The development of China’s coal and seam gas industries is now a key policy goal of the country’s peak economic planning agency, the National Development and Reform Commission (“NDRC”).
In 2013, fifteen new coal projects – with an initial investment value of USD8.9 billion – were commenced. They are expected to add more than 100 million tonnes of annual coal production to China’s extractive capacity. And it doesn’t stop there, with the NDRC confirming that it wants to approve an additional 860 million tonnes of coal production by 2015.
Also in 2013, the National Energy Administration of China (“NEA”) new policies to boost shale gas exploration and production. With shale gas production in the US now reported to be in the region of 8.5 trillion cubic feet each year and rising, China sees both opportunity and advantage in developing its own capabilities as well.
What does this mean for Australian business? There will be new threats – volume and price challenges for our own resource industries – and also significant opportunities, for both investors and for our mining services industry. With a long history in mine technology and infrastructure, Australian companies have the credentials to participate and profit share in China’s massive coal and shale upgrade. Expertise in extraction, in overcoming geological and environmental obstacles, and in mine-side processing and transportation will be keenly sought-after.
In this newsletter, Christopher Hewitt and Charles Zhan provide an update on China’s natural resources boom, and give six key tips on contracting to help Australian service providers looking to this new market to maximise their potential and minimise their risk.
China’s natural resources – a new inward focus
Over the past year, the Chinese Government has shifted its focus towards the better exploitation of natural resources within its own borders. China now has impressive national infrastructure in place. Trade liberalisation, facilitated by domestic marketization and by WTO membership, and “going out” by Chinese enterprises, has propelled the initial stages of China’s industrial development. Attention is now being directed towards China’s natural resources, especially coal and shale-gas, which the NDRC sees as being strategic natural resources.
In particular, the NEA’s First Shale Gas Industrial Policy includes incentives for shale gas exploration and production, seeks financially stable investment for new shale gas projects, and encourages cooperation with foreign technology and engineering companies.
Australian engineering, drilling, mining, construction and professional services business are well positioned to provide the expertise that China needs for this new wave of resources and infrastructure projects. While it is true to say that Australian engineering and professional services business have some experience in China, this experience has mostly involved servicing existing clients and non-Chinese businesses located within China.
With the growth in Chinese private enterprises and the focus on Chinese natural resources, Australian service providers are now perfectly positioned to service Chinese businesses and resource projects in China. The challenges are first to get the work, and then to ensure that when you “sign on the dotted line” your contract is as sensible and as protective of your interests as it can be.
To avoid repeating the costly and time consuming mistakes of many others that have sought to enter the Chinese industrial marketplace, we offer these tips for foreign mining, petroleum and engineering service providers now looking to do the same thing.
Tip 1 – Introduce yourself, and show your respect and your commitment
Every relationship involves getting to know the other person involved, and neither side gets what they want out of a relationship until the relationship is strong. This takes time, planning and effort. Find the right people to work with and to communicate with, both in terms of intermediaries and in the ultimate customer as well. Spending time getting to know the people and the organisation that you intend to do business with is essential. Remember that this may require many visits before the prospect of doing business emerges. Politeness, courtesy, humbleness and modesty are greatly valued by the Chinese.
This is not really the place for a primer on Chinese business etiquette. Nonetheless no summary like this would be complete without mentioning the importance of guanxi – a quality that Western business all-too-often forgets.
Tip 2 – No matter what you have heard, you will need a written contract
You may have heard it said that business in China operates without formal contracts. This is simply not the case. There is a Chinese saying that “the palest ink is better than the best memory”. While handshake agreements may have been common in China 20 years ago, the commercial environment has become much more sophisticated and commercial contracts are absolutely necessary.
China has a large body of legislation governing the operation and enforcement of commercial contracts, and it is continually expanding. This includes laws and regulations that specifically relate to foreign businesses and services contracts. The principal law relating to contracts is the Contract Law of the People’s Republic of China (“the Contract Law”). It contains a number of provisions that relate specifically to service, engineering and technology contracts. For example:
- contracts for construction projects must be in written form, otherwise they will generally be unenforceable;
- under a works contract, the contractor must provide all of the equipment and materials unless otherwise stated in the written contract – foreign contractors have been caught out by being required to pay for all equipment and materials;
- if a contractor is using the sub-contractor, then the principal must approve the sub-contractor, and if approval is not obtained the principal may terminate the contract;
- contracts for construction need to include, at a minimum, terms relating to scope, timing, quality assurance and testing, and warranties;
- technology contracts need to include provisions relating to the ownership and allocation of technology benefits developed as part of the project.
As with most legal jurisdictions, many Chinese regulations may be expressly excluded by the written contract, while some regulations will apply regardless of the contract.
Tip 3 – Think about how to handle a dispute before it happens
Many Australian companies – and their lawyers – believe that any dispute with a Chinese company would be best resolved in Australian courts, and will insist on an Australia-centric jurisdiction clause. A key point is that “home field advantage” is not always an advantage at all, and that in most cases this would be a big mistake. Australian court judgments cannot be registered or enforced in China. “Winning” such a case would be no victory at all. Even starting or “restarting” the legal process in China may not be an option, because a Chinese court might decline to hear the matter on the basis that the contract requires all litigation to be undertaken in Australia.
Many Australian companies do not want to submit to a Chinese court in the event of a commercial legal dispute. In our view such an objection becomes less defensible as time progresses and as the rule of law in China continues to improve. Nonetheless an alternative is to include an international commercial arbitration clause in your contract. The location of the arbitration may be within China – but be careful when selecting an arbitration body in China – or within a third country, such as Singapore. Arbitral awards are directly enforceable in China.
Tip 4 – you must do your best to protect your intellectual property rights
There is a common belief that intellectual property (“IP”) cannot be protected in China. Although the difficulty of doing so varies, there are contractual steps that you can and should adopt to try to better protect your IP. For instance:
- clearly state in the contract who owns IP, including who owns any IP developed as part of a project;
- include a licence in the contract in relation to the use of certain IP, with licence fee payments, clear limits on usage and damages for breach;
- include reasonable and well-constructed liquidated damages and account of profit clauses to deal with any misuse of IP by one or other of the parties;
- complete IP registration (patents, technologies, business names and trademarks) with the State Intellectual Property Office of China and the Trademark Office of the State Administration for Industry & Commerce of China respectively.
Practical means of protecting the value of your IP should also be considered. Are there technological ways of protecting your IP? Can your own IP be delivered to the project only by your key personnel stationed on the ground in China? If you believe it is very likely that your IP will be misused, then make sure you overvalue it, or get the other side to make upfront payments for the use or transfer of IP.
Tip 5 – punitive indemnities and damages clauses may not be enforceable
Contracts for infrastructure development and for other mining and petroleum services have traditionally included provisions requiring one party to provide extensive indemnities and pay significant damages for specific breaches.
There is an ongoing debate within Australian courts regarding the validity of such clauses and their limitations. The same debate is going on in China. When entering into a services contract with a Chinese business, consideration needs to be given to what a court or arbitrator will actually enforce.
Liquidated damages clauses – which have become more common in services contracts – describe a predetermined quantum of compensation that a party must pay to the other party in the event that a specific breach of contract occurs. Chinese courts and arbitrators will generally uphold a liquidated damages clause, provided that it is not punitive and has been negotiated in good faith. However, if a liquidated damages clause is unreasonably harsh against a party – particularly against the Chinese party – then the judge or arbitrator is likely to interpret it narrowly, or to strike it out.
Chinese law does not impose specific limits on the quantum of liquidated damages that can be included in a contract, although there are some important refinements to consider:
- under the Contract Law, if the amount of liquidated damages is less than the actual damage suffered, then the injured party may apply for additional damages;
- under a 2012 judicial interpretation of the Contract Law, if the amount of liquidated damages is 30% more than the actual damage suffered, then the injured party may apply for a reduction in damages.
Equally, Chinese courts and arbitrators have demonstrated a willingness to enforce indemnity clauses against contracting parties if the indemnity is reasonable and connected to the commercial arrangement and expectation of the parties.
Chinese courts and arbitrators will review and consider indemnity clauses in context of the principles of fairness and good faith. Indemnity clauses must be drafted with care and an understanding of the Chinese legal environment. Blanket clauses that attempt to impose all liability on the Chinese party are at risk of being struck out by a Chinese court or arbitrator.
Tip 6 – Chinese law will apply to your contract, staff and operations, so be diligent
Most modern contracts include a so-called “choice of law” provision that specifies what laws will govern the contract. Australian companies providing goods or services in mainland China have often included provisions stating that the contract will be governed by the laws of Hong Kong or Australia.
Choice of law provisions can be difficult to enforce internationally. Even if the choice of an external jurisdiction is enforceable, that does not mean that Chinese laws will not apply to the contract and to your operations in China in other ways.
For example, environmental regulations will apply to all work and production services provided within China, regardless of the law of the contract. Even if a contract states that a Chinese company must indemnify the Australian company in respect of damages flowing from certain events of default, the Australian company may still have a primary liability under Chinese law. Managers and directors of the Australian company may also be personally liable.
It is important to know the local laws that will be applicable to the kind of things that are to be done under a contract, regardless of any choice of law provision which refers to a non-local jurisdiction. The areas that typically require the greatest due diligence are these:
- health and safety regulations applying to all stakeholders, including employees and the community;
- employment restrictions for both local and international workers, including salaries and termination of employment;
- licensing for exploration, development and construction;
- permits to operate a business within China;
- compliance with local industry codes and standards.
At the same time, there may be overlapping operations of both Chinese and Australian laws on the same subjects such as employment, import and export of special equipment, and corporate governance, etc. – compliance to both jurisdictions may be required.
As the Chinese Government shifts its focus towards its domestic mining and resources sectors, it is important to closely monitor and to understand changes to the regulatory and policy environment. The energy and resources sector can be especially sensitive to legal and policy settings in a range of areas, from environmental issues, OH&S, cross-border funds and assets transfer, governmental permit and approval, to the broader level of economic policies.
In China, the impact of regulatory and policy changes is intensified by overlaps between national and provincial government, and additional regulations imposed at the local level. Chinese companies tend to pay close attention to regulatory and policy changes and Australia companies operating in China should be equally vigilant.
This memo presents an overview and commentary of the subject matter. It is not provided in the context of a solicitor-client relationship and no duty of care is assumed or accepted. It does not constitute legal advice.
© Moulis Legal 2014