A commentary by lawyer and partner of BRACE Roman Shabrov has been published for the magazine “Pharmaceutical Bulletin” on what to include in a foreign economic activity contract with a Chinese manufacturer?
As Roman noted, failure to meet production and delivery deadlines, deterioration in quality after the first deliveries, a high percentage of defects, improper fulfillment of obligations regarding product labeling are among the most common violations of foreign economic activity contracts with Chinese manufacturers that the Russian pharmaceutical business faces.
Before concluding a contract, a thorough check of the selected manufacturer is required: not just legal, but also factual – with a visit to the production site.
In China, there are three types of partners with whom Russian entrepreneurs usually cooperate: manufacturers, trading companies and sellers with a focus on small wholesale. Compatriots prefer to deal with manufacturers, since they can control the work directly and set their own quality standards, while trading companies and retailers usually set a higher price than manufacturers and ship only standard goods.
The contract must regulate the quality of the purchased products in as much detail as possible, with references to specific documents that specify the requirements. What is not directly specified may not be fulfilled or not fulfilled as required, which is what the Russian pharmaceutical business often faces.
According to Chinese law, the seller must deliver the goods in accordance with the quality requirements agreed upon by the parties. If the goods delivered by the seller do not meet the quality requirements, the buyer may require the seller to bear responsibility for failure to fulfill obligations in accordance with the contract between the parties. Paragraph 8 of the Protocol on General Conditions for the Delivery of Goods from the USSR to the People's Republic of China and from the People’s Republic of China to the USSR requires that the parties regulate the provisions on quality in the contract, and also establishes that the quality and technical characteristics of the goods are determined by references in the contract to national standards, standards of international organizations or other normative and technical documents. The quality of the goods may be established by reference to a sample agreed upon between the parties or to the agreed quality characteristics of the goods.
Since the legislation of the PRC and Russia does not contain provisions regulating the specifics of contract manufacturing, they must be regulated in detail in the contract. Currently, the following models of contract manufacturing have developed in China:
1) “OEM” (“original equipment manufacturer”): production of products under the customer's brand name using the manufacturer's technology;
2) “ODM” (“original design manufacturer”): production based on the customer's samples, technology and/or technical documentation/project. This production format is mainly typical for large businesses. It involves a large amount of financial and time costs for product development and subsequent launch of the production line, but it allows for a higher level of control over production;
3) “OBM” (“original brand manufacturing”). The manufacturer owns the brand and is fully responsible for the design, development, production and sale of the product. At the same time, outsourcing of production and engineering activities is not limited.
When concluding foreign trade contracts, one of the main issues is the choice of the applicable law and the dispute resolution body (court), that is, where and by which body the disputes will be resolved. In addition to national law, the Protocol on the General Conditions for the Supply of Goods from the USSR to the People's Republic of China and from the People's Republic of China to the USSR and the UN Convention “On Contracts for the International Sale of Goods” dated 11.04.1980 (Vienna Convention) are in effect for the PRC and Russia. At the same time, the parties to the contract may exclude the application of the Vienna Convention and the Protocol. One of the decisions of the ICAC at the RF CCI concluded that if the parties have not excluded the application of the Vienna Convention, it shall apply to the disputed legal relations. In addition, in some cases the ICAC at the RF CCI concluded that the Protocol has priority over the Vienna Convention.
If the contract does not provide for an arbitration clause, then, in accordance with paragraph 52 of the Protocol, disputes shall be considered according to the following rules:
- if the defendant is an enterprise or organization of the USSR (Russia), the dispute shall be considered in the Arbitration Court at the Chamber of Commerce and Industry (i.e. in the ICAC at the RF CCI as the legal successor);
- if the defendant is a foreign trade enterprise or organization of the PRC, then in the China International Economic and Trade Arbitration Commission under the China Council for the Promotion of International Trade in Beijing in accordance with the Rules for the Proceedings of this Commission.
However, the provisions of the Protocol are not mandatory and do not limit the right of the parties to determine, at their own discretion, international commercial arbitration for the consideration of the dispute.
The choice of state (arbitration) courts of the Russian Federation may lead to the fact that its decision will be very difficult to enforce in China. In the case of choosing courts in China, it should be taken into account that the application of Russian law will cause significant difficulties for the Chinese court. In this regard, when choosing to consider a dispute in China, it is necessary to think over in advance the option of judicial protection in the event of a breach of contract by the manufacturer.
It should be taken into account that if a foreign business begins to threaten to go to court during negotiations, then for the Chinese this is actually a declaration of war. It is necessary to initiate legal proceedings if alternative methods of dispute resolution have been exhausted. Economic and other disputes are resolved, first of all, by negotiations and mediation. Pre-trial settlement is the essence of the entire judicial system, therefore, at any level – government, courts – it is possible and necessary to take measures for pre-trial settlement of the dispute.
Finally, it is important to determine the procedure for settlements under the contract. Given the strict sanctions compliance of many Chinese banks, it is necessary to provide for both the main methods of payment and alternative ones, including the involvement of intermediaries.
When making payments, the parties must pay attention to the frequency of payments, their amount, fixing or refusing to fix in the contract the right to unilaterally change the contract price. In order to provide additional leverage over the Chinese manufacturer, it is recommended to abandon the conditions of 100% prepayment for planned deliveries.
To reduce its risks, a Russian company is recommended to:
1) a comprehensive legal audit of the manufacturer and a visit to the production site before concluding a contract;
2) a detailed description of the supplied goods in the contract or technical specifications, or, which is more reliable, concluding a separate quality agreement as an appendix to the contract;
3) production of product samples, on the basis of which the quality of deliveries will be checked;
4) a requirement for the seller to confirm the compliance of the products with the legislation of the Russian Federation and the EAEU by issuing certificates for the supplied products. However, in practice, not all manufacturers are ready to engage in certification;
5) securing in the contract the buyer's right to conduct an examination of the quality of the goods, as well as the conditions for returning the goods and compensating for their cost and other costs (delivery, customs clearance, etc.);
6) quality control of the goods before their shipment, independently or through intermediary companies. It is also possible to agree with the Chinese manufacturer on the procedure for monitoring all stages of production;
7) determine in the contract which authority will consider the dispute;
8) clearly spell out the payment procedure;
9) if a dispute has arisen, it is necessary to take pre-trial measures to resolve it, including negotiations and mediation before initiating legal proceedings.
More detailed information about the article and commentary can be found on the website of the publication: https://pharmvestnik.ru/articles/Kitaiskaya-gramota-Chto-predusmotret-v-kontrakte-s-proizvoditelem-iz-KNR-2.html, as well as in the appendix here.
