China: China´s Supreme Court Broadens Mandatory Application Of PRC Laws To Foreign-Related Contractual Disputes

The number of foreign-related contractual disputes is growing in China, along with the rapidly developing economy. While many foreign investors are accustomed to identifying which nation's laws govern the contracts they execute, such choices may not be recognized by Chinese courts. In fact, laws and regulations in the PRC concerning the application of laws to disputes arising from foreign-related contract disputes are quite limited and lag behind practical development. In this article, we will discuss recent developments in the application of choice of law provisions to foreign-related contracts and how the courts are expected to interpret these provisions.

Under the current Chinese legal system, the Civil Code and Contract Law ("Contract Law") governs all civil and commercial contracts.¹ While the Contract Law permits parties to a contract involving foreign interests² to choose the contract's governing law, there are certain exceptions to the rule requiring application of Chinese law: Sino-foreign equity joint venture contracts ("EJV Contracts"), Sino-foreign cooperative joint venture contracts ("CJV Contracts"), and contracts for Sino-foreign cooperative exploration and development of natural resources ("Exploration and Development Contracts") (collectively "Exceptions").³

According to an official spokesperson for the Supreme People's Court of the PRC, the Exceptions have lagged behind legal and practical developments in the current economic environment. Therefore, some ministry-level regulations have even enlarged the number of Exceptions. For example, last August six different Chinese ministries promulgated the Regulations on the Merger with or Acquisition of Domestic Enterprises by Foreign Investors ("M&A Regulations")⁴ mandating that the purchase of equity interests and/or assets, as well as capital increases of domestic enterprises by foreign investors is to be governed by PRC law.⁵ To date, there have been no national-level laws concerning or interpretating the M&A Regulations. Therefore, it is unclear how a court might interpret them.

On June 11, 2007, the Supreme People's Court passed the Provisions on Several Issues Concerning Application of Laws for Trial of Disputes Arising from Foreign-related Civil or Commercial Contracts ("Provisions"), which became effective on August 8, 2007. The Provisions have broadened the scope of the statutory application of PRC law to contracts and further clarified the application of laws under the principle of proximate connection to the disputes arising from foreign-related civil and commercial contracts.

The disputes identified in the Provisions include disputes arising from the conclusion, validity, performance, amendment,andassignmentand termination of foreign-relatedcontracts, as well as liabilities for breach of contract. In addition, the laws whichgovern foreign-related civil or commercial contracts onlyrefer to substantive laws of the relevant countries or regions, exclusive of the conflict and procedural laws.

Statutory Application of PRC Laws

Apart from the Exceptions, PRC law statutorily applies to the following six kinds of contracts performed in the PRC:

1. Equity transfer contracts for EJVs, CJVs, and wholly-foreign owned enterprises ("WFOEs");
2. Contracts for foreign natural persons, legal persons, or other organizations to contract and operate PRC-established EJVs and CJVs;
3. Contracts for foreign natural persons, legal persons or other organizations to purchase the equity interests in non-foreign invested enterprises established in the PRC;
4. Contracts for foreign natural persons, legal persons or other organizations to subscribe the capital increase of a limited liability company, or a limited liability company by shares that are established within the PRC but not invested by foreign investors;
5. Contracts for foreign natural persons, legal persons, or other organizations to purchase the assets of non-foreign invested enterprises established in the PRC; and
6. Other contracts to which PRC law shall apply according to PRC laws and administrative regulations.

According to the Provisions, courts must apply the "principle of proximate connections" in determining which nation's law governs a disputed contract provision. This principle requires the court to determine which country's law has the strongest proximate connection with the subject matter of the contract. Factors to be considered are the special nature of the contract and the performance of the obligations under the contract by the parties ("performance obligation"). According to the Provisions, domicile is the key factor in determining performance obligation.

In addition, the Provisions identify the choice of law for seventeen types of contracts. These principles are summarized below:

1. For purchase and sale contracts, the laws of the domicile of the seller at the time of concluding the contract apply. In the event that the contract is negotiated and concluded in the place where the domicile of the purchaser is located, or the contract expressly stipulates that the seller shall perform the delivery obligation in the place where the domicile of the purchaser is located, then the laws of the purchaser's domicile apply.
2. For contracts to manufacture using supplied materials, and contracts to assemble using supplied parts as well as various work contracts⁶, the laws of the contractor's domicile apply.
3. For contracts to supply assembled equipment, the laws of the place where the equipment is to be installed apply.
4. For contracts to purchase, sell, lease, or mortgage immovable property, the laws of the place where the immovable property is located apply.
5. For contracts to lease movable property, the laws of the lessor's domicile apply.
6. For contracts pledging movable property, the laws of the pledgor's domicile apply.
7. For loan contracts, the laws of the lender's domicile apply.
8. For insurance contracts, the laws of the insurer's domicile apply.
9. For financial leasing contracts, the laws of the lessee's domicile apply.
10. For construction contracts, the laws of the place where the construction project is located apply.
11. For storage and custody contracts, the laws of the depository's domicile apply.
12. For guarantee contracts, the laws of the guarantor's domicile apply.
13. For entrustment contracts, the laws of the entrustee's or agent's domicile apply.
14. For contracts to offer, sell, and transfer securities, the laws of the place where the securities are offered, sold, and transferred apply, respectively.
15. For auction contracts, the laws of the place where the auction is conducted apply.
16. For commission agency contracts, the laws of the commission agent's domicile apply.
17. For intermediation contracts, the laws of the broker's domicile apply.

According to the Provisions, the parties to a contract must expressly identify the choice of governing law, otherwise Chinese law will govern. There are, however, two clarifications to this rule.

If the parties fail to identify the governing law before executing a contract, and if the matter is being litigated, the Provisions allow for the parties to supplement the contract before the end of augment at the trial-level court. The contract cannot be so supplemented during the appellate stages of litigation.

If the parties fail to identify the governing law regarding contract disputes, but the parties cite the laws of the same country or region regarding dispute resolution, and neither party opposes the citation, the contract shall be construed as being governed by the cited law.

The Provisions have broadened the scope of statutory application of PRC laws and further clarified the application of laws under the principle of proximate connections to disputed foreign-related civil and commercial contracts. For foreign investors doing business in China or engaging in cross-border transactions with China, they have fewer choices than they once did concerning choice of law. Even under these restrictions, however, foreign investors can still choose to have disputes resolved through arbitration within or outside the PRC. Compared with the option of PRC-based litigation, arbitration is a more favorable alternative for foreign investors because arbitration gives them more options. In addition, the Chinese courts recognize and enforce arbitration awards obtained from foreign arbitration tribunals.⁷ If arbitration is preferred to litigation in China's courts, then contracting parties are well advised to expressly identify this agreement in their contract.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.