China, Contracts

Beware Of Being Burned By The China MOU/LOI

Be careful, because signing an LOI or an MOU can cause all sorts of legal problems in China.

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At least once a month, a U.S. company comes to one of our China lawyers after having spent considerable time in China negotiating a complex transaction. The U.S. company shows us a Letter of Intent (LOI) or a Memorandum of Understanding (MOU) detailing the terms of their proposed China deal. We then explain how it is a bad idea in China to enter into this type of LOI or MOU with a Chinese company, and the U.S. company usually responds by saying that “the document clearly states it’s non-binding. What problems can possibly arise?”

These U.S. companies may be exposing themselves to substantial liability. Most U.S. (and many European companies) assume that no party is exposed to any liability during the negotiation period as liability arises only after the parties have executed a formal, written contract. If their written document states that it is non-binding, no liability can arise.

The rule in China is the opposite. The Contract Law of the PRC has formally adopted the German law principle of liability for negligence in contracting. Where negotiations have commenced but no contract is concluded, the party that caused the failure to contract can be liable to the other party for damages. The damages in this situation are not contract damages, but rather damages for compensation for loss resulting from the reasonable reliance of the damaged party on the conduct of the other.

This doctrine is embodied in Article 42 of the PRC Contract Law, which reads as follows:

Article 42 Pre-contract Liabilities

Where in the course of concluding a contract, a party engages in any of the following conduct, and thereby causes loss to the other party, that party shall be liable in the event of a claim for damages:

(i) negotiating in bad faith under the pretext of concluding a contract;

(ii) intentionally concealing a material fact or supplying false information relating to the conclusion of the contract;

(iii) any other conduct which violates the principle of good faith.

Items (i) and (ii) are directed at situations where a party negotiates in bad faith to prevent the other party from pursuing a business advantage. Though these two provisions are fairly specific, item (iii) is quite broad and leaves Chinese judges with wide latitude to impose liability. And they often do.

What all of this means is that failed contract negotiations in China can result in liability under this Article 42 and so care must be taken to make clear the commitments being made by negotiating parties. An abrupt termination of negotiations with no warning and no explanation is dangerous under this principle. Even more dangerous is failing to conclude a deal when the terms have been memorialized in a detailed LOI or MOU. In the case of a typical commercial LOI or MOU, compensation can be demanded for the following:

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  • Direct damages. These include costs incurred in preparing for the business venture, including the costs of drafting (attorney’s fees), research and development, and travel, and for costs for time spent negotiating and or preparing and delivering product samples.
  • Indirect damages. These include costs arising from abandoning negotiations with a third party for a similar transaction, lost profits from the needing to pursue the project independently, or from needing to pursue other funding or related business opportunities.

Assume that a U.S. and Chinese company negotiated for six months and executed a detailed LOI that mentioned how the U.S. company would purchase product from the Chinese entity, transfer technology to the Chinese entity, and make a capital equipment loan to the Chinese entity to produce the product. After the end of the six-month preparation period set out in the LOI, the U.S. party “terminates” its relationship with the Chinese company to enter into a substantially similar deal with a Chinese competitor of the Chinese party to the LOI.

As it turns out, the U.S. company was all along investigating the same basic deal with multiple Chinese parties but merely entered into the LOI because it was the best deal on the table at the time. The U.S. company did not inform any of the Chinese companies of that it was simultaneously negotiating with multiple parties. Chinese companies and Chinese courts generally view multiple negotiations without notice to all involved as a basic violation of the Chinese law requirement of good faith in contract negotiations.

Now assume the worst case. The Chinese company goes bankrupt and the bankruptcy trustee finds the executed, dated, sealed LOI in the Chinese company’s files. After investigating the facts, the bankruptcy trustee brings a damages claim against the U.S. company for the following losses:

  • The Chinese company failed to follow through on potentially lucrative sales of its products to competitors of the U.S. company after it signed the LOI.

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  • The Chinese company failed to act on a technology transfer offer from a Russian company that would have opened access to several new markets in Russia and Europe.
  • The Chinese company failed to accept a financing offer from a local bank in reliance on the commitment of the U.S. company to provide capital equipment financing.

Will the bankruptcy trustee prevail on all three of the above claims? It is clear the U.S. company violated a written LOI and nearly as clear that it also violated Chinese principles of good faith in contract negotiation. This alone creates a very real risk that a Chinese court would require the U.S. company pay some compensation.

When we warn U.S. companies of these sort of risks, their response is to say: “I have no risk for two reasons. First, the LOI clearly states that it is not binding and that no liability will arise for either party. Second, the LOI also we states that it is subject to U.S. law.”

Neither of these arguments work. The good faith requirement of Article 42 is a statutory requirement that applies to all parties who negotiate contracts in China. Article 42 creates an obligation that exists entirely separate from an agreement between the parties. More important, China’s good faith negotiating requirement applies to the conduct of the parties, not to what they say in a written document. For this reason, a Chinese court will examine the underlying conduct of the parties to determine whether liability arises and self-serving statements that no liability will arise will be ignored. Even worse, the court might view such statements as part of a plan to deceive the Chinese party about the U.S. company’s bad faith intent to cause harm. Reference to U.S. law will also be ignored because liability arises under compulsory statutory law, not because of any consensual agreement of the parties.

Our advice is that foreign companies should almost never enter into an LOI or an MOU with a Chinese company that contains detailed deal provisions. Just about the only time an LOI or an MOU should be used is when the parties need to set out specific steps needed to complete due diligence for a specific transaction. In this case, such a document should be treated not as an LOI or an MOU, but rather as a due diligence contract. The U.S. party should understand that it can be held liable if it does not perform as required in the contract.

The risk of using an LOI or an MOU with Chinese companies is high and the compensating benefits low. Not only can signing an LOI or an MOU cause all sorts of legal problems in China, it also can result in business problems, which problems I will discuss in next week’s post.

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 [email protected].

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