Drywall cases reveal supply chain weak points

Taking action
In cases such as these, many affected foreign enterprises in the supply chain may assume that they should, and can, simply sue in China. Although this may in some circumstances be cheaper and quicker than turning to the US courts, it is likely to be extremely challenging. Harris & Moure partner Dan Harris wrote on the China Law Blog recently that “in most cases, the American companies would probably lose if they were to sue the drywall manufacturers in a Chinese court”.

“Bottom Line: Doing business in China is not like doing business in Kansas,” he wrote.

For American companies, there are other benefits to suing in the US, including familiarity, certainty and not least the amount of money that may be recovered. This has led US lawyers to focus on US companies and US-based subsidiaries of foreign companies.

“In that the amounts of damages recoverable in the US typically dwarf what can be recovered in other countries, it is usually not worth the effort and expense for US attorneys to pursue companies in foreign courts on these types of claims,” said Steven Napolitano, a New York-based partner of Skadden Arps Slate Meagher & Flom.

“However, if there is a legal basis for a litigant to move to enforce a US money judgment in China or some other country, it could pose a significant risk to a foreign manufacturer or distributor,” Napolitano added.

This illustrates another route affected parties may choose to take: obtain a US court judgment, and then try to enforce it in China. But, as the feature on page 29 shows, attempting to enforce in China raises many problems of its own.

A question of quality
So why is it so hard for foreign companies to sue and get a favourable decision in a Chinese court? According to Harris, it is due in part to mistakes that foreign companies often make in contracts with Chinese companies.

Specialists advise thinking ahead when drafting contracts and considering, among other things, where disputes should be adjudicated.

“Foreign companies are well-advised to consider stipulating arbitration in a neutral venue as a means of dispute resolution in their contracts with Chinese parties,” said Yang Ing Loong, a dispute resolution partner of Sidley Austin in Singapore.

Arbitration has been a well-accepted means of dispute resolution in China for many years, and arbitral awards are generally well enforced by Chinese courts under the New York Convention. Other means of alternative dispute resolution are also a possibility.

“If the parties are able to agree, they might also stipulate negotiation or mediation as a less adversarial means of dispute resolution, prior to arbitration being commenced,” said Yang.

Sidley Austin partner and Beijing chief representative Henry Ding agreed, adding: “Related to contracts, if it is not a joint-venture contract, the foreign party could always insist on using foreign law as governing law, plus arbitrating outside China. All of these are permitted under PRC law.”

But documents are not everything. Harris listed good contracts as being among the “three main aspects to protecting oneself from bad Chinese product”, the others being good relationships and good quality control monitoring. Yang agreed strongly with the final aspect, saying that from a commercial perspective, quality control is “probably the single most important factor in minimising or avoiding disputes.”

Some foreign companies with limited resources on the ground in China may find quality control a difficult proposition, but specialists' comments highlight how highly businesses should rate it. Yang suggested ways in which it could be used to their advantage.

“Foreign companies do this by, for example, pre-qualifying their suppliers or contractors and carrying out regular audits and inspections of their suppliers' or contractors' facilities,” he said.

While agreeing that manufacturers in China, as elsewhere, should always have a diligent, properly documented, quality control programme in place at all times, Napolitano added that this could be irrelevant under the theory of strict products liability (a familiar concept in common law jurisdictions that has now been affirmed by legislation in many US states).

“[I]t is irrelevant whether the manufacturer exercised a high level of care if the resulting product is deemed defective and unreasonably dangerous,” he said. “Nevertheless, careful product control may be used to defend against a claim of negligence, and would go to the important issue of punitive damages.”

As well as helping to build a defence should a dispute arise, putting in place quality control may also help to prevent problems from escalating that far in the first place. Coming back to the issue of contracts, Napolitano suggested that a manufacturer could attempt to limit its risk by shifting liability through contractual indemnification provisions.

“US courts will generally respect such provisions if freely negotiated between sophisticated business entities. However, an injured plaintiff, who typically is not in a contractual relationship with the manufacturer, will still be able to assert his or her product liability claim for damages to person or property,” he said.

Know your supplier
To back up contractual precautions and quality control, specialists say foreign companies should never underestimate the value of due diligence. In an earlier blog post, Harris mentioned the relatively simple step of running a credit check on a Chinese supplier or manufacturer. This can not only reveal the true ownership of factories but can also show which other foreign companies have been dealing with the supplier.

“Learning that a well regarded Western company has been purchasing products from the Chinese factory without major problems for the last five years is obviously a good sign,” wrote Harris.

At press time, the US Consumer Product Safety Commission was said to be preparing to issue a report of its study into exactly why the drywall is causing problems. Foreign suppliers may have to wait to determine their final course of action, but until then it is clear there are steps they can take to reduce their liability. These are relatively simple steps that should be taken by all foreign companies dealing with Chinese manufacturers or suppliers – simple steps which can have great benefits.