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Betting on China with Legal Uncertainty: An Investment Case Study
Zhaodong Jiang
Faculty of Business Administration,
The Chinese University of Hong Kong,
Shatin, NT, Hong Kong SAR
Email: jiang@cuhk.edu.hk
Phone: (852) 3943 7751
2/25/2014
I would like to thank my wife Yan for her untiring supports during my research as well as
invaluable comments on my early draft.
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Abstract: Certainty or predictability is essential to business and investment decisions.
China’s past economic accomplishments have been largely due to the ability of
businesses to secure their deals through informal channels in the absence of official
intervention. As the country’s next phase of development requires sophistication such as
private equity financing, however, legal uncertainty should pose significant hurdles to its
achievement of the same success as in the past. By studying a recent Chinese court case
on the validity of the valuation adjustment mechanism in a private equity deal, this paper
discusses issues and questions raised by the judicial rulings that showed little respect for
privately negotiated bargains, which point to a lack of predictability in adjudication of
commercial disputes. It looks into various institutional and cultural factors and examines
how they contributed to the courts’ decisions. Those factors include Chinese courts’
broad powers to invalidate contracts; non-statutory considerations behind their rulings;
absence of rules and practices by which one may ascertain the validity or applicability of
a norm; liberty with which judges may decide a dispute on any ground they see fit; and
lack of reasoned decisions. Against this background, Chinese judges have been
motivated more by career and policy considerations than by reputational concerns. Two
policy considerations that animated the courts’ decisions in particular were protection of
banks/creditors and local/national protectionism. The paper concludes by summarizing
some of the steps the country should take in improving judicial predictability as well as
difficulties it encounters to achieve the goal.
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Betting On China with Legal Uncertainty: The Study of an Investment Case
ABSTRACT
Certainty or predictability is essential to business and investment decisions.
China’s past economic accomplishments have been largely due to the ability of
businesses to secure their deals through informal channels in the absence of official
intervention. As the country’s next phase of development requires sophistication such as
private equity financing, however, legal uncertainty should pose significant hurdles to its
achievement of the same success as in the past.
By studying a recent Chinese court case on the validity of the valuation
adjustment mechanism in a private equity deal, this paper discusses issues and questions
raised by the judicial rulings that showed little respect for privately negotiated bargains,
which point to a lack of predictability in adjudication of commercial disputes. It looks
into various institutional and cultural factors and examines how they contributed to the
courts’ decisions. Those factors include Chinese courts’ broad powers to invalidate
contracts; non-statutory considerations behind their rulings; absence of rules and
practices by which one may ascertain the validity or applicability of a norm; liberty with
which judges may decide a dispute on any ground they see fit; and lack of reasoned
decisions. Against this background, Chinese judges have been motivated more by career
and policy considerations than by reputational concerns. Two policy considerations that
animated the courts’ decisions in particular were protection of banks/creditors and
local/national protectionism.
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The paper concludes by summarizing some of the steps the country should take in
improving judicial predictability as well as difficulties it encounters to achieve the goal.
A. INTRODUCTION
“Betting on China” has been a familiar leitmotiv since Adams Smith (Koepp 2012, 4243). Many agree that an economic bet has been winning since the Country’s launch of
modernization reform in late 1970s. But what has been less noticed is how risky a bet on
China’s legal system could be. Recent cases which reveal the execution of businessmen
for having engaged in shadow banking operations testify to “law-enforcement
departments that infringe upon law, property and life” of ordinary people with impunity
(Schuman 2014).
Cruel punishments for so-called economic crimes, while very
frightening, are not common and may not be the biggest risk for investors, domestic or
foreign. Legal uncertainty or lack of judicial predictability, however, could be.
This paper looks into this risk through the analysis of the courts’ decisions on the validity
of the valuation adjustment mechanism (“VAM”) in the case of Haifu Investment limited
Company of Suzhou Industrial Zone v. Shiheng Non-Ferrous Resources Recycling
Limited Company of Gansu (“Haifu”). The VAM is an agreement between a private
equity (“PE”) investor and the investment-recipient enterprise to address problems of
information asymmetry and incentives. It has been adopted in numerous PE deals across
China. While its validity has not been questioned outside China, all the three courts
involved in Haifu defied the principle of freedom of contract and ruled against the
validity of the VAM, wholly or partly. More disturbing are the various grounds the
courts relied upon to support their ruling as well as the ways those grounds were invoked
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and explained by the courts. The case illustrates that adjudication of routine commercial
disputes in China can be fraught of uncertainty and unpredictability. An analysis of the
case further reveals several statutory, institutional, and cultural factors that contribute to
such risk for domestic and foreign businesses and investors. It also illuminates the
arduous task of those who try to create new policy and institutional environments aiming
at spurring more sustainable economic growth in the country. Absent an improvement in
law in general and legal certainty in particular, the economic bet on China would go sour
as the existing growth model and its underlying institutional infrastructures may not be
able to support the country for moving to the next phase of development.
The discussions are organized as follows. Section B introduces the VAM and the case of
Haifu, followed by discussions on legal certainty and freedom of contract, two notions
central to business deals and expectations in market economies. Section D examines the
development of China’s contract law and examines Haifu in light of the statutory
backgrounds.
More institutional and cultural explanations for the lack of judicial
predictability are presented in Section E.
The paper concludes in Section F by
summarizing difficulties and challenges China’s reformers are facing in modernizing the
country’s law and judicial process.
B. THE VAM IN CHINA AND THE CASE OF HAIFU
When funding an enterprise, the PE investor suffers disadvantages vis-a-vis the
entrepreneur, who is in control of information and management of the enterprise.
The
PE’s business valuation of the enterprise may turn out to be incorrect if the entrepreneur
has been less than truthful in supplying information or too optimistic in his projection.
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The investor also faces the risk of expropriation by the entrepreneur. The VAM provides
a contractual protection for the PE. It sets a financial, business or performance target such as net profit, profit growth rate, turnover volume, sales growth rate, market share, or
events such as M&A and IPO - for the enterprise/ entrepreneur to meet. Should the target
fail, the enterprise and/or entrepreneur would compensate the PE investor by paying a
pre-determined amount of cash or transferring or selling some or all of its/his shares at a
discount to the latter. Should the target be reached, the PE may reward the enterprise
and/or the entrepreneur through additional investment or share transfer. As its effect
depends on future events which are uncertain at the time it is made, the VAM is often
dubbed in China as a “betting” agreement or 对赌协议, because of its contingent nature.
The VAM has been a common practice in China’s nascent private equity markets.
Among the best known examples of VAM was the deal in 2003 between Morgan Stanley
and two other international investors (“Morgan Stanley and others”) on the one hand and
the management of Mengniu Diary (“Mengniu”) on the other. In 2002, Morgan Stanley
and others became Mengniu’s shareholders, and invested the next year $35.23 million
which could be converted into Mengniu shares at the price of about $0.1 per share. The
deal included the target of an annual growth rate of 50% for Mengniu to achieve; Morgan
Stanley and others would transfer their existing Mengniu shares to the Mengniu
management should the target be met; otherwise the Mengniu management would give
Morgan Stanley and others six to seven million shares of its own. The deal worked out
for both sides. As the target was successfully met, Morgan Stanley and others exercised
the option price when the share price was over $0.8 per share; meanwhile, the Mengniu
management received shares from Morgan Stanly and others as rewards. Another winJuly 1-2, 2014
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win case was the deal concluded by Goldman Sachs and two other private equity firms
with Yurun Food. In 2005, the three investors put together $70 million for Yurun Food
and the controlling shareholder of Yurun agreed to buy back their shares at a 20%
premium if the company’s 2005 profit was below RMB 259.2 million yuan.
The
company’s 2005 financial report showed a 72 percent increase in sales and a 110 percent
rise in net profits amounting to RMB 360 million yuan. In return, the investors also
agreed not to exit until after one year of the company’s IPO. Meanwhile, there were
cases where the VAM targets were missed.
In 2005, Morgan Stanley and CDH
Investment, a domestic PE fund, made an investment in Yongle, an electronic product
chain, and both the investors and the management of Yongle agreed on a multilayer
valuation adjustment: either the investors or the management would transfer shares to the
other party depending on the profit level of the enterprise. As Yongle’s profit was
disappointing, its management lost control and the company was the subject of a takeover.
Despite its popularity, the VAM was not legally tested for its validity and effectiveness
until 2011 when the case of Haifu came up.
Shiheng, a zinc mining company, was
wholly owned by Diya, a Hong Kong-based company. Both Shiheng and Diya were
managed by Ms. Lu Bo, a Shanghai resident. In November 2007, Haifu, a Suzhou-based
private equity firm, agreed to invest RMB 20 million yuan in Shiheng, of which RMB
1.15 million yuan went to the latter’s registered capital, representing 3.85% of the total.
Ms. Lu then agreed to transfer certain mining assets to Shiheng, and Shiheng also agreed
to prepare its Initial Public Offering (“IPO”) in a domestic stock exchange. According to
the VAM of the parties, should Shiheng’s 2008 net profit come below RMB 30 million
yuan Haifu would receive a compensation calculated on the basis of how much the profit
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target1 was missed, either from Shiheng or from Diya. In addition, should Shiheng fail to
get its IPO by October 20, 2010 Haifu would have the right to demand Diya to buy back
its shares in Shiheng at an annual return rate of not less than 10% since 2008. Shiheng’s
2008 net profit was RMB 26,858.13 yuan.
Haifu filed a claim with the Lanzhou
Municipal Court in December 2009, requesting Shiheng, Diya, and Ms. Lu to pay RMB
19.98 million yuan in compensation according to their VAM.
The Lanzhou Municipal Court ruled that the VAM in question was invalid for two
reasons. First, it violated the principle that one’s return should be commensurate with his
investment as Haifu would be able to recoup its investment even when the company
suffered losses. Secondly, it harmed Shiheng and Shiheng’s creditors. On an appeal by
Haifu, the Gansu Provincial Court disagreed on both grounds, but still invalidated the
VAM provision because, according to a Supreme Court’s 1990 directive, the underlying
deal between Haifu and Shiheng was not an equity investment as it was risk-free for
Haifu and therefore was indeed an illegal loan. As Haifu agreed to invest because of its
reliance on the promises of Shiheng and Diya, however, it should be recoup its
investment, the Provincial Court found, and therefore awarded Haifu RMB 18.85 million
yuan to be paid by Shiheng and Diya. Upon the petition by Shiheng and Diya, China’s
Supreme Court intervened. For the Supreme Court, the Provincial Court’s reasoning was
flawed and to be rescinded, but the argument that the VAM would hurt Shiheng and its
creditors had merits and should be supported under Chinese company law. But the
highest court held Diya liable to pay Haifu RMB 19.98 million yuan under the VAM.
C. LEGAL CERTAINTY AND FREEDOM OF CONTRACT
1
Amount of compensation = (1 – 2008 actual net profit)/RMB 30 million yuan.
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The Supreme Court’s eclectic approach, which invalidates one part of the VAM but
enforces the other part of the same, should have pleased both the supporters and
opponents of the VAM. In the end, the investor got exactly what it had been asking in
the lawsuit. The real loser, however, is a central value of law, which is certainty and
predictability. On the surface of the Supreme Court’s ruling, the validity of the VAM
seems to be settled now: it is invalid if the enterprise/company is liable to pay
compensation, but, it is valid if a third party is liable to do so. But many issues remain
unclear.
If the enterprise/company is the only party named in the VAM to pay
compensation, what is the legal consequence if the agreement is invalid? Is the VAM
always valid when a party other than the enterprise/company is liable to compensate the
investor? Will the ruling apply to other agreements on calculating the investor’s return,
which may or may not be contingent on future events, for example, an agreement setting
a fixed return regardless of the company’s performance or an agreement for a variable
rate of return depending on future events? To answer those questions, one has to decipher
the underlying rationale of the Supreme Court’s ruling. The case has also raised a
number of issues relating to the operation of the Chinese judicial process and giving rise
to concerns for uncertainty and unpredictability. For examples, Chinese courts enjoy
broad powers to invalidate contracts; their rulings are motivated by considerations not
based on public announced rules; there is neither rule nor practical way by which one
may ascertain the validity or applicability of a Supreme Court directive like the one cited
by the Gansu Provincial Court; judges appear to be free to decide a dispute on any ground
they see fit; and they do not have to explain their rulings.
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Legal uncertainty or lack of predictability is nothing new in China. Donald Clarke found,
for instance, that Chinese law provides no clear answer to whether a business
organization exists (Clarke 2005).
Does predictability really matter to economic
development? The answer should be yes. Although law is associated with justice (Sandel
2009, 6), for many people, especially, businesses and investors, law is also valuable for
providing certainty and predictability. Business and investment decisions are made with
the expectation that such decisions are lawful and therefore will be given effect to if the
aid of law is called for. Law functions as guidance to tell what people can do or cannot
do. “‘Let us know where we stand’ is the demand of the liberal individualists, ‘so we can
get on our lives’” (Atiyah 1995, 139). Once business and investment decisions are made
according to law’s demands and promises, they are expected to be judicially recognized
and enforced.
If a dispute is brought to court, the result should match the one
contemplated by the agreement of the parties. Naturally, if law yields uncertain and
unpredictable results, people would lose faith on the system and business would suffer.
By providing certainty and predictability, law primarily binds government officials
including court judges to a well-defined course of action. This is the essence of the rule
of law and what American jurist Lou Fuller called standards of law’s morality. Those
standards include generality, namely, law being capable of general application;
promulgation, namely, law being publicly communicated; respect for legal precedent; and
congruence between announced law and judicial actions, among other (Fuller 1964, 4651, 79-91).
Support for legal certainty is not, however, universal. Some claim that as each case is
different and unique and arguments can often be made on both sides, court decisions can
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never be one hundred per cent predictable. Others might even go so far as to contend that
certainty is not even desirable since rules of law need to evolve as society changes.
Those claims have their supports and distractors, and this is not a place to debate on the
underlying issues (Atiyah 1995, 141-143). It suffices to say that from the viewpoint of
expectation, legal certainty is critical to any investment and business planning. While it
is impossible to predict the outcome of a judicial case with absolute certainty, a wellfunctioning legal system needs to contain basic rules to constrain official discretion and
power so the expectations of businesses and investors would be as much respected as
possible. In such system, as Henry G. Manne has noted, judges “are not there to regulate
individuals’ behavior in accordance with the judge’s own preferences, but rather to
enforce the free choices, private contracts, and reasonable expectations of the parties.”
(Manne 1997, 33)
Then, why has the Chinese economy been able to grow in phenomenal ways so far while
its legal system provides little certainty? Behind the importance of legal certainty is the
idea of security in one’s property and business dealings. This sense of security comes
from law and legal enforcement in a mature and developed system; but it may also be
based on non-official channels and mechanisms, as in the case of China (Clarke 2003).
What has happened to the VAM testifies to this theory. As discussed, the VAM existed
long before the case of Haifu. Aware of uncertainty on the agreement’s validity, the
parties that adopted the VAM believed that the agreement would likely be self-executing
and chances of litigation would be rather small. That was what happened in many
investment arrangements. Of course, the legal risk was always there. PE investors just
kept their fingers crossed, hoping everything would be going well. Now, the Supreme
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Court’s ruling in Haifu is wreaking havoc on the industry, and complicating any future
PE deals.
To be sure, Chinese courts are not oblivious of the importance of the parties’ expectations
to the operation of business. Even when the Gansu Provincial Court held the VAM
invalid, it must have realized that the investor expected to recoup its investment and had
the investor lost its investment because of the invalidity of the VAM, a very negative
signal would be sent out about the local environment for business. That explains why it
awarded the investor most of what had been claimed for under the VAM, despite its
negative view on the same agreement. Haifu is primarily about judicial enforceability of
freely concluded contracts between private business parties, and the starting point for
understanding Chinese courts’ decisions in the case is an examination of to what extent
Chinese law and judicial practices respect freedom of contract and the parties’
expectations.
“Contract law is largely concerned with economic exchange which takes place in the
market.” (Atiyah 1989, 3) Modern contract law arises as a companion of the laisser-faire
ideology. Under the ideology, individuals are free to conduct their business and engage
in voluntary exchange.
Free economic exchange is believed to be foundational to
economic efficiency for two reasons. First, in a system that is based on individualism,
free exchange increases consumer satisfaction and even the overall wealth of society.
And secondly, free exchange is the standard answer to the very basic question of how our
limited resources should be allocated among different uses.
As consumers are the
ultimate deciders, their choices have a normative bearing on the society’s answer to the
question (Atiyah 1989, 4-5).
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Law should therefore strive to meet the parties’
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expectations and protect and enforce agreements they have entered. As Sir George Jessel,
an English judge of the Nineteenth Century, declared, “if there is one thing more than
another which public policy requires, it is that men of full age and competent
understanding shall have the utmost liberty of contracting and that their contracts, when
entered into freely and voluntarily, shall be held sacred and shall be enforced by Courts
of Justice.” (Atiyah 1989, 9) This policy inclination has been captured by the principle of
freedom of contract which stresses the parties’ mutuality of agreement as well as their
free choice unbridled by government or legislative inferences (Atiyah 1989, 10).
A
country’s law that honors and upholds freedom of contract facilitates market exchanges
and the development of commerce. Conversely, a legal system that slights freedom of
contract will not provide predictability and therefore is unable to maintain a proper
market order for exchanges.
The principle of freedom of contract indeed compels courts to invalidate contracts if
consent is not freely given. By stressing free choices of the parties, modern contract law
protects those who were misled, coerced, or unduly influenced to enter into an agreement.
These so-called vitiating factors primarily deal with “procedural aspects of contractual
fairness”, making sure that “bargains are fairly arrived at” (Atiyah 1989, 308). Law may
also impose substantive requirements on the validity and enforceability of contracts. In
the UK, the Gaming Act of 1845 declares that wagering contracts are null and void; and
the Unfair Contract Term Act of 1977 invalidates contract terms that exempt negligence
liabilities for bodily injury or death. Apart from statutory prohibitions, common law also
refuses to enforce contract terms on policy grounds. An agreement which contracts out a
party’s right to settle disputes in court, contract terms that impose penalties on a party in
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breach, contracts that impose limitations on personal freedom, or contracts that
unreasonably restrict a person’s ability to work or conduct business or profession, will
not be judicially enforced on public policy grounds. So is a contract to commit a crime, to
obstruct justice, or defraud government. But in the UK, at least, those public policy
grounds are “strictly limited by the precedents … [and] it is not open to a judge to reject a
contract merely because he thinks that it is contrary to the public interest.” (Atiyah 1989,
360-361)
If the court avoids a contract because of the procedural aspect of fairness such as
misrepresentation, duress, or undue influence, it does not really threaten freedom of
contract because the vitiating factors aim at restoring the free and voluntary nature of a
contract. If law requires some kind of substantive fairness between the parties under a
statist view about what is good for society, the principle of freedom of contract can be
undermined. Understandably, if a contracting party belongs to a class whose members
are likely to lack bargaining power and therefore procedural unfairness may be a concern,
legal intervention is more justifiable. For instance, contract law becomes increasingly
accommodating consumer and labor protection regulations as consumers and workers are
typically in a disadvantaged bargaining position vis-a-vis producers and employers.
Much less justifiable under freedom of contract, however, are rules and practices that
give government officials an open-ended authority to second-guess the merits or demerits
of a commercial deal in the name of public interest.
It is therefore fair to say that the more market-oriented an economy is the greater respect
it shows for freedom of contract through its legislation and judicial practices. On the
other hand, the more government-controlled an economy is the less it cares about
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protecting and enforcing the parties’ expectations and agreements. We may further
assume that how a system’s law and judicial practices regarding the validity and
enforceability of contracts provides a key indicator of its policy toward protecting and
enforcing the parties’ expectations. Law functions through creating and enforcing duties
and obligations on the public.
Judicial practices that venerate freedom of contract
“tended to elevate the law of contract into the central position in the law of obligations as
a whole.” (Atiyah 1989, 11)
Any country that is keen in developing its economy based on market principles should
adopt a modern contract law embracing freedom of contract to a fairly large extent. Its
court judges are expected to give effect to business bargains as law announces. If a
regime only pays a lip service to freedom of contract without making serious efforts to
enforce private agreements, it risks in bringing uncertainty and unpredictability that
undermines the confidence of business and investors. In the end, its economy would bear
the cost. Studies have found that an efficient legal system can lower economic cost
through low interest rates and more lending for businesses (Laeven & Majnoni, 2005). A
legal system is efficient if it produces predictable decisions and protects individual rights
including property rights (Esposito et al. 2014).
D. DEVELOPMENT OF CHINESE CONTRACT LAW AND GROUNDS FOR
VITIATING CONTRACTS: A FURTHER ANALYSIS OF HAIFU
Prior to the country’s 1980s economic reform, there wasn’t legislation regulating
commercial contracts. As the Chinese economy was then characterized by state and
collective ownerships as well as the dominance of government planning, contracts as
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voluntary exchanges and bargaining between self-interested parties were insignificant, if
they existed at all. Although the expression hetong or “contracts” was used by factories,
it primarily referred to orders or transaction documents the contents of which – like
quantities and prices of commodities - were largely determined according to government
regulations and state plans. Factory managers didn’t have much to say on matters such as
what they could produce and sell and how much they could charge. In case of a dispute,
government bureaucrats were called on to coordinate among the parties involved.
Legislations on private contracts emerged in the early 1980s as a result of the country’s
embarkation on economic reform. From early on, the question has arisen as to how freely
individuals and businesses could contract between themselves. The legislation on the
principles of civil law stresses voluntariness as the basis for all civil acts. The first
contract legislation prohibited any unit and individual from illegally interfering with the
parties’ right to make contracts.
Meanwhile, a contract could be found invalid for
reasons ranging from violating government policy or planning to contravening state
interest or social and public interest.
The court could declare invalidity if it found a
party in question was not a recognized legal entity, the quantity, quality, or price of the
contract deviated from state planning, regulations or policy, or the content of the contract
went beyond the scope of business of the parties involved, among others.
Despite continuous efforts to liberalize contract regulations in favor of party autonomy in
an increasingly market-oriented economy, Chinese legislation today still contains a rather
vague, opaque and uncertain set of rules that allow a court to invalidate contracts as it
sees fit. Like common law, Chinese legislation directs courts not to enforce contracts that
have been procured through fraud, duress, or other improper means. Contract terms may
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also become unenforceable on grounds such as exempting a party from liabilities for
physical injury or intentional/reckless damaging others’ property, or manifest unfairness.
Unlike common law tradition, however, Chinese legislation gives courts an unbridled
power to declare the invalidity of a contract on broadly undefined grounds such as
“damaging the interest of the state”, “damaging the interest of the state, collectivity, or a
third party”, “covering illegal purposes”, or “damaging society and public interest”.
Moreover, uncertainty has been hanging on as the legislation continues to allow courts to
avoid any contract that is deemed to “violate mandatory rules of law or government
regulations”.
There is no statutory definition or guidance as to what constitute a
mandatory rule of law or government regulations. It is therefore up to courts to declare
when a rule of law or government regulation is mandatory so contractually made bargains
can be trumped as a result.
As many in China have dubbed the VAM a betting agreement, there is a tendency to
frown upon it. A wagering contract that falls within the UK legislation against gambling
has been narrowly defined to require, for example, “one to lose, other to win”, and “no
other interest” (Treitel 1991, 456-458).
A VAM such as the one in Haifu is obviously
not a void contract within this definition as it does not necessarily result in a “one to lose,
other to win” situation. If the target of the VAM is reached, both the investor and
company are winners. This is also the reason why both parties to the VAM have interest
other than the sum of compensation to be paid. In China, while gambling could be a
crime under certain circumstances, there is no legislation like the UK Gaming Act of
1845 to explicitly spell out which contract can be invalidated for illegal wagering.
Undoubtedly, Chinese courts can legitimately declare a contract involving betting void on
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state law or public interest grounds.
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Interestingly, however, no one in Haifu ever
suggested that the VAM should be invalid because it involved betting or gambling.
Lawyers and court judges in this case seem to have been wise enough not to be deluded
by the popular misnomer into thinking that the VAM was really about betting without
economic benefits for the parties.
Does a VAM function like a penalty between the private parties? It might be argued that
by requiring the payment of an amount disproportionate to the return the investor may
reasonably receive for its investment, the VAM is close to a penalty. But what is a
reasonable return on one’s investment? Investments made by a PE are supposed to be
both high-risk and high-return. The VAM supposes that the parties may have different
views on the valuation of the enterprise in question and therefore provides a contractual
method to handle such differences. It is more like an option than a penalty. In any event,
Chinese law has no equivalent of common law prohibition against contractual penalties
and in fact allows the parties to agree on liquidated damages as they wish.2 Thus, no one
claimed in Haifu that the VAM was a voidable penalty.
None of the three courts involved in that case questioned the procedural fairness of the
VAM in question. Nor did they hint the possibility that the agreement could fail on wellrecognized grounds such as misrepresentation or duress. They disagreed, however, on
which mandatory rules of legislation or government regulations the VAM ran afoul of.
For the Lanzhou Municipal Court, article 8 of the Chinese-Foreign Joint Venture Law
(“Joint Venture Law”) which states that the net profit of a joint venture should be
2
Under article 114 of the Contract Law, upon petition, a court may reduce, however, the
amount of liquidated damages as agreed by the party if the amount is found excessive
compared to the actual losses of the innocent party.
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distributed in proportion with one’s share of the registered capital was mandatory rules
that trumped the VAM provision which required the enterprise and its main shareholder
to give compensation to the investor in disregard of their respective shares of the
enterprise’s registered capital. This is a rather one-sided reading of the VAM. As the
Gansu Provincial Court found, the thrust of the VAM provision was not about profit
distribution, instead, it was about risk sharing, and therefore article 8 of the Joint Venture
Law was inapposite.
The provincial court, however, invalidated the VAM for this
precise reason, by relying on a 1990 Supreme Court’s directive which voided any form of
joint venture in which a partner would receive a fixed return and share no risk regardless
of the venture’s performance. The directive, in essence, invalidated corporate lending by
non-financial enterprises. While the Supreme Court did not think its 1990 directive
supported the Gansu Provincial Court’s ruling, it came up with a ruling prohibiting the
VAM because by benefiting the investor regardless of the company’s performance, the
agreement harms the interest of the company and its creditors. Although the Court did
not explicitly say how the interest of the company and its creditors could be adversely
affected by the VAM, the rationale seems to be that if the company pays a fixed return to
the investor regardless of its actual performance, less would be left for itself and its
creditors.
E. INSTITUTIONAL AND CULTURAL EXPLANATIONS FOR LEGAL
UNCERTAINTY IN CHINA
A primary source of legal uncertainty for commercial cases in China is sweeping
statutory authorization for courts to invalidate contracts whenever state or public interest
is perceived to be under threat. All three courts in Haifu invoked this authorization. The
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broad empowering language alone may not create uncertainty, however, if it is carefully
and judiciously exercised. It is the combination of a number of institutional and cultural
characteristics that have led to the courts’ decisions in this case.
China’s contract
legislation permits avoiding a contract that “violates mandatory rules of law or
government regulations.” But what counts as “law” and “government regulations” can be
a thorny issue. So is the word “violate”. The Gansu Provincial Court referred to the
Supreme Court 1990 directive that refused to give effect to non-financial institutions’
loans to businesses as a “mandatory rule of law or government regulations” the violation
of which invalidated the VAM.
Although Chinese legislation does not classify a
Supreme Court’s directive as part of “law or government regulations”, the Gansu
Provincial Court has the responsibility to obey the Supreme Court’s directives as a matter
of administrative hierarchy.
Unpredictability of court decisions is also due to the fact that Chinese courts, unlike their
counterparts in common law jurisdictions, need not to explain their decisions. When the
Supreme Court in Haifu ruled that the Gansu Provincial Court mistakenly relied on its
1990 directive, it did not explain what mistake the lower court had committed. Was it
because the 1990 directive was no longer good or the lower court in that case had
misunderstood or misapplied the directive which remained valid.
Absent any such
explanation, the Supreme Court created more confusion than it tried to clear up regarding
its 1990 directive, leading to another potential uncertainty for contracting parties and
lower courts in the future. It did not explain why the VAM violated the Company Law’s
provision protecting creditors, either. The VAM is part of a large deal for making an
investment which should have benefited the company and its creditors. Presumably, the
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deal wouldn’t have been made had there been no VAM. It was only fair to expect the
court to elaborate on the relationship between the deal and the Company Law’s
protection of creditors.
Closely related to lack of judicial reasoning is the absence of constraints on the authority
of Chinese courts to frame and resolve the dispute between the parties. A common law
court judge would resolve a dispute by only addressing issues and claims raised by the
parties. She should not go beyond the pleadings of the parties. A Chinese court judge is
not so constrained, however, when deciding cases. In Haifu, the Gansu Provincial Court
ruled that the contract between the enterprise and the investor was in reality an illegal
loan agreement according to the Supreme Court’s 1990 directive. This point had neither
been raised by the lower court nor argued by either party. It was made by the Gansu
Provincial Court on its own motion. The possibility that court judges may take their own
initiative to raise a new issue or rely on a rule that neither party has cited before is as
unfair it is unsettling for litigants, making the outcome utterly unpredictable.
Chinese courts are not bound by the common law doctrine of judicial precedent. Absent
meaningful statutory or institutional constraints, Chinese judges, especially those sitting
at the highest court, would be guided only by career incentives, policy considerations,
and reputation concerns. Career incentives and policy considerations usually go hand in
hand. Article 20 of the Company Law prohibits shareholders from infringing upon the
interests of other shareholders and the company’s creditors. This was a key statutory
basis on which the Supreme Court found the VAM invalid because it harmed the interest
of Shiheng and its creditors. There are several problems with the Supreme Court’s
reasoning. No one would dispute the importance of legal protection for shareholders and
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creditors, but as mentioned the effect of the VAM on the company and its creditors
cannot be appreciated without considering the underlying funding arrangement. Haifu’s
RMB 20 million yuan investment in Shiheng presumably benefits Shiheng and therefore
its creditors. The VAM merely determined how the return on the investment was to be
calculated contingent on the performance of the company. As such it does not violate
any law in China. Law does not prohibit an investor from receiving a return higher than a
certain benchmark. Nor does it dictate how a return on one’s investment should be
calculated. The VAM may adversely affect the company and its creditors only in a zerosum scenario where the investor’s gains must be the company’s and its creditors’ losses
or vice versa. In Haifu, no court judge even bothered to ask how creditors of Shiheng, if
any, might be harmed by the VAM. No evidence seemed to be presented to show, for
example, Shiheng’s inability to pay other creditors because of the VAM. The Supreme
Court came to its conclusion on its own assumption without evidence.
The Supreme Court’s eagerness to protect Shiheng’s creditors came from the country’s
traditional corporate financing model which depends on bank lending, and Chinese banks
are overwhelmingly government-owned and -controlled. As a matter of policy, law
protects banks and, by extension, favors a company’s creditors over its private investors.
The Supreme Court’s ruling invalidating the VAM to the extent that Shiheng’s creditors
were concerned is in line with this policy.
Its 1990 directive, cited by the Gansu
Provincial Court, which refused to give legal recognition to non-financial institutions’
loans to businesses, is another example of the Court’s readiness to protect banks’ interest
by outlawing non-bank lending competition. Those decisions must have pleased the
country’s powerful banking institutions and their backers in government.
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Another policy bias is local and national protectionism. The decisions by the Lanzhou
Municipal Court and Gansu Provincial Court, both favoring Shiheng, a local enterprise,
against a non-local PE, prove that local protectionism is pretty much alive. The Supreme
Court had no interest in protecting a Gansu enterprise against a Suzhou-based PE, and
should indeed protect both parties. As a result, a Hong Kong-based company ended up
paying the price, as the Supreme Court gave effect to the VAM to the extent that Diya
was liable to compensate the investor. If the VAM harms Shiheng and its creditors, why
didn’t the same logic apply to Diya and its creditors? If Shiheng’s payment to the
investor hurts its creditor, how can Diya’s payment not have the same effect on its
creditors? Is it because Diya was a Hong Kong company and unlikely to borrow money
from Chinese state banks or Chinese banks are not supposed to lend to a Hong Kong
company? As creditors of Diya are likely not Chinese banks, their interest should not be
the Supreme Court’s concerns. This is the message from the country’s highest court.
In sowing confusion and uncertainty, the Supreme Court’s decision has damaged its
reputation among members of the legal and business communities. But reputational
concerns are left on the back burner. Unlike judges in other jurisdictions whose careers
depend as much on political patronage as on the professional and business communities’
endorsement, Chinese judges’ career paths are entirely political. Professional views and
opinions hold little or no sway over judicial deliberations. This is another institutional
characteristic to explain why Chinese courts are not much concerned about predictability
for their decisions.
F. A BUMPY REFORM ROAD AHEAD
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China’s economic growth in the last three decades has been nothing but a miracle, and its
law has also gradually taken a modern form during the last three decades. But, the
underlying ideology has not much changed. Market-friendly principles such as freedom
of contract and respect for individual autonomy have not yet taken root in the country’s
legal system. What’s worse - from a business viewpoint, at least - is that the current
institutional and cultural environments have led to legal uncertainty and judicial
unpredictability.
So far business expectations in China have been largely satisfied
informally and thanks to the absence of legal intervention. But as the country’s economy
and finance evolved with an increasing sophistication, the risk associated with
shortcomings of the formal system will become more noticeable and unsettling to the
business and investment communities.
Just a legislative change of broad statutory authorization that empowers courts to
invalidate contracts on state or public interest grounds would not be enough to bring
transparence and predictability to the system. Changes in both hardware and software of
China’s political and legal machine are required. Legal certainty and predictability can
be improved only if some major changes take place. First, law should be shifted from an
exercise of power to that of reasoning. Judges must shake off their taciturnity and start to
explain their decision and address opposing arguments in more details. They should not
be allowed to settle a case on points not raised by the parties. Meanwhile, there should
be better training for judges on the art of reasoning and persuading.
Lawyers
representing the litigants should be given a bigger and more influential role to play in
court proceedings, forcing judges to become accountable not to their political superiors
but to members of the legal profession and ultimately the public.
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involvement of legal professionals and members of the public in judicial procedures,
common values and techniques can gradually emerge to control and regulate the judicial
process.
Those changes are unlikely without the rule of law. Top leaders’ rhetoric suggests their
desire and willingness to embrace the rule of law, but there is no clear sign that they
actually move in that direction. As the regime continues to depend on layers of officials
and bureaucrats for legitimacy, support and daily operation, it is not interested in
stripping them of de facto law-making powers over subordinates and ordinary citizens.
Nor would it submit party and government actions to judicial scrutiny. Finally, judicial
independence which is the pillar for the rule of law remains as elusive as ever. Absent
significant changes, business deals and investment decisions remain thwarted by law and
judicial practices that do not take privately negotiated bargains and parties’ expectations
seriously.
References:
Atiyah, P.S. (1989). An Introduction to the Law of Contract. Oxford: Clarendon Press.
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Clarke, Donald C. (2003). Economic Development and the Rights Hypothesis: The China
Problem. American Journal of Comparative Law 51 (Winter): 89-111.
Clarke, Donald C. (2005). How Do We Know When An Enterprise Exists?
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Esposito Gianluca, Sergi Lanau, & Sebastiaan Pompe (2014). Judicial System Reform in
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Fuller, Lou L. (1964). The Morality of Law. New Haven, Yale University Press.
Haifu Investment limited Company of Suzhou Industrial Zone v. Shiheng Non-Ferrous
Resources Recycling Limited Company of Gansu (“Haifu”), The Gansu Provincial
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Chinese) is available at http://vdisk.weibo.com/s/DqAs270sIji1.
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