International Communiqué: Sourcing in China for China - Standard Terms and Conditions for Chinese Purchase Orders

September 1, 2009

As China becomes a bigger player in the global marketplace and the Chinese and American economies become further intertwined, many American firms find themselves operating inside China. These operations often source raw materials, components, and other goods and services within China. Firms in this position are well aware of problems that can spring up in these sourcing relationships. Conventional wisdom about China is rife with anecdotes about quality control failures, intellectual property infringements, and supply interruptions. Purchasers within China know that they need to take steps to protect their interests. But the playing field is different. U.S. companies operating in China are often much less familiar with Chinese laws associated with commercial contracts than they are with their U.S. counterparts. This article briefly considers some important issues for inclusion in a standard set of terms and conditions that would accompany a purchase order agreement between a U.S.-owned Chinese facility and its Chinese suppliers.

The Contract Law of China

In the time since China began to decentralize and open its economy, authorities have introduced several laws and more than ten regulations governing commercial contracts. Authorities enacted the most recent contract law, the "Contract Law of China," to provide uniformity and consistency with its modern counterparts in other countries, such as the Uniform Commercial Code (the "U.C.C.") and the UN Convention on Contracts for the International Sale of Goods (the "CISG"). The main change introduced by the Contract Law of China vis-à-vis predecessor laws is an increased emphasis on freedom of contract, meaning greater flexibility in constructing contracts.

Contract formation under the Contract Law of China has been significantly simplified. Parties can now come to an enforceable agreement by a written or oral offer and acceptance. By contrast, predecessor laws required an exchange of written agreements and a formal closing in order to ensure enforceability. The law also provides guidance on when an offer has been made and when it has been accepted, thereby concluding contract formation. These principles provide ease of contracting, but may also lead to confusion about which agreements apply. A party that wants its terms and conditions to govern should be careful to disclaim any other agreements that may have formed by other means.

The Contract Law of China also gives parties significant flexibility on the content of a contract. Whereas previous laws mandated inclusion of a range of provisions, a recent interpretation by the Supreme People's Court requires only that the names of the parties, the subject matter of the contract, and the quantity be specified. This gives parties greater options in the realm of open-ended contracts, which some industries find desirable or even indispensable.

Despite these reforms, U.S.-style small print and "backside" purchase order terms and conditions are still inadvisable because an emphasis on demonstrable agreement continues to exist in China. Instead, a separate set of governing terms and conditions in clear font and, preferably, signed by both parties will work best.

Intellectual Property in China

As companies continue to engage in new transactions and seek opportunities in China, the government has taken steps to address concerns regarding enforcement of intellectual property ("IP") rights. China is also interested in increasing its competitiveness by ramping up efforts to protect the IP rights of its domestic companies.

One of the main IP issues for China is not so much the development of legislation to protect IP rights, but rather how to effectively enforce legislation already in place. A properly structured set of terms and conditions can reinforce China's IP enforcement scheme with a means of enforcement based in contract law. Terms and conditions should include provisions defining the IP rights to be protected and allocating ownership rights among the parties. Perhaps most importantly, the terms and conditions must clearly describe indemnification and damages for breach of its IP provisions, being sure to specify injunctive relief as one option.

Quality Control in China

Foreign companies and consumers are frequently concerned about the reliability of products sourced from China. Over the past several years, these concerns have been tangible in the form of defects and recalls in Chinese-manufactured products. Major US companies such as Mattel and RC2 Corp., maker of the popular "Thomas and Friends Wooden Railway" toys, implemented recalls of millions of their products as a result of various manufacturing defects and safety hazards. The numerous product recalls in 2007 highlighted the importance of establishing quality standards. Such standards should not only comply with regulations, but also play a central role in any company's plans to enter the highly-competitive China market.

Firms sourcing in China can best protect the quality of their source materials by including provisions in their terms and conditions allowing for inspection rights and a certain amount of supervision over the supplier's manufacturing process. The provisions should define particular inspection rights such as where the inspection will take place, when inspectors can gain access to products and manufacturing facilities, and how such inspections will be conducted. Provisions should maximize the level of discretion inspectors have in rejecting a product due to defects or nonconformity with established quality standards. Purchasers would also be wise to assert through their terms and conditions some degree of supervision over their suppliers' quality control process. It may even be appropriate to specify supervision and inspection rights over the entire supply chain. Another issue to consider is the extent to which a supplier may subsequently change its business operations so as to affect the agreed-upon terms of the purchase order. Foreign companies can reinforce agreed-upon terms by including a "No Changes by Supplier" clause in the terms and conditions.

Warranties

Unlike with the U.C.C. and the CISG, purchasers cannot rely on the minimal implied warranties contained in the Contract Law of China, which provides that the seller shall deliver the product to the purchaser in compliance with agreed-upon quality standards. This implies that express warranties will be enforced but leaves it to the parties to define the scope of those warranties. A wise purchaser will include detailed warranties in its terms and conditions that describe the intended fitness and quality of the product and specify remedies for breach of these warranties, including incidental and consequential damages such as recall costs.

Limitations of Liability

Among the important interpretations of the Contract Law of China issued by the Supreme People's Court is a requirement that limitation of liability clauses be graphically set off in a contract. Article 39 of the Contract Law requires that the party proposing a standard set of terms "call the other party's attention" to the provision limiting the proposing party's liability. A purchaser looking to limit its liability in its terms and conditions may meet this requirement by using a conspicuous color, text size, or other graphic marker that calls the other party's attention to the provision.

Liquidated Damages

Purchasers may be tempted to avoid confusion with respect to damages by specifying the monetary penalties for certain anticipated breaches. As with U.S. law, China limits enforcement of such "liquidated damages" clauses. The Supreme People's Court's interpretation of the Contract Law of China indicates that liquidated damages clauses are unenforceable if they exceed actual damages by thirty percent. This interpretation effectively eliminates the intended purpose of a liquidated damages clause by requiring actual damages to be calculated, regardless.

Additional Terms

The inclusion of the following additional clauses in a standard set of terms and conditions could minimize operating surprises over the duration of the purchase order agreement:

The foregoing topics are worth noting while keeping in mind that individual firms should tailor their own standard terms and conditions according to applicable industry regulations and product idiosyncrasies. Frost Brown Todd has an active China practice and stands ready to assist businesses in wording terms and conditions in Chinese and English. Our numerous posts of recent articles relating to China can be accessed at www.fbtchina.com.

For more information, contact Matthew P. Forgue, Joseph J. Dehner or any other attorney in Frost Brown Todd's International Services Group.

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