Restructuring Import Contracts: How American Companies Can Protect Themselves From the Risks Associated With Importing Goods From China

“Chinese Tires Recalled.” “ Chinese Toy Scare.” “More Deaths from Pet Food Likely.” These troubling headlines, which are invariably succeeded by lawsuits, allege defects associated with the domestic sales of products manufactured in China. Not surprisingly, plaintiffs are not suing the Chinese manufacturers, but rather the U.S. importers and distributors. Also, because the National Highway Traffic Safety Administration (NHTSA), the Food and Drug Administration (FDA), and the Consumer Product Safety Commission (CPSC) lack the authority to force Chinese companies to recall such products, the recall burden falls squarely on American companies.¹

Small importers like Foreign Tire Sales, recently instructed to recall around 450,000 tires, have found themselves facing bankruptcy with little available legal recourse against the Chinese manufacturer. Perhaps more significantly, liability in ensuing suits and the costly legal expenses of defending these suits are falling squarely on the American sellers and distributors of allegedly defective Chinese products. For example, a class action suit was recently filed in the Northern District of Illinois against Learning Curve Brands because toys that company distributed had been imported from China and were made with lead paint.² What lessons can be learned from this fallout, and what preventative steps should be taken when dealing with Chinese companies?

General Contract Considerations

There are a myriad of options for companies looking to insulate themselves contractually to avoid unintentionally assuming the entire risk in a transaction, yet not all options offer equal protection. American companies can include in their contracts risk-shifting provisions by which the Chinese manufacturer agrees to indemnify or buy back defective products, but such provisions still require the ability to enforce the contract against a Chinese manufacturer, which often proves problematic. Moreover, the Chinese judicial system will generally not enforce American judgments, especially default judgments. As an alternative, American companies may consider assuming more control in the production process, rather than less, by reserving the right to conduct quality control visits and audits.

For companies that are still disinclined to become involved in the manufacturing process, one solution may be to seek safe harbor in a third party – by, for example, requiring an irrevocable letter of credit from a mutually-agreed-upon bank. An importing company may structure its letter of credit such that the products must be shipped and inspected prior to issuance of any payment. This solution, while adding some protection, still may not insure against a large-scale product recall due to a defect not discoverable upon initial inspection.

Insurance Options

A better approach for American companies is to require their Chinese suppliers to obtain and maintain product liability insurance. There are different types of insurance that companies may consider in addition to their commercial general liability policies, which usually do not cover the costs associated with a product recall. Separate recall insurance, which generally covers the cost of informing the public of the recall, the cost of having the product recalled, overtime expenses for employees due to the recall, and the cost of hiring additional help, has been available in the food and cosmetic industries for years, and is now being offered in the automotive and original equipment manufacturing markets. Additionally, extra coverage can be purchased to cover other recall costs, such as storing and/or disposing of defective goods. Language can also be added to a policy to cover business operation losses, i.e., the costs associated with shifting resources away from normal, productive business operations toward the recall. Another related option is for U.S. companies to contractually require Chinese manufacturers to carry their own recall insurance and include the U.S. company as an additional insured. Due to recent events, several international underwriters, including AIG/AIU, have dedicated significant resources to developing and marketing products to meet the needs of international businesses.

Arbitration Clauses

Even with insurance protection, given that the Chinese courts steadfastly refuse to honor judgments obtained in American courts, American companies may also consider incorporating a specialized arbitration clause into contracts with foreign suppliers. When dealing with Chinese exporters, great care must be taken in the crafting of these clauses. For example, in Guanghope v. Mirant,³ the Chinese Supreme People’s Court found that an arbitration clause was invalid because the parties had not expressly identified an “arbitral commission.” Thus, the arbitration provision must be clear, unambiguous, and must specifically and accurately identify the presiding arbitral body. Based on this and other recent decisions, it seems clear that the standard arbitration clause will not be effective.

There are two viable options for obtaining an arbitration award that would be enforceable in China, both having their share of benefits and shortcomings. The first option is arbitrating pursuant to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards, commonly called the New York Convention,⁴ to which China is a signatory. Article 3 of the Convention states that “[e]ach contracting State shall recognize arbitral awards as binding and enforce them in accordance with the rules of procedure of the territory where the award is relied upon … .” Theoretically, an arbitral award rendered in any of the more than 130 signatory states must be recognized and enforced by other participating states. Although London, Paris and Geneva are some of the more popular venues, Stockholm remains China’s favored neutral venue because of its longstanding tradition favoring arbitration over litigation.

Once a company has received an arbitral award from a signatory state, it must follow the enforcement guidelines set out by China’s Civil Procedure Law. First, it must apply to the Intermediate People’s Court to have the judgment recognized and enforced.⁵ After receiving the application, the Intermediate People’s Court is required to perform a thorough review and is obligated to recognize and enforce the judgment. However, the award can be challenged on procedural grounds, such as the validity of the arbitration clause, the lack of fair opportunity to be heard,⁶ and the sufficiency of notice.

There is a significant loophole in both the New York Convention and China Procedural Law. Article V(2)(b) of the Convention⁷ and Article 260 of China’s Civil Procedure Law allow Chinese courts to refuse to enforce a judgment based on the “public policy of the forum.” Chinese courts have historically interpreted this language very broadly and have allegedly succumbed to pressure exerted on them by the local communities, governmental bodies and local businesses. In the hopes of removing local influence, recent Chinese procedural amendments now require the approval of the Supreme People’s Court, China’s highest court, to refuse enforcement of a foreign arbitral award.

The second option for enforceable arbitration is the China International Economic and Trade Arbitration Committee, or CIETAC.⁸ Established in 1956 and originally named the Foreign Trade Commission, CIETAC includes over 1,000 arbitrators, approximately 25 percent of which are non-residents of mainland China.⁹ CIETAC now handles more international arbitration cases than any other arbitral body. Additionally, CIETAC has made strides to become more flexible, offering many contractual options to the parties. CIETAC is also speedy, averaging just eight months before awards are issued, and inexpensive, offering fees that are relatively low compared to other arbitration institutions. It also now offers MED-ARB (mediation-arbitration) as an alternative to straight arbitration.¹⁰

Foreign parties should be extremely careful to ensure its enforceability when drafting a CIETAC arbitration clause. If the clause states that disputes may be submitted either to an arbitration commission or to litigation, or if it only gives one party the right to choose arbitration, Chinese courts will deem it invalid.¹¹ Additionally, there are certain requirements that, if omitted, will void an arbitration clause. Most importantly, an arbitration clause must state that all disputes will be submitted to CIETAC. Additionally, the arbitration clause should include the arbitration’s venue, the language to be used during the arbitration, the number of arbitrators, and the nationality of the presiding arbitrator. Although Article 31 of the CIETAC Arbitration Rules provides that the parties can agree on the place of arbitration, it is unclear whether that extends outside of mainland China. To date, there have been a few CIETAC arbitrations held in Hong Kong. Parties can also agree on the language for the arbitration, but in the absence of a written agreement, the default language is Mandarin Chinese. Likewise, if the parties don’t agree on the nationality of the presiding arbitrator, he or she will be selected by CIETAC and will most likely be Chinese. While recent changes to CIETAC’s rules have centered around flexibility and the parties’ freedom to contract, a poorly drafted arbitration clause can have disastrous results for a U.S. company.

Despite these positive changes, CIETAC still has a reputation for being slow and for offering fees so low that many foreign arbitrators are unwilling to serve. Furthermore, even when foreign companies have used CIETAC to arbitrate their disputes, there have still been enforcement problems. As stated above, Article 260 of the Chinese Civil Procedure Law allows the courts to refuse to enforce a judgment or award if it would be detrimental to the social or public interests of the community.¹² Insolvency has also proved to be a major roadblock to enforcement, accounting for 43 percent of all cases where judgments were not enforced in China. Banks have allegedly compounded the problem by ignoring judicial orders to freeze a defendant’s assets, making it impossible to collect a judgment.¹³

While there are uncertainties when dealing with a Chinese manufacturer, one thing has become clear: the process has become more expensive. As ostensible manufacturers, U.S. companies cannot shift liability to the Chinese manufacturer despite a low level of involvement, lack of control over the Chinese company, or a total lack of negligence on their part. Buying from a manufacturer that has American assets, a letter of credit or its own product liability insurance will increase the chances of collecting on a judgment in the event of a manufacturing defect. However, U.S. companies dealing with Chinese manufacturers are still best protected by having their own insurance policy and by including a carefully-drafted arbitration clause.

1 “Liability attaches even when such non-manufacturing sellers or distributors do not themselves render the products defective and regardless whether they are in a position to prevent defects from occurring.” Restatement Third, Torts: Products Liability, §1 Liability of Commercial Seller or Distributor for Harm Caused by Defective Products. Comment – Nonmanufacturing sellers or other distributors of products. 

2 Channing Hesse v. Learning Curve Brands, Inc., No. 07C3514 (N.D.Ill. June 22, 2007). 

3 Guanghope v. Mirant, Civil Ruling of the Supreme People’s Court, (2002) Min Si Zhong Zi No. 29 [not published]. For facts and comments, see Paul Donovan Reynolds & Song Yue, The PRC Supreme People’s Court on the Validity of an Arbitration Clause, 142 J. of the Chartered Institute of Arbitrators 70 (2004). The case is also referenced in: Joseph T. McLaughlin, Kathleen M. Scanlon, & Catherine X. Pan, Planning for Commercial Dispute Resolution in Mainland China, 16 Am. Rev. Int’l Arb. 133, 144 (2005). 

4 Convention on the Recognition and Enforcement of Foreign Arbitral Awards, Art. 3, June 10, 1958, 21 U.S.T. 2517, 330 U.N.T.S. 3. 

5 See Xiaowen Qui, Enforcing Arbitral Awards Involving Foreign Parties: A Comparison of the United States and China, 11 Am. Rev. Int’l Arb. 607, 626 (2000). It is important that all applications be submitted within the limitation period prescribed by the 1991 Civil Procedure Law. 

6 Convention on the Recognition and Enforcement of Foreign Arbitral Awards, Art. V(1)(b), June 10, 1958, 21 U.S.T. 2517, 330 U.N.T.S. 3. Despite its broad language, this refusal provision has been interpreted similarly to a denial of procedural due process and has been construed narrowly by the courts. See Parsons v. Whittemore Overseas Co. v. Societe Generale de L’Industrie du Papier, 508 F.2d 969 (2d Cir. 1974); Biotronik Mess-und Therapiegeratete GmbH & Co. v. Medford Medical Instrument Co., 415 F.Supp, 133, 140 (D.N.J. 1976); Laminoirs-Trefileries-Cableries de Lens, S.A. v. Southwire Co., 484 F.Supp. 1063 (N.D.Ga. 1980). 

7 Convention on the Recognition and Enforcement of Foreign Arbitral Awards, Art. V(2)(b), June 10, 1958, 21 U.S.T. 2517, 330 U.N.T.S. 3.  

8 Fore more information on CIETAC, including its rules, arbitrators, fee schedules, model contracts and laws, visit http://www.cietac.org. 

9 See Melanie Ries & Bryant Woo, International Arbitration in Japan & China, 61-JAN Disp. Resol. J. 63 (2007). 

10 See generally, Wang Sheng Chang, Resolving Disputes Through Conciliation and Arbitration in the Mainland China, 2 Ann.2000 ATLA CLE 1643 (2000). 

11 See Joseph T. McLaughlin, Kathleen M. Scanlon, & Catherine X. Pan, Planning for Commercial Dispute Resolution in Mainland China, 16 Am. Rev. Int’l Arb. 133, 141 (2005). 

12 See Rebecca Fett, Forum Selection for Resolution of Foreign Investment Disputes in China, 62-APR Disp. Resol. J. 73, 78 (2007). 

13 Id.