Pre-contractual liability in China – be careful with LoI and MoU

published on 8. December 2022 | reading time approx. 5 minutes

Even before the outbreak of the Covid pandemic, but especially in times of the Covid pandemic, where personal meetings and negotiations with potential business partners are associated with considerable difficulties or even hardly possible, so-called Letters of Intent (LoI) or Memoranda of Understanding (MoU) become even more important. Many potential business partners in China wish to sign such documents. However, it often remains unclear what legal effects a LoI or MoU can have if the planned busi­ness transaction is not concluded, e.g. the establishment of a joint venture, the com­missioning of a company with production or the granting of a distribution right. As a rule, such documents are usually understood on the German or European side as mere "declarations of intent" without legally binding effect.

• But what is the legal situation in China? »

• What does this mean for LoI and MoU? »

• What damages can occur? »

• Can the applicability of article 500 CC be excluded? »

• What is recommended for practice? »
  

But what is the legal situation in China?

Generally, LoI or MoU with Chinese interested parties are governed by Chinese law. At this point, it is therefore worth taking a comparative look at the corresponding civil law provisions of German law and Chinese law.
 
German law recognises the so-called "culpa in contrahendo" (cic; cf. §§ 311 para. 2, 241 para. 2 German Civil Code). In simple terms, this means that a relationship of trust can arise through the initiation of a contract or a comparable business contact in such a way that the partners are obliged to exercise due care towards each other. The reason for liability is the "granting of relied trust". The breach of a duty arising from this relationship of trust can therefore (if further conditions are met) lead to liability of the partner in breach of duty for damage caused to the other party. This is compensation for the loss caused by the fact that the injured partner rea­sonably relied on the conduct of the other party.  
 
Chinese law has legal provisions comparable to these German regulations in Article 500 of the Civil Code (CC). This reads as follows (own translation):

Alternatives 1 and 2 relate in particular to situations in which one party acts in bad faith with the intention of preventing the other party from obtaining a business advantage, for example, by the other party refraining from implementing its own business idea or from negotiating with third parties. Alternative 3 is a very broad catch-all provision that gives the court wide discretion in the event of a dispute.

What does this mean for LoI and MoU?

If the negotiating parties agree on such a document and the main transaction is not concluded, obligations may nevertheless arise from these documents. Already the cessation of contract negotiations without warning or giving reasons can fall under Article 500 of the Civil Code. However, the risk increases considerably if the main transaction is not concluded even though the essential terms of the transaction were previously laid down in a LoI or MoU.
 
The following example will serve as an illustration: Company X from Germany intends to commission a company in China with the production of preliminary products. Therefore, it contacts the Chinese company Y. In the course of the negotiations, the term of the contract, technical details and quality of the preliminary products, the granting of licenses if necessary, quantities, delivery times, prices, terms of payment, etc. are negotiated. The negotiating partners record the most important points in a MoU. To the surprise of company Y, company X unexpectedly informs company Y that it is no longer interested in a cooperation. It turns out afterwards that company X has been negotiating with other competitors of company Y and has decided to cooperate with company Z for various reasons. Company X did not disclose these parallel negotiations with competitors to Company Y or to the other negotiating partners. From a Chinese perspective, such conduct may constitute a breach of good faith and thus fulfil the requirements of Article 500 CC, so that there may be an obligation to pay damages on the merits.
 

What damages can occur?

In the above example, company Y may have suffered direct as well as indirect damages, and the extent of any potential damage can be very significant. Direct damages may include, for example, the costs of negotiations including the costs of consultants, the costs of travel, the costs of converting equipment and producing samples. Indirect damages may have been caused, for example, by Company Y ceasing negotiations with other possible business partners (loss of other orders, loss of access to other markets), non-realization of possible cost savings due to failure of the originally planned technology transfer, or even possible lost profits. Whether and, if so, to what extent a court will affirm a claim for damages depends, of course, on the individual case. In principle, however, there is a risk that the foreign company will be ordered to pay compensation.

Can the applicability of article 500 CC be excluded?

As already mentioned at the beginning, foreign companies often assume during contract negotiations with potential business partners in China that LoI or MoU are non-binding and therefore no liability can be estab­lished. In addition, it is often stated that the interpretation of the document should not be subject to Chinese but to foreign law. However, this is contradicted by the fact that compliance with the principle of good faith is not subject to the will of the negotiating parties but exists by law. Moreover, the principle of good faith applies in particular to the conduct of the parties and less to their written understanding. A Chinese court will primarily base its assessment of whether there has been a breach of good faith on the conduct of the parties. Accord­ingly, the court will also ignore a possible disclaimer in such a document. Moreover, such a disclaimer also carries the risk that the court will understand it as part of a plan to maliciously harm the Chinese business partner, e.g. by discouraging the latter from negotiating with other third parties on similar transactions.

What is recommended for practice?

If negotiations are started in China, the principle of good faith applies with the possible legal consequences mentioned in the event of a violation of the same if no contract is concluded between the parties. The foreign business partner should be aware of this. If no contract is concluded, the reasons for this should therefore be carefully documented.
 
The LoI or MoU should therefore explicitly state that it is a non-binding expression of interest and that the contract negotiations do not guarantee any claim to success. However, this should also be underpinned, for example, by making it clear that the negotiations will not be conducted on an exclusive basis, that contract negotiations can be ceased without giving reasons and that no claims will arise from this on the part of the other party, that the parties themselves will bear the costs they incur as a result of the negotiations (e.g. travel costs, consultancy costs) or make possible dispositions in the course of the negotiations (e.g. use of machines and personnel for the production of samples) at their own expense and risk.
 
If the decision on whether to conclude a contract after negotiations depends on prior checks, e.g. due dili­gence, these steps and a possible exit from the contract negotiations should be precisely defined in the LoI or MoU. The conditions of the negotiations, including a possible cessation, and the obligations to be entered into by both sides should be set out as precisely as possible. In addition, a confidentiality agreement should be concluded before an LoI or MoU is agreed.
 
In connection with LoIs and MoUs, it should also be considered that, from the point of view of Chinese com­panies, it is already a contractual agreement and subsequent substantial changes are usually not wanted or may be met with incomprehension. When formulating such documents, it should therefore be made unam­biguously clear that they do not represent the final agreement between the parties, but that this final agree­ment will only be concluded between the parties afterwards.