Large enterprises typically implement robust and sophisticated mechanisms to ensure the reliability of their procurements, whereas small and medium-sized enterprises (SMEs) tend to have far fewer resources and therefore are more vulnerable to the risks of unilateral breaches of contract by suppliers. This greater susceptibility is attributable to SMEs’ often insufficient awareness of potential legal risks, limited understanding of the Chinese market and legal practices, and frequent neglect of necessary precautions in their procurement processes. Consequently, they are at an increased risk of falling prey to frauds and breaches of contract, which can have significant financial and operational repercussions. 

This article discusses approaches that SMEs are strongly advised to take in their purchases from suppliers in China (for the sole purpose of this article, excluding Hong Kong SAR, Macao SAR, and Taiwan province) to mitigate the above vulnerabilities.

Company Checks on Suppliers

A company check, which could be understood as a simplified corporate due diligence, is essential to accurately identify the Chinese counterparties and to assess their contractual performance capabilities, thereby ensuring secure and efficient transactions. We have frequently observed instances where our foreign clients either fail to specify the exact Chinese entities they have engaged in trade with or exhibit a substantial misapprehension regarding the manufacturing capabilities of their counterparties.

It is imperative to recognize that Chinese law does not mandate the registration of company names in languages other than Chinese with the local market regulatory administration. Consequently, English names are not sufficiently regulated and often prove to be insufficient for the international buyers to pinpoint their Chinese counterparties. For an in-depth analysis on this subject, please refer to our previous article: 《Navigating Risks in Company Names in China-Related Transactions》.

While many international purchasers utilize online B2B platforms to identify suppliers, it is crucial to understand that the information provided on these platforms, including certifications, may not always be reliable. Our past experiences have revealed that some suppliers may falsely present themselves as manufacturers with extensive operations on their official and third-party websites. However, the certifications and other supporting documents may be counterfeited or obtained from another entity, and there is a significant likelihood that the purported manufacturer is, in reality, a small-scale trading company.

Therefore, international buyers must exercise caution in verifying the information provided about a supplier’s credentials and certifications. Engaging a third-party service provider with expertise in Chinese law and practices, such as a reputable law firm, to conduct a company check is often the preferred method for this purpose.

In contrast to the comprehensive legal compliance checks conducted by large corporations, which encompass various aspects of their suppliers’ operations, including anti-corruption, labor rights protection, and ESG, the company checks conducted by SMEs on potential suppliers need to be more focused, thus balancing effectiveness with cost. The primary objective of the SMEs’ company checks is to safeguard the transaction. Generally, a review of the suppliers’ registration details, public litigation records, and other publicly available information should suffice to provide a preliminary assessment of the suppliers’ capacity and trustworthiness.

Proper Agreement

In transactions, international buyers often opt to enter into transactions with Chinese suppliers through the signing of a rudimentary and standard invoice or order form furnished by the suppliers. This practice, despite its efficiency and cost-effectiveness, may not provide adequate legal protection, especially when the transaction amounts are substantial, totaling millions of RMB.

Here are four critical aspects that international buyers may inadvertently overlook when engaging in trade with their Chinese suppliers, which can frequently lead to disputes:

•Intended Contracting Party

•Quality Standards

•Damages

•Dispute Resolution

Intended Contracting Party

Company checks on a supplier are no guarantee to discern in every case discrepancies between the name showed by the seller’s stamp and the entity’s legal name, and such discrepancies, if not caught timely, could lead to legal complications. It is not uncommon for Chinese international trading companies to establish affiliated entities in Hong Kong, leveraging the region’s relatively relaxed foreign exchange controls and potentially more favorable tax policies. These affiliated entities may open bank accounts and conduct business, often under the same or similar names as their Chinese counterparts, which can lead to confusion. Sales representatives may represent both the Chinese and Hong Kong entities, further obfuscating the sellers’ identities.

While sellers may present themselves as China-based companies, it may be their affiliated entities in Hong Kong that execute the contractual documents. This can result in challenges to the pursuit of legal remedies in China, including issues related to jurisdiction, asset preservation, enforcement, and claiming legal liabilities against the Chinese entities.

A key indicator to differentiate between Chinese and Hong Kong entities is their company stamps, as the stamp formats used by entities in China and Hong Kong are distinct. It is crucial for international buyers to scrutinize the stamps on contracts and other legal documents to ensure a contracting party is the company with which the international buyers intend to do business.

Quality Standards

Quality-related disputes are prevalent in international sales of goods. Both the United Nations Convention on Contracts for the International Sale of Goods (“CISG”) and Chinese law provide frameworks for assessing the conformity of goods to contracts. Typically, in the absence of explicit agreements, buyers may refer to the intended use of the goods and relevant regional or industry standards as benchmarks for quality.

However, statutory protection may not always be effective, especially when non-conformity stems from product details that are not covered by existing standards and when it is difficult to establish the connection between these details and the goods’ intended use. For instance, in a case involving the painting of products, we observed that third-party inspection bodies applied different standards when assessing the quality of painting, creating significant obstacles for claimants in proving agreed-upon standards and the products’ compliance therewith.

To circumvent such issues, it is imperative to define quality standards with precision. Buyers can incorporate detailed descriptions of quality expectations into contracts and use samples or sample images during negotiations to ensure mutual understanding. These communications can serve as valuable evidence in the event of future disputes.

Damages

The recoverability of losses under CISG and Chinese law generally aligns in scope, yet there are noteworthy differences in some respects in legal practice. 

One of such differences is that Chinese courts and arbitral tribunals may apply more stringent evidentiary standards when evaluating evidence pertaining to claimed losses. We have observed numerous instances where claims for damages are not sustained due to the claimant’s inability to provide adequate proof of the occurrence and extent of the alleged losses. Incorporating a clause on liquidated damages (for example, a fixed amount of liquidated damages or a formula for such calculation) within the contract can mitigate this risk by providing a pre-agreed measure of damages in the event of a breach.

Another point of note is that, Chinese courts, in practice, often diverge from courts in some other jurisdictions by typically rejecting claims for costs associated with a claimant’s legal actions, such as attorneys’ fees and expenses for notarization, translation, and the like. For an in-depth analysis of this aspect of Chinese legal practice, you may refer to our previous article: 《Chinese Court Practices of Attorneys’ Fees under CISG》, It is advisable to include explicit provisions on the recoverability of such legal costs in contracts, especially in cases where disputes are subject to Chinese jurisdiction, to better safeguard the legal interests of the parties involved.

Dispute Resolution

Incorporating an effective dispute resolution clause is crucial in international contracts. If in a transaction, the seller is based in China, it is often advantageous for the international buyer to opt for dispute resolution within China. This choice enhances convenience for the buyer and increases the likelihood of successful service of court documents, asset preservation, and enforcement. In such scenarios, selecting a governing law other than Chinese law is discouraged due to the complexities and additional costs associated with foreign law ascertainment and interpretation. When it comes to Chinese law and the CISG, comparatively, the latter may offer stronger protections and more predictability for international buyers.

Regarding jurisdiction, in the context of transactions between international buyers and Chinese suppliers, arbitration in China is often recommended due to its benefits, such as expedited procedures, less stringent documentation requirements, procedural flexibility, and the option for foreign language arbitration, which can be more efficient and cost-effective for foreign parties. If the respondent has assets in Hong Kong, asset preservation measures can be sought under the Arrangement Concerning Mutual Assistance in Court-Ordered Interim Measures in Aid of Arbitral Proceedings by the Courts of the Mainland and of the Hong Kong Special Administrative Region.

However, arbitration may not be suitable for every case. In instances where the non-breaching party wishes to hold the respondent’s Chinese affiliates liable, given concerns about the respondent’s financial situation, arbitration may be of limited use. Arbitration agreements typically bind only the parties who have consented to arbitration, preventing the involvement of third parties in the dispute between the contracting parties. In such instances, separate legal actions before Chinese courts may be necessary to hold the affiliates liable.

In conclusion, the selection of governing law and jurisdiction should be carefully considered and tailored to each transaction, taking into account the specific legal risks involved. This strategic approach ensures that international buyers are well-equipped to navigate potential disputes effectively.

Concluding Remarks

In this article, we have underscored the importance of taking precautionary measures to mitigate the risks of future disputes and to ensure a foundational level of protection when engaging in international trade. We have delved into the critical aspects that international buyers should consider before entering into contracts for sourcing from China. 

In our subsequent article, we will delve deeper into the crucial steps that aggrieved buyers should take to enhance their prospects of recovering from losses and may address other pertinent topics aimed at empowering international buyers to navigate the complexities of international trade with confidence and strategic foresight.