New Rules on the Choice of Law for Foreign-related Contracts

DEFINING FOREIGN-RELATED CONTRACTS

A key characteristic of foreign-related contracts is that they involve transnational elements, and therefore may extend into different jurisdictions. Because of this, parties to such contracts are generally free to elect the laws of countries other than those of the PRC to operate as the governing law. It is important to highlight that although foreign-related contracts are generally defined as such because they contain transnational elements, it does not necessarily follow that every contract with a transnational element is a foreign-related contract.

Under current PRC law and judicial practice, only foreign-related contracts are allowed to be governed by foreign law or arbitrated outside the PRC. This highlights the importance of foreign investors being clear about exactly what type of contract constitutes a foreign-related contract. Having such clarity allows investors to avoid the dangerous assumption that any contract with a foreign element can be governed by foreign law.

The SPC's existing judicial interpretation of the Civil Procedural Law⁴ deems a contract to be foreign-related if any of the circumstances exist:

(1) One or both parties to the contract are foreign nationals, stateless persons, or foreign legal persons;

(2) The subject matter of the contract is located in a foreign country; or

(3) The act which gives rise to, modifies, or extinguishes the rights and obligations under the contract takes place in a foreign country.

Although the existence of the above circumstances can lead to there being a foreign-related contract, foreign-invested enterprises within the PRC are not necessarily defined as such. This is because they have the status of Chinese legal persons and this may negate the existence of a transnational element.

MANDATORY USE OF PRC LAW

Article 126 of the Contract Law stipulates that parties to a foreign-related contract are free to choose the governing law except for the following:

(1) Chinese-foreign equity joint venture contracts;

(2) Chinese-foreign cooperative joint venture contracts, and

(3) Contracts for Chinese-foreign cooperation in the exploration and exploitation of natural resources.

The Contract Law repealed two earlier laws that dealt with foreign-related economic contracts and technology import contracts respectively. The SPC provided an interpretation of the now obsolete Foreign Economic Contract Law⁵ which provided a much wider scope of contract subject to PRC law. The new Provisions seem to re-affirm this broad scope, which includes the following:

(1) Contracts for the assignment of equity of a foreign investment enterprise;

(2) Contracts for the contracted management by a foreign party of Chinese-foreign equity or cooperative joint ventures;

(3) Contracts for the purchase by a foreign party of the equity of a shareholder in a domestic enterprise;

(4) Contracts for the subscription by a foreign party to the capital increase of a domestic enterprise; and

(5) Contracts for the purchase by a foreign party of the assets of a domestic enterprise.

The Provisions permit this list to be further expanded where applicable laws and regulations require that the contract be subject to PRC
law.

These newly added categories of contract subject to PRC law are also covered by articles 22 and 24 of the Merger and Acquisition Provisions.⁶ The expanded scope will mainly affect foreign investors conducting merger and acquisition activities in China. They will no longer be able to choose a foreign law to govern these transactions. That being said, in recent years the relevant PRC approval authorities have not accepted foreign law as the governing law for such contracts. Despite this, numerous foreign investors have continued to argue strongly during negotiations with their Chinese counterparts for the governing law to be foreign law.

^{CHOICE OF LAW TO BE USED}

Scope of Choice

The governing law chosen by the parties or determined by the court pursuant to the 'most closely connected country' principle must be substantive law instead of conflict or procedural law. This means that the choice of governing law of foreign-related contracts would avoid the complications of remission or transmission that can occur under private international law. Therefore, although substantive law can be elected, parties cannot elect the procedural law if their dispute is heard in a PRC court. Further, the parties can elect the substantive law governing evidence heard in a PRC court but cannot elect the procedural law for such evidence.

Where the parties agree on the governing law then there are no restrictions either in the Provisions or any other PRC laws or regulations requiring the selected foreign law to be of the country most closely connected to the contract – except where PRC law is mandatory.

In an Express Manner

The Provisions require the parties to choose the governing law in an express manner. This means parties must clearly specify their choice of governing law.

Choosing and Altering Governing Law

Prior to the Provisions, parties were required to choose the governing law at the time when the contract was executed, or from the time when a dispute arose to when the court heard that dispute. This requirement remains largely unchanged. The Provisions require the choosing or changing of the governing law to be done so in an expressed manner. Parties are also permitted to choose or change the governing law before the end of a court hearing of first instance.

Where the parties do not choose a governing law but reference is made to the same applicable laws without objections, for example, by the defendant, then it will be deemed that the parties have in fact chosen that law to which they have referred.

The Most Closely Connected Principle

If the parties have not made a choice and have not reached any subsequent agreement as to the governing law, the law of the country to which the contract is most closely connected must be applied. The Provisions stipulate that the court must consider the particular characteristics of the contract and the extent in which a party's obligations embody the nature of the contract when determining the most closely connected country. This means elements such as the parties' nationalities, places of business, where the contract was executed, places of performance, as well as the places where the subject of the contract is located, to name a few, are all considerations.

The Provisions set criteria by which the governing law of seventeen categories of contract must be determined (listed in the table below). The application of such rules generally results in PRC law governing the contract.

Type of Contract Governing Law

Sale, lease or mortgage of immovable assets Law of the place where the assets are located

Lease of movable assets Law of the domicile of the lessor

Financial lease Law of the domicile of the lessee

Loan Law of the domicile of the lender

Guarantee Law of the domicile of the guarantor

Pledge of moveable assets Law of the domicile of the pledgee

Sale and purchase Law of the domicile of the seller unless the negotiations and execution took place in the buyer's place of domicile or the contract provides that the seller must perform the delivery obligations at the buyer's place of domicile

Insurance Law of the domicile of the insurer

Construction Law of the place where the project is located

Processing Law of the domicile of the party undertaking the processing

Judicial interpretations of previous laws have already determined that the domicile of a citizen is the place where that citizen has permanent residency. The domicile of a legal person is that legal person's principal place of business or the place where its principal office is located.

The Provisions also provide that, in the event a contract is “clearly more closely connected to the laws of another country or region”, a court may apply the laws of that country or region.

Evasion of Mandatory PRC law

According to a judicial interpretation of the Civil Law, any choice of foreign law which evades mandatory PRC laws, rules, or regulations, or conflicts with public interests will be invalid. The Provisions reiterate this position and state that any dispute over such a contract will be governed by PRC law.

Verification of Foreign Law

During contractual disputes concerning foreign-related contracts and foreign law, verifying the foreign law sometimes becomes a critical issue. The judicial interpretation of the Civil Law deals with the issue of 'verification of foreign law'. Five methods are stipulated to help determine the applicable law. The five methods involve having the parties provide the content of the law, having the foreign government provide the content in accordance with any judicial agreements made between that government and the Chinese government, referring to content provided by the Chinese embassy in the other party's country, referring to content provided by the other party's embassy in China, or using content provided by foreign and domestic legal experts. If a solution cannot be found then PRC law may apply.

It was previously unclear whether the parties had an obligation to verify the law to be applied, under what conditions the court would or could provide assistance, or what procedure would be followed to determine the content of the law to be applied and verified. Moreover, the previous interpretation did not make clear whether the five prescribed methods used to verify the foreign law should be exhausted, nor when the court should rule that because of lack of verification, PRC law should apply.

'Verification of foreign law' is made slightly clearer by the Provisions – they prescribe that parties who have elected a foreign law must provide the court with, or prove to the court, the relevant contents of the foreign law. Where the parties have not chosen a foreign law but foreign law shall be applied in accordance with the 'most closely connected country' principle, the court may itself find that law or require the parties to provide the law. The Provisions restate that where the selected foreign law cannot be found either by the court or the parties, the court may apply PRC law.

Despite the new Provisions, other issues surrounding 'verification of foreign law' remain vague. Some remain optimistic that the new PRC Civil Code being drafted will deal more specifically with this issue, although the contents of this draft and when it will be passed remain uncertain.

CONCLUSION

Most merger and acquisition activity in China has now been clearly placed under the jurisdiction of PRC law. Although the Provisions recognize the freedom of parties to choose the governing law of their contracts, the scope of choice has been narrowed and the discretion of the courts to intervene and determine the governing law has increased. Some of this discretion, it appears, can be based on considerations not clearly defined in the new Provisions.

Endnotes

1 Provisions on Several Issues Concerning the Application of the Law in the Trials of Foreign-related Civil or Commercial Contract Disputes issued on July 23 2007 by the Supreme People's Court (Provisions).

2 General Principles of the Civil Law of the People's Republic of China issued on April 12 1986 by the National People's Congress (Civil Law), and the Contract Law of the People's Republic of China issued on March 15 1999 by the National Peoples Congress (Contract Law).

3 For the purposes of this article 'PRC' refers to Mainland China and not the Hong Kong SAR, Macao SAR, or Taiwan.

4 Civil Procedure Law of the People's Republic of China issued on April 9 1991 by the National People's Congress (Civil Procedure Law).

5 Law of the People's Republic of China on Economic Contracts Involving Foreign Interest issued on March 21 1985 by the Standing Committee of the National People's Congress.

5 Merger and Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions promulgated on August 8 2006 by the Ministry of Commerce, State Asset Supervision and Administration Commission, China Securities Regulatory Commission, State Administration of Taxation, State Administration for Industry and Commerce, State Administration of Foreign Exchange (Merger and Acquisition Provisions).