Contract law in the People's Republic of China - rule or tool: can the PRC's foreign economic contract law be administered according to the rule of law?

Author:Lewis, Mark C.

    "Arbitrary Justice: Breach of contract in China becomes test case;"(1)

    "S&P Warns China That Confidence May Be Hurt by Contract


    Despite the size and growth potential of the People's Republic of

    China (PRC), some international investors are questioning the

    wisdom of doing business with Chinese companies.(3)

    Highly publicized contractual disputes between Chinese and foreign enterprises have focused attention on the PRC's perceived failure to consistently enforce contractual obligations according to the rule of law.(4) China has drawn the attention of the international community for two reasons. First, despite perceived problems with contractual enforcement, the PRC represents a large and attractive market for foreign enterprises. China's economy is the most dynamic of any size in the world.(5) With a population of 1.1 billion,(6) an average annual gross domestic product growth rate of seven percent over the last fourteen years,(7) an abundance of low-cost labor, natural resources and space, and its proximity to other booming markets in East and Southeast Asia,(8) the PRC is an attractive target for firms seeking to open new markets. For example, from 1979 to 1982, the amount of money committed for investment in China by U.S. companies totaled $2.81 million.(9) By 1995, U.S. investment in China had increased to $7.471 billion.(10)

    Second, Hong Kong, a hub for foreign ventures in the Pacific Rim,(11) is scheduled to revert to PRC sovereignty in 1997.(12) Hong Kong is one of the most prosperous economies in the world in part because of its commitment to a free market economy and to the application of the rule of law in business practice.(13) The concern is that when the PRC takes over Hong Kong, Hong Kong's relatively effective legal system will be replaced by one resembling the PRC's.(14) The comments of a U.S. judge in a recent wrongful death case exemplified these fears.(15) Holding that the case could be tried in the United States, the judge noted that "the uncertain future of the Hong Kong legal system, given the island's reversion to Chinese sovereignty in less than two years, counsels heavily in favor of jurisdiction to ensure that the [plaintiffs] have an opportunity to obtain redress, if any be appropriate, for the grievous loss they have suffered."(16)

    The judge's comments reflect the belief of many experts in the United States and Hong Kong that the rule of law will be eroded in Hong Kong after the island reverts to Chinese sovereignty in 1997.(17) Erosion of the rule of law would expose companies in Hong Kong and those that deal with them to the same risk of contractual non-enforcement as that faced by companies currently doing business with or in the PRC.(18) Further, Hong Kong is a major source of free and unrestricted economic information concerning the PRC.(19) Some speculate that this source of information will dry up after reversion, thus increasing the risk of investing in mainland China.(20)

    The adjudication of contractual disputes according to the rule of law is extremely important to the international business community because the PRC is an attractive market and adjudication according to the rule of law significantly increases the predictability of contractual enforcement.(21) However, because the law traditionally has been viewed from an instrumentalist perspective in the PRC.(22) the question has been raised of whether, given the PRC's current system of government, the law can ever be the kind of overlying, guiding principle that makes contractual enforcement predictable. The goal of this Note is to answer this question, at least with respect to the PRC's Foreign Economic Contract Law (FECL), which governs disputes between enterprises of the PRC and foreign businesses.(23)


    In the West, a key characteristic of a "civil society" is autonomous economic organization and transactions."(24) The belief that giving individuals the freedom to maximize their own wealth results in the maximization of society's wealth is a cornerstone of capitalist philosophy.(25) As the noted economist John Maynard Keynes stated in his defense of capitalism during the depression of the 1930s, the allocative efficiencies and experimental creativity achieved through autonomous economic organization and transactions are "powerful instrument[s] to better the future."(26)

    The rule of law is a predicate for achieving autonomous economic organization and transactions.(27) The rule of law has two basic principles: (1) people should be ruled by the law and obey it, and (2) the law should be such that people will be able to be guided by it.(28) Hence, the rule of law assures that individuals know what the law is so they can maximize their own welfare within its confines. It also assures that individuals can pursue this wealth-maximizing autonomy without interference from either other individuals or the state.(29) By assuring that the law is applied equally to all, is binding on the state, and prevents arbitrary actions by the state, the rule of law provides the freedom for the members of a "civil society" to order their own economic affairs.(30)

    Unlike the West, where the law embodies universally held ethical norms and is traditionally regarded as absolute,(31) China has taken an instrumentalist view of the role of law.(32) Under the instrumentalist view, law exists not as an embodiment of commonly held ethical norms, but as a tool for advancing the goals of the state.(33) The state's policy is the "soul of the law."(34) Individual rights are defined by the law,(35) as opposed to the law being shaped by natural rights.(36) Under the rule of law, because law embodies commonly held ethical norms, legal change occurs only in response to changes in other spheres.(37) Under the instrumentalist view, legal change does not occur in response to changes in other spheres, but rather, is frequently used as a means of promoting change elsewhere.(38)

    There is a strong relationship between the rule of law and Western contract law. In the West, it is believed that the objective and predictable enforcement of contracts is desirable because it maximizes the welfare of the parties involved, thus promoting the welfare of society as a whole.(39) Individuals enter into contracts because they believe that an exchange will make them each better off.(40) Where contracts are enforced in an objective and predictable manner, individuals are better able to determine which transactions will be wealth-maximizing and are able to shift the risk of uncertain events in economically efficient ways.(41) On the other hand, where contractual enforcement is subject to changing state policy wealth-maximizing transfers may be voided by the state or never attempted due to the risk of contractual non-enforcement.(42) Further, the resolution of contractual disputes by a legal system that is an impartial mediator of interests is beneficial for society because it establishes rules to resolve future disputes and "encourage[s] socially desirable behavior by future bargainers."(43) Because of the advantages inherent in a system that provides consistent enforcement of contractual obligations according to the rule of law--i.e., welfare maximization and a reduction of risk--the international business community has become increasingly concerned about the perceived risk of contractual nonenforcement in the PRC. This concern has developed despite economic and legal reforms in the PRC ostensibly designed to make the law governing Sino-foreign contracts more like Western common law.


    In the late 1970s, the PRC initiated its "Four Modernizations program" program aimed at modernizing the PRC's agriculture, industry, defense, science, and technology. thus transforming China into a "powerful, modern, socialist country by the end of this century."(45) The primary focus of the economic reforms was to change the economic system(46) from one that was centrally planned to one that was decentralized and market driven.(47) Towards this end, the PRC instituted a series of changes(48) with a common characteristic: "the responses in all cases emphasized notions of contract, the legal responsibility of economic actors to perform their agreements, and the value of individual autonomy in setting the terms of economic transactions and relationships."(49) These reforms mandated that the PRC transform its legal system from one based on an instrumentalist perspective of the role of law into one more closely resembling a legal system governed by the rule of law, at least in the context of the contract law governing economic transactions between Sino and foreign enterprises.

    1. The Modern History of Contract Law in the PRC

      Until recently, contractual relations in the PRC were subject to the government's instrumentalist view of the role of law. The goal of Chinese contract law was to support the government's economic plan rather than to promote the autonomous ordering of economic transactions. However, the PRC's efforts to decentralize the economy and make it market driven would have been undercut by a legal system in which the law had only an instrumentalist role. Consequently, along with economic reforms, the PRC instituted legal reforms which appeared to herald the coming of the rule of law.

      1. Pre-Reform Contract Law: The Instrumentalist Approach

      Before the economic reforms of the 1970s, contract law was no more necessary to settle disputes in the PRC's planned economy than it would have been to settle disputes between the divisions of a vertically integrated firm. Within China's planned economy, every organization theoretically worked towards the same goal--the achievement of the state's economic objectives. Hence, the PRC functioned like one large, vertically-integrated firm.(50) Manufacturers and suppliers were part of the same organization. Under this system, administrative orders...

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