China Construction Law: Structural Revisions and Aesthetic Adjustments

Probably the most significant aspects of the Draft Law relate to the types of contracting models that would be available in China if it were to be enacted.

Contracting Models

At present, construction companies in China and construction service companies, such as designers, engineering consultants and project managers, must obtain a skill qualification certificate before they can contract for work. The certificate specifies not only the nature of the work that they can undertake, for example main contracting, piling, engineering and design, but also the size and complexity of the projects. The purpose of the certificates is to ensure that only suitably qualified entities carry out construction and related activities. The current Construction Law also provides that in most cases, a company cannot contract for work in respect of which it does not hold the relevant certificate.

There is also a prohibition on most types of subcontracting and an obligation on the main contractor to carry out construction of the main structures itself. This was introduced to tackle the problem of a large construction company winning projects and then subcontracting the whole of the work to much smaller construction companies with little or no supervision.

These provisions have effectively prevented the development in China of the EPC and turnkey contracting models that are seen commonly elsewhere in the world. Employers and contractors have sought creative ways of overcoming this problem but these solutions are obviously not without some risk as to their enforceability.

Articles 42 and 44 of the Draft Law would introduce EPC and turnkey contracting into China. An enterprise that holds the relevant skill qualification certificate for one part of the project could contract for the whole of the project provided that it subcontracted those aspects of the project for which it is not qualified to other suitably qualified subcontractors.

As with many ideas that China absorbs as it modernizes, however, EPC and turnkey contracting in China would not be without “Chinese characteristics”. Typically in an EPC contract in Australia, the UK or elsewhere, the main contractor is solely responsible to the owner for delivery of the project, and the subcontractors are liable to the main contractor for their respective portions of the project. Unless the owner secures collateral warranties from the subcontractors, they have no direct relationship with or responsibility to the owner.

Article 45 of the Draft Law recognizes this concept. However, the article then continues by stating that in respect of subcontracted work the main contractor and the subcontractor would be jointly liable to the owner for such work “as contractually specified”. It is not clear which contractual terms would apply between the owner and the subcontractor, since there would be no direct contractual relationship between these parties. Consequently it would be difficult for a subcontractor to ascertain, and therefore price, its liability to the owner. This will hopefully be clarified before the Draft Law is enacted.

Although EPC and turnkey contracting are permitted, the wholesale transfer of contracted work to other parties and excessive subcontracting would still remain prohibited (Article 46). The dividing line between acceptable EPC or turnkey subcontracting and excessive subcontracting needs further clarification.

Parallel Contracts

Another significant provision in the Draft Law addresses the problem of parallel contracts for the same work. It is common in China for employers and contractors to enter into two contracts for the same work. The first is the official contract that is registered and used to apply for permits, to report tax and other such procedures. Alongside that is a second contract that sets out the real commercial deal agreed between the parties, but which is not declared to the authorities. If the project runs into difficulties there is almost inevitably a conflict between the terms of the official and unofficial contracts. Article 31 of the Draft Law clearly states that if there is a dispute about contractual terms the official, registered contract will prevail. This must be the correct position to take and can only help to reinforce the rule of law in China. Practically, however, it is likely to have little effect on the practice of parallel contracts unless the approval process for construction projects is also simplified.

As noted above, the Draft Law brings within its scope the regulation of construction-related services. This is to be welcomed as part of an ongoing process within China to simplify the regulatory environment and make it more transparent and accessible. This process has also seen the enactment of a number of other construction-related laws in recent years including the PRC Invitation and Submission of Bids Law, the Government Procurement Law and the Administrative Licensing Law.

While making the construction sector more transparent and accessible, at the same time the government has taken this opportunity to include onerous penalty provisions for enterprises that act in breach of the Draft Law. Some of these provisions seem to us to be unnecessarily severe. If these provisions are enacted unchanged, parties engaged in construction and construction-related activities will need to make very sure that they comply with the provisions of the Draft Law.

THE FICE CIRCULAR

The FICE Circular is the third piece of supplementary legislation to have been issued by the MOC in connection with the harmonization of the treatment of foreign and domestic contractors under the Administration of Foreign-invested Construction Enterprises Regulations (the FICE Regulations, issued on September 27 2002 and effective from December 1 2002).

Before the FICE Regulations, a foreign contractor wanting to contract in China generally had to obtain a Registered Foreign Contractor skill qualification certificate, and a project by project business licence and project permit under the Administration of Foreign Enterprise Skill Qualifications for Contracting Construction Works Within the Territory of China Tentative Procedures (Decree No. 32) 1994 (the Tentative Procedures). This regime was separate from the regulatory regime applicable to domestic contractors.

The FICE Regulations provide that the Tentative Procedures were to be repealed from October 1 2003 and that all foreign contractors active in China should then operate under the FICE Regulations. These require foreign contractors to establish a wholly foreign-owned construction enterprise or a Sino-foreign construction joint venture in China (a Foreign-invested Construction Enterprise or FICE). As with all foreign-invested enterprises in China, each FICE must obtain approval from the local Ministry of Commerce (previously MOFTEC) to be established, and then obtain a skill qualification certificate from the MOC under the same regulations that apply to domestic Chinese construction companies. When applying for a skill qualification certificate, the FICE had to start with the lowest grade of certificate, and experience outside China was not considered.

The FICE Regulations contain certain transitional provisions that, among other things, allow foreign contractors to contract for new projects under their Foreign Registered Contractor certificate until October 1 2003. They can also complete existing projects even if the work extends beyond that deadline. In September 2003, the transitional period between the Tentative Procedures and the FICE Regulations was extended from October 1 2003 to April 1 2004, ostensibly because of the SARS outbreak.

The FICE Circular has further extended the transitional period until July 1 2005, but only for the benefit of foreign contractors that have established an FICE.

For contractors that have established an FICE and obtained the relevant skill qualification certificate, the FICE Circular permits them to contract for new projects either within the scope of their skill qualification certificate or within the scope of their old Foreign Registered Contractor certificate. Given that FICEs have to start at the lowest level of skill qualification certificate, this will allow foreign contractors to pursue larger projects more rapidly in China.

Contractors with an FICE that has not yet obtained a skill qualification certificate are permitted to continue to secure projects on the basis of their old Foreign Registered Contractor certificate until July 1 2005.

Foreign contractors holding only a Registered Foreign Contractor certificate can still complete existing projects but they can no longer undertake new projects simply on the basis of their old certificate. Their right to contract new business in China expired on April 1 2004.

The other major benefit to foreign contractors arising from the FICE Circular is that experience overseas can now be considered by the MOC when evaluating the grade of skill qualification certificate that should be granted. This will enable foreign contractors to secure a much higher grade of certificate than was previously the case.

These changes indicate that the MOC has recognized how unattractive and unreasonable it was to expect multinational construction companies that were previously engaged in major projects in China to start again from scratch. It should be noted, however, that the higher the grade of skill qualification certificate, the greater the capital investment required in China.

THE PROJECT MANAGEMENT PROCEDURES

It has long been recognized that project management activities were something of an anomaly in China's construction sector, as they were not covered by any specific regulations. This allowed foreign companies considerable flexibility, including engaging in project management activities without setting up any form of entity in China. The MOC expressed an intention to close this loophole and, as noted above, the Draft Law includes project management in its definition of construction activities. The Project Management Procedures are the first regulations of the MOC to implement this intention.

The Procedures define project management very widely. Project management includes assisting with preliminary strategy, economic analysis and procurement as well as on site project supervision of construction. Any enterprise that carries out these activities as part of its business is subject to the Project Management Procedures.

The Procedures do not establish a new skill qualification certificate for project management, although it would not be surprising if such a system were introduced in due course, but instead require an enterprise engaged in construction project management to hold one or more of the existing construction-related skill qualification certificates. The enterprise can then undertake project management services for projects within the same scope as its skill qualification certificate.

Foreign companies that have, until now, provided project management in China without having established an entity in China and without having obtained one of the construction-related skill qualification certificates, will need to review their business model. The Procedures came into force on December 1 2004 and contain no provisions for an interim period during which foreign companies can establish the required business and obtain the necessary skill qualification certificate. The legal status of companies currently engaged in project management who do not comply with the requirements of the Procedures is unclear and will need to be resolved through discussions with the MOC.

CONCLUSION

As has been noted, the Draft Law and new legislation contain a number of issues that require further consideration and clarification by the MOC. Overall, however, these documents and the regulatory framework that they impose are to be welcomed as being beneficial to foreign contractors and companies operating in China's construction sector.