NNN for China: firing silver bullets or just blanks?

Introduction & background

“. . . Don’t worry, we have the NNN agreements in place…”

A snippet of a telephone conversation more fully overheard in the lounge of a major hotel in New Orleans. The speaker was American, presumably a lawyer, and speaking confidently to a client about a China manufacturing deal.

Many, including lawyers, now regard the NNN agreements as the key to risk management in dealing with China. That is an error.

NNN Agreements

The NNN agreements (non-disclosure, noncompete and non-circumvent) have been the subject of much Internet chatter and numerous articles. Unfortunately, their claimed effectiveness gets fortified only by repetition. Little, if any, of the NNN commentary comes from China licensed local or foreign law firms. Licensed Chinese lawyers are also mostly silent. Why?

China is a sovereign country

China is sovereign country. It is a Civil Law jurisdiction with its own civil procedure, court system, trial procedures and rules of evidence. As might be expected, it is a little different from other Civil Law jurisdictions. It is totally different from a Common Law jurisdiction. Commercial and legal strategies that might be perfect elsewhere may not be as effective in China.

NNN agreements are just contracts

NNN agreements are just contracts. A contract by definition is an agreement enforceable at law. To have commercial value, a contract needs to be technically and practically enforceable. Enforcement has to be cost effective to be practical. This is rarely addressed by NNN commentary where various remedies are mentioned as if they are items on a menu awaiting selection.

A brief contract refresher

A contract can only bind the parties to it. So your remedy must come from the other party to a contract. Your counter party. If others offend you must be able to prove a material link in the offending to your counter party. Your counter party is the only one that you can sue in contract.

A basic principle in contract is that if it is breached, the innocent party should be restored to the position that they would have been in if the contract had been fully performed. The preferred remedy is damages or monetary compensation. Sometimes, although it is known that the contract has been breached, there are not yet losses that can be quantified in terms of money. It might be very clear however that there will be real losses in the near future.

Then an injunction (an enforceable court order to do or refrain from doing something) can be sought. These take two forms: an interim injunction restraining the other party until a full court hearing is completed; and a permanent injunction issued at the end of the case as part of the judgement.

To end this very quick and incomplete outline, there are also liquidated damages. Sometimes it is difficult to quantify and prove the actual amount for damages. Parties to a contract might agree, for example, that delayed delivery will result in damages of $5,000 per day. There are jurisdiction specific rules about this.

Each of these remedies is discussed below in the context of NNN agreements.

NNN remedies for breach

The NNN agreements are just contracts for specific purposes. They may also be terms to similar effect in more comprehensive contracts.

Breach scenarios

Weeks, months or years after your China contract has shipped, something very similar or identical appears on the market. Originating from a city that you have never visited and from a company that you have never previously heard of. You suspect that your previous counter party may have something to do with it. What then?

You may have actual losses to support a claim for damages. The issue then is to find and prove the link to your previous counter party so that the NNN agreements can be enforced. All the issues referred to below, except showing actual losses, are there. You have the burden of proof.

Sometimes contracts are breached, but there are no immediate losses. For example, you have just become aware that your miscreant counter party has set about copying your tooling – say a mould for making plastic parts. Or your confidential information has been disclosed, but preparations for use are ongoing. Or your competitor seems to have new knowledge about how to make products very similar to yours.

Do you have to sit back and wait until your business is really harmed so you can show monetary losses? That is one option, but who wants to wait until their business suffers harm? Enter the injunction.

China injunctions

Injunctions are hard to get in China. Funds have to be guaranteed to offset any potential losses of the injuncted party if the case is lost. Except for IP infringement or unfair-competition, interim injunctions are rarely issued by the courts. At the end of a case a final injunction may be issued, but that can be long after the event. Chinese courts are very cautious in granting any injunction and would usually review the actual substance of the whole case for an interim injunction, and would not be easily persuaded. Because of the different role of judges, prior contractual consent to injunctive relief is largely irrelevant.

Liquidated damages

Because of the difficulty in getting an injunction in China, NNN advocates often suggest that substantial liquidated damages be specified. Millions of Renminbi, the Chinese currency, are sometimes suggested as the amount of liquidated damages to induce
fear of breach in the other party.

The real problem with that strategy is Chinese law. Chinese law provides that where there is a material discrepancy between the amount of liquidated damages and the actual damages, either party can apply to the court to set the liquidated damages aside or to reduce them to align with the actual harm suffered. If the court finds that the agreed amount is not fair, it will adjust the claim accordingly. In our simple examples above you don’t yet have any actual losses. It is going to be hard to sustain an argument for your liquidated damages.

Freezing bank accounts

NNN advocates also suggest that the counter party will fear having its bank accounts frozen by a Chinese court (an interim remedy analogous to an injunction that is available in China). The advocates are right: they will fear that – to a point! Let’s take a realistic look at this remedy.

You are the plaintiff and have the burden of proving your case. There is no pre-trial discovery and almost all relevant information is in Chinese. There are few publicly accessible registers of business information. You have to prove to the satisfaction of the court that you have losses because of your counter party’s breach of NNN obligations. Stop and think about that for a moment. In China, as everywhere else, there is a big gap between believing something has occurred and being able to prove it in a court of law. Particularly in a court system that prefers documentary evidence that has been notarised. Quite rightly, the first step in freezing a bank account, or preserving evidence, is to file your case. To do that you will need to have evidence linking your counter party to the breach. Filing fees will be based on the amount you claim as compensation – your millions in liquidated damages?

Back to freezing bank accounts. First, you have to be able to identify to the court the bank account and its links to your counter party. Knowing litigation is pending there may be a move to a different bank. You will have to prove to the court that your rights will be irrevocably damaged if the court does not approve your application to freeze the bank account. Then you have to deposit funds with the court or provide a guarantee – 30% of the amount to be frozen is typical. The wisdom of the RMB 10 million specified as liquidated damages in your NNN agreements may not be quite so apparent now. And the difference between actual and liquidated damages is not relevant at this point.

It is also not simply a matter of transferring money in. China is a foreign exchange controlled country. It is very difficult to get the security funds into China. The usual practice is to get a guarantee from a local security company. They charge a percentage of the guaranteed amount for this. They will typically also require security.

Damages

Damages are the routine remedy for breach of contract in China, as elsewhere. The process for proving the amount must take account of China’s rules of evidence, but that is not unduly onerous.

Commentary

The Internet is an amazing source of information. Unfortunately, much of the information about China is incomplete, out of date, or just plain wrong. Are the NNN agreements silver bullets? Clearly not! But that does not mean that you are always firing blanks. As part of a well thought out and executed China engagement strategy they have a role, but they are not a substitute for real management of the China project.

For example, have you registered all of your registrable IP in China? Calling it IP in a contract does not make it legally so.

Legal and other due diligence is far more important than the NNN agreements because it is preventative, not attempting to be remedial. Who is the other party? What is their reputation in China? Do they have the necessary approvals and licences to make your product? Are they financially sound? Are they really a manufacturer or just a hidden agent for a real manufacturer? Or even worse, are they fraudsters?

Practical China knowledge and experience in the drafting of China specific contracts is important. The often seen verbiage about liquidated damages being a carefully considered estimate of damage, or consent to injunctive relief, or agreement not to oppose injunctive relief, usually suggest that it is not a “China” contract. Understanding where things are likely to go wrong in China and having contract terms and procedures to cover them is important. If you have done your homework the NNN agreements may be an added security. We use them in appropriate cases but we make sure our clients understand their limitations. Our clients also know that if you have really done your homework, and have contracts drafted specifically for the purpose, the need to rely totally on enforcing NNN agreements
will probably not be an issue of great concern.

Take-aways

• A contractual right without a cost effective remedy, or a remedy at all, is empty.
• NNN agreements provide little real protection in many common China contract situations.
• China is a sovereign country and a Civil Law jurisdiction. Its civil procedure, court process, rules of evidence and the role of judges follow that system.
• China legal strategies based on another system are unlikely to be effective. Irrespective of how effective they might be elsewhere.
• If NNN agreements are unlikely to be practically enforceable in your particular situation, you are just getting empty comfort from moving risk around on paper.
• There is no substitute for real legal and other due diligence when engaging with China.
• Legal advice should be supported by on the ground experience in China.

Contributing Advisors