At least once a month, an American or sometimes a British company will come to one of our China attorneys after having spent considerable time negotiating a complex transaction with a Chinese company. They then show us a Letter of Intent (LOI) or a Memorandum of Understanding (MOU) that sets out in great detail the terms of their proposed China deal. We then explain to them that this type of detailed LOI or MOU will be viewed as a contract in China. The US company then usually says: “the document clearly states it is non-binding. What liability could possibly arise?”
These US and British companies are making a major mistake and exposing themselves to substantial liability. They just assumed they are covered by the rule that prevails many countries outside China: no party is exposed to liability during the negotiation period; liability arises only after the parties have executed a formal, written contract. Under this rule, if the written document clearly states it is non-binding, no liability arises.
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 (缔约过失责任). Contrary to the classic common law view of the United States and England, under this principle, parties to a contract owe one another a duty of good faith. In a case 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 very broad and it leaves Chinese judges with wide latitude to impose liability.
For this reason, failed contract negotiations in China can result in liability under this Article 42 and you thus need to make clear the terms of negotiation and the commitments being made. An abrupt termination of negotiations with no warning and no explanation is dangerous under this principle. However, even more dangerous is the failure to conclude a deal when the terms have been memorialized in a detailed LOI or MOU.
The magnitude of potential damage is far greater than most companies imagine. In the case of a typical commercial LOI or MOU, compensation can be demanded for the following:
- 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. These also include costs for time spent negotiating and the costs spent in 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 other needing to pursue the project independently, or from needing to pursue other funding or related business opportunities.
Consider how how a claim for this type of Article 42 liability could arise in the case of a complex business transaction in China. Assume the foreign and Chinese parties negotiated for six months and executed a detailed LOI that involved the foreign company purchasing product from the Chinese entity, the foreign company transferring technology to the Chinese entity and the foreign company making substantial capital equipment loans to the Chinese entity to produce the product. After the end of the six month preparation period set out in the LOI, the foreign party terminates the LOI and enters into substantially the same deal with a Chinese competitor of the Chinese party to the original LOI.
As it turns out, the foreign company was investigating the same basic deal with multiple Chinese parties at the same time. It merely selected the best of the deals on the table. The foreign company did not inform ANY of the Chinese companies 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 while looking for claims against creditors, the bankruptcy trustees find the executed, dated, sealed LOI in the company files. After investigating the facts, they bring a damages claim against the foreign company for the following losses:
- The Chinese company lost out on several lucrative contracts for sales of its products to the competitors of the foreign company.
- The Chinese company failed to act on a transfer of technology offer from a Russian company. Though not as good as the technology of the foreign company, adoption of the Russian technology would have resulted in substantial cost savings for the Chinese company and would have opened access to several new markets in Russia and Europe.
- The Chinese company failed to accept the offer of financing from a local bank in reliance on the commitment of the foreign company to provide capital equipment financing.
Consider the magnitude of the financial damage that has resulted from the Chinese company’s reliance on the commitments of the foreign company as stated in the LOI. In essence, the bankruptcy trustees would be seeking compensation for all costs resulting from the bankruptcy of the Chinese company. Would the trustees prevail in a claim of this magnitude? It is not certain. But, since it is clear the foreign company executed the written LOI and violated Chinese principles of good faith in contract negotiation, the risk is considerable that a Chinese court would require the foreign company pay compensation.
A common response to this by foreign companies is to say, “I have no risk for two reasons. First, the LOI clearly states it is not binding and no liability will arise for either party. Second, because of our concern with the Chinese adoption of the good faith principle, we state in the LOI that interpretation of the LOI is subject to U.S. law.”
These arguments do not work. The good faith requirement of Article 42 is not a principle parties need to create by written contract; it is a statutory requirement that applies to all parties who negotiate contracts in China. It is an obligation that exists entirely separate from the agreement of the parties. More important, this good faith 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.
Thus, self serving statements of a party in its LOI or MOU that no liability will arise will be ignored. Even worse, such statements could be seen as a part of the plan to deceive the Chinese party about the foreign 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 the consensual agreement of the parties.
Stated bluntly: there is no contractual way for a party that negotiates in China to escape from its good faith obligations. This is particularly true when applied to a foreign company that has caused damaged to a Chinese entity. Since the basic principle is the opposite of what most foreign companies think is the rule, you should always exercise caution when entering into an LOI or MOU with a Chinese company.
Just about the only time an LOI or an MOU should be used is when the parties need to set out specific steps 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 and the foreign party should understand that it can be held liable if it does not perform strictly as required in the contract.
In all other settings, an LOI/MOU should generally be avoided. The risk is high and there is usually no compensating benefit. A unilateral term sheet is the normal alternative and that is generally acceptable. However, the principle of good faith will still apply even in this case; once negotiations have begun in China, the rule of good faith applies. If no contract is ultimately concluded, the risk of Article 42 damages is always there. For this reason, if no contract is concluded after negotiations have begun, the foreign side should carefully document the reasons and even consider providing those reasons in writing to the Chinese side.
Not only can signing an LOI or an MOU cause you all sorts of legal problems in China, it more commonly can result in business problems. In China MOUs and LOIs: Use Them at YOUR Peril, we detailed a recent conversation a couple of our China lawyers had with a reporter on how differences in laws can so often lead to problems arising between Chinese and American/British companies:
The impact of this difference is that we frequently see the following: American company comes back from China and shows us their five page MOU and says they now want us to draft them a contract, even though what they have given us is probably a contract. We tell them that we are of the view that their five page MOUR is the contract and they tell us we are wrong. We tell them to tell their Chinese counterpart that they now want a contract and see what happens. Almost every time, the Chinese company tells the American company there is no need for a contract and then the American company insists that there is and then the Chinese party thinks the American is being a jerk. The parties have already gotten off on the wrong foot.
There is a major gap in legal systems here. It is not culture, it is the legal system itself. Both sides are behaving in a manner consistent with their own legal system. But in the end, both sides look to the other as though they are acting in bad faith, when in fact both sides are doing nothing more than trying to reach a deal as best they know how.
Neither side has malevolent intent. The Chinese side just puts more stock in the MOU than the American side. The American side will sign the MOU thinking it is nothing, and planning to turn it over to their attorneys to draft the final agreement.
And then the problem starts when we tell the American company that the MOU it just signed is almost certainly a legally binding contract and that it is virtually certain the Chinese side sees it as a contract and that the contract is terrible and that “it needs the following ten additions/changes.” The American company then goes back to the Chinese company with the ten things that need to be changed or added and the Chinese company then gets offended because it thought it had a deal and that only super minor things needed to be resolved and that those would be resolved over time. So now you have a situation where what could have been a good relationship starts off on the wrong foot or fails to start off at all.
Bottom Line: China LOI and MOU are different in China. Don’t let them happen to you.