In early 2005, a subsidiary of listed Hong Kong and China Gas Company Limited (0003.HK) bought a controlling stake in a Chinese joint venture company.

Initial payments were made, but then the audited financial statements apparently failed to show the asset value of the joint venture company as warranted, or that the relevant associated companies were free from encumbrances.

The buyer alleged the seller had breached the guarantees and warranties provided under the Agreement and commenced arbitration in Hong Kong. The seller was ordered to pay damages, and the buyer was released from his obligation to pay the balance of the purchase price.

These are the relevant facts in Sun Tian Gang v. Hong Kong & China Gas (Jilin) Ltd, the case in which the seller asked the Hong Kong Court to set aside the arbitral award on the ground he was not given proper notice of the arbitration, and was therefore unable to present his case.

The Court duly set the award aside, and presumably the dispute will now be re-heard.

Pausing there, this was a relatively exceptional outcome. Hong Kong is regularly lauded as an arbitration-friendly jurisdiction, with a pro-enforcement bias, but this case also demonstrates that the Special Administrative Region’s courts have a firm understanding of the importance of due and fair process.

The alleged facts in the Hong Kong & China Gas case neatly illustrate some of the key challenges facing foreign companies investing and operating in mainland China; including commercial disputes arising from inappropriate revenue recognition practices, disputes over intellectual property rights, and of course outright fraud. Other challenges are FCPA (the Foreign Corruption Practices Act) or corruption issues as well as the complex and uncertain regulatory regime.

In fact the China Business Climate Survey Report published by the American Chamber of Commerce in China in January 2017 reveals that inconsistent interpretation and enforcement of regulations and unclear laws (followed by rising labour costs), remain the biggest challenges facing AmCham members in mainland China.

Despite these challenges, China remains a very attractive destination for FDI (Foreign Direct Investment). According to China’s Ministry of Commerce, FDI in the Chinese mainland increased by 4.1 percent in 2016 compared to the previous year, reaching USD118 billion.

Given the conflict between continued investment appetite, on the one hand, and a difficult legal and compliance environment, on the other, it is obvious that investors must be fully prepared to avoid, or at least mitigate, their legal risk.

In addition of course to undertaking comprehensive due diligence, and obtaining skilled legal and other professional advice, one of the most important (but often sadly ignored, or at least neglected) strategies is to structure their dispute resolution provisions properly.

Arbitration, not litigation

In practice, this means insisting disputes are resolved by arbitration in a reliable New York Convention jurisdiction. There are good reasons for choosing arbitration over litigation. Certainly, voluntarily going to court in China is something most well-informed business people would avoid given the well-known weaknesses of the Chinese court system, of which protectionism is just one example.

Litigation outside China, even in jurisdictions with strong commercial courts and rule of law credentials, is also problematic if enforcement will eventually take place inside China given the difficulty (if not impossibility) of executing foreign court judgments.

For offshore arbitration involving Chinese parties, however, the recommended choices are usually Hong Kong or Singapore, using the rules of well-respected institutions such as (HKIAC) (the Hong Kong International Arbitration Centre), the Singapore International Arbitration Centre or the International Chamber of Commerce. These two jurisdictions, with their sophisticated, court-supported, arbitration environments, provide a reasonable compromise between conducting the arbitration in, say, Stockholm, New York or London, and having it in mainland China.

The advantages of arbitration, whether it happens in Hong Kong, Singapore, or other New York Convention jurisdictions, include:

• ease of enforcement in other New York Convention jurisdictions, including China: awards made in one convention country should be recognised and enforced in the others, and there are very limited grounds on which the courts can refuse enforcement (It is worth noting that the New York Convention cannot be used to enforce Hong Kong awards in China, or vice versa, but there is instead a bilateral agreement which operates similarly to the Convention);
• confidentiality – unlike in court, arbitration is a private procedure – there should be little or no risk of embarrassing information, or trade secrets, leaking out;
• party autonomy – the parties can contribute to the choice of arbitrators, having regard for instance to their qualifications and experience, and can also work with the tribunal to customise the procedure;
• the parties are free to select a neutral venue to ensure that neither party enjoys a home turf advantage;
• availability of third party funding – Singapore passed legislation in January 2017 permitting third party funding in international arbitrations, and similar legislation is presently passing through the Hong Kong Legislative Council.

Foreign companies should, however, be aware that only “foreign-related” disputes with Chinese parties can be arbitrated outside mainland China. The range of factors which determine whether a dispute is “foreign-related” is broad, and decisions are made on a case-by-case basis.

However, foreign investment vehicles in the form of WFOEs (Wholly Foreign-Owned Enterprises), CJVs (Cooperative Joint Ventures) and EJVs (Equity Joint Ventures) are all considered to be domestic entities under mainland Chinese law, meaning that disputes involving these type of entities must in principle be arbitrated in mainland China. A failure to appreciate this will inevitably result in frustration, delay and wasted expense, not to mention difficulties in enforcing the arbitral awards.

Executable assets

Even in cases where the parties have agreed an effective dispute resolution regime, it is preferable, and arguably critical, that offshore guarantees are provided, or that there are at least executable assets outside China. This is because, although Hong Kong and New York Convention awards are usually recognized in China – the HKIAC, for example, maintains that the Chinese courts have not refused to enforce one of its awards in the past five years - effective execution against assets can be problematic due to the nature of the legal system in China, in addition to the usual basic collection issues.

Concluding remarks

Foreign investors into China need to have a clear understanding of the risks involved. Conducting comprehensive due diligence, obtaining skilled legal and other professional advice, and structuring their dispute resolution provisions properly, can help them succeed in one of the world’s fastest-growing and most appealing commercial jurisdictions.

This article was originally published by RMB Week on April 12, 2017 and is reprinted with permission. The original article can be viewed online here [subscription required].