly criticized 205 companies and almost 1,700 people. They looked at the share prices of the targeted firms, both when they disclosed the conduct for which they were being criticized, and when the criticism was published. The admissions typically preceded the rebukes, and in the few weeks that followed, the firms’ share prices underperformed the Shanghai stock market by an average of up to 6%. After the criticism, there was a further lag of up to 3% on average.

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Furthermore, after an entity goes on the government “black list” through public criticism and shaming, raising money through equity markets and banks became more costly, and sometimes impossible, for companies that had been criticized. Suppliers and customers also took a tougher line. Some people lost the right to be a director or senior manager, and suffered from pariah status in a country where there is little pity for failure. The criticisms were sometimes even a prelude to formal investigations by the regulatory authorities.

From a comparative law point of view, this study points out not only the vast differences between legal regimes that actually work for different markets, but also highlights the relevance of culture in establishing them. In the United States, being sued, investigated, and/or prosecuted is pretty much a legal matter; while in China, it is more than that. When someone gets sued, it is as if she has lost part of her integrity in the public eye. For example, a few years ago, a Chinese friend of mine was sued by his boss down in Houston, and he was extremely distressed and felt humiliated by the lawsuit even though he understood that lawsuits in the United States are as common as cheese burgers. Public shaming goes deeper into the psyche of the Chinese (in general terms) because of the fear of failure and the love and care of one’s “face.”

It is shockingly common for the Chinese company to respond to these letters by admitting its fault and even explaining in some detail why the problem occurred. Most importantly, these letters work to generate payments fairly frequently as Chinese companies very much want to avoid the reputational problems that come from being sued.

Unfortunately, we are finding — particularly recently as a result of China’s economic downturn — that even threats of imminent humiliation do not work on Chinese companies that no longer exist or simply lack the funds to pay.

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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.

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