No More Excuses

Foreign firms in China are cracking down on unpaid debt

Edward E. Lehman and Brinton M. Scott

With the Asian slowdown, the sudden failure of the Guangdong International Trust and Investment Corp. (GITIC), and stricter regulations on foreign-exchange transactions, foreign firms in China are paying more attention to accounts receivable than ever before. It is no longer the case that foreign companies in China are reluctant to collect bad debt for fear of ruining their relationships and reputation within the business community. Today, a China-based creditor's determination to collect debt sends a strong message that would-be deadbeats, as well as those who like to string out payments over long periods, can no longer get away with non-payment.
The need for a big stick

Though many financial officers of foreign-invested enterprises (FIEs) believe debt collection to be illegal, it is, in fact, permitted in China--but only by PRC law firms. The Ministry of Public Security and the State Administration for Industry and Commerce in 1994 issued the Regulation Concerning Establishing Debt Collection Companies, after a number of unscrupulous companies and individuals employed heavy-handed tactics to collect debt. The regulation forbids any person, organization, or entity--except Chinese law firms--from engaging in debt collection.
After selecting a law firm, the creditor will want to s tart the debt-collection process as quickly as possible. Since debt cases usually have two-year statutes of limitations, any delay can foreclose recovery. In addition, if a debtor is not paying one party, it probably is not paying others. Thus, collection becomes a race to the bottom, with secured creditors first in line.
The creditor must give the Chinese law firm power of attorney to manage the debt, execute an escrow agreement with both the debtor and the Chinese law firm, and sign a retainer agreement with the firm outlining the services it will render. The creditor should then execute an affidavit of authority, verifying that the person executing the power of attorney has the creditor's authority to act on behalf of the company. The law firm will need copies of original contracts and other related documentation to commence these types of settlements. In a contested debt collection, the Chinese law firm will also need copies of the creditor's business license and all other related documentation.
Depending on the type of debt, the law firm generally begins the process of collecting overdue receivables by conducting due diligence on the debtor. The law firm's investigative services division should perform the due diligence, to determine if the debtor is able to pay and whether the money can be recovered. A law firm's due-diligence fee can be incorporated into the total collected if the creditor decides to proceed with the collection.
The next step is to have the law firm wield a big stick--by sending dunning letters, making phone calls, knocking on doors, and, if necessary, filing lawsuits. It can also obtain and enforce judgments, which may involve seizing property, freezing bank accounts, or garnishing wages. A few well-written letters and faxes, combined with attorney telephone calls, can frequently work wonders on a bad debtor's attitude, as fear of a lawsuit is often sufficient to motivate quick settlement. If a debtor still refuses to pay, however, the creditor must be ready to sue. Suing bad debtors acts as a signal to other businesses that the creditor is neither weak nor afraid to enforce its rights in China.
Ins and outs of litigating in China

Contrary to popular belief, litigation in China, especially for debt-collection cases, can be relatively simple, expedient, inexpensive, and transparent. Many members of the judiciary are both well-educated and fair. Judgments can sometimes be obtained within one month of filing. In Beijing, for example, the courts have made great efforts to clear debt-collection cases from their dockets, indicating a willingness to resolve bad-debt issues quickly, and most cases are decided within about six months of filing. The litigation process in China is also not as expensive as many believe. Generally, court fees are based on a percentage of the amount in dispute. The court filing fee is less than 2 percent for claims of Yen1,000,000 ($120,806) or more. Attorney fees typically amount to 30-45 percent of the amount recovered, depending on the extent of litigation, effort expended, and expenses incurred.
The creditor initiates a suit by submitting a complaint to the relevant court, which then schedules an initial hearing, usually within one month of accepting the case. Between the court's acceptance of the case and the hearing, the defendant must answer the complaint. At the initial hearing, the court hears the evidence and attempts to mediate a settlement. If mediation fails, the judiciary schedules additional hearings. If mediation fails again, the court decides the issue. Armed with the court's judgment, the creditor may begin to collect what is owed. If payment is still not forthcoming, the creditor may seize bank accounts or other forms of property. Each of the judicial organs authorized to handle debt-collection cases has a special security division that enforces judgments when necessary.
Though cases are generally resolved satisfactorily, the administrative aspects of litigation in China may be more cumbersome than in other countries. For example, the creditor's legal representative must sign and seal every court document with the company seal.
Friendly collections

Debt collection in China is not always a hostile situation. Sometimes, the debtor wis hes to pay, but is unable to do so for a variety of reasons. For example, State Administration of Foreign Exchange (SAFE) regulations and tighter banking and customs policies have left many Chinese importers and distributors unable to open letters of credit, though they often have renminbi (RMB) available (see p.26). In these instances, an action involves debt management rather than adversarial proceedings. Uncontested debt collection usually takes about three months.
Under such circumstances, the creditor should work with its Chinese law firm to establish a debt-management agreement that gives the PRC law firm authority to receive RMB into an escrow account on the creditor's behalf. Once the law firm collects the amounts owed in RMB, it holds the money in escrow. Next, the law firm should file the debt-management agreement with the relevant Chinese judicial authorities, and then with the banking authorities. Upon receiving approval from these authorities, it can wire the money out of China at the exchange rate in effect on the day the money is transferred.
As long as the law firm receives payment by check or direct draft, its fees are generally based on a percentage of the total amount, plus expenses. If payment is in cash, there is an additional 3 percent charge to cover the 3 percent that all Chinese banks charge for depositing cash. Most law firms prefer to receive demand drafts, cashier's checks, or wire transfers , since counterfeit currency is a problem in China. The exchange rate the creditor applies to its debts should not affect the law firm's fee.
If the debtor pays by direct draft in China, the transfer to the Chinese law firm's account generally takes two days within China. Three more working days are required to transfer the money to Hong Kong from the law firm's account. If the debtor pays by cashier's check, the clearance and transfer within China can take up to five days. While transfer is immediate if the debtor pays in cash, the law firm must verify the authenticity of these notes with the bank. Verification can be done immediately, however.
Contested debt collections

Under a contested-debt scenario, the collection process becomes more complicated and drawn-out. The receipt process and movement of funds for contested debt collection are the same as in a friendly collection.
Several different methods of payment are possible, including direct payment to the creditor. Under a direct-payment arrangement, the Chinese lawyers would most likely require the creditor to notify them of any payments received. All funds should be paid into the law firm's escrow account so that it may manage the account for the creditor. Unfortunately, when debtors pay directly to the creditor, the law firm finds itself in the sometimes awkward situation of having to ask the creditor for payment.
When the debt is contested, a creditor has the option of either paying the Chinese law firm a percentage of the total collected--or paying by the hour. Under a contingency, the percentage paid to the law firm is generally determined by the stage of the collection process. The exact amount is determined on a case-by-case basis and may be negotiated between the law firm and creditor.
If the debt is collected before litigation, the law firm receives around 33 percent of the amount collected. If, on the other hand, the collection goes to litigation, the Chinese law firm should receive 40 percent of the amount collected. Finally, appeals of judicial decisions typically drive the law firm's fee up to 45 percent. Alternatively, the creditor may decide to pay the law firm's regular hourly rates.
Pro-active debt management

But creditors need not wait for debt-collection problems to surface before acting. They can and should anticipate such scenarios and plan accordingly. Adopting debt-management and -collection procedures can help firms minimize both their occurrence and the costs of resolving them.
PRC lawyers can coordinate with a firm's accounts receivable department to arrange for the law firm to collect debt in arrears. The company then drafts sales contracts stating that debts exceeding a set period of time (for example, 60 days) will automatically be assumed by a law firm that will thereafter take action and settle the accounts. Such an arrangement insulates the creditor from engendering clients' resentment, si nce debt management will appear to be beyond the creditor's control. It can also serve to rein in sales staff activities, as sales staffs of firms in China have been known to sign contracts recklessly to push numbers up. Sales staff should be informed that after 60 days the debt will be turned over to a law firm, not the in-house accounting department. Furthermore, entities that contract with China creditors will not have grounds for complaint if they have been made aware in the initial contract that they must fulfill the contract or risk collection by a law firm. This option, termed "fictional factoring," thus helps those operating businesses in China to maintain good client relations.
On a case-by-case basis, certain law firms with the financial wherewithal are purchasing the debt of creditors--generally FIEs operating in China--for a set price, usually a percentage of the total. This method, called factoring, can be a good option for some law firms for two reasons. The regular payments that come from the collection of non-disputed debt can be a good source of guaranteed cash flow. Other law firms benefit from factoring when a creditor is preparing to write off a debt--or the debt is beyond or nearing the statute of limitations--and the creditor is prepared to sell it for cents on the dollar. Creditors that choose this option tend to be companies located outside of China that deal with PRC companies, perhaps the parent of an FIE.
Selecting a Chinese law firm

With so much of the process dependent on the Chinese law firm, perhaps the greatest determinant of success is selecting the right law firm for the job. Before making a decision, FIEs looking for a PRC law firm should carefully consider the qualities and abilities of a potential firm, particularly:

Mobility Does the law firm have the ability to visit the debtor in person and discuss the debt face-to-face? Companies should find out whether the firm has other offices around China, and if so, where they are located.
Investigative services A good Chinese law firm that engages in debt collection should have an investigative services division with employees qualified to conduct background checks and thorough due diligence.
Experience with debt collection Companies should also speak to the lawyers about past debt collections. Many Chinese law firms have engaged in litigation (which happens to be a debt collection matter) but have not actually created a separate area of practice dedicated to debt collection. Though Chinese attorneys are bound by attorney-client privilege, they may (with a client's permission) disclose some information about their experience in this area.
Automation Companies should look for a firm whose entire pro-active debt collection system is well-structured and computerized. The firm must also have telephone capabili ties commensurate with the volume of business that debt collection creates. Ideally, the law firm should have a 24-hour answering service, especially if it deals with cross-border trade issues and creditors who may be located in different time zones.
Communication For most FIEs, the working language is English. Certainly, the reporting language is English, and the legal procedures of debt collection typically must be explained to the client in English. Thus, the Chinese law firm should be able to communicate in English with the creditor, as well as in Chinese with the debtor. Further, the firm must have a solid grasp of international business, including accounting principles.
Accountability The law firm must have at least one or two people who can be identified as contacts responsible for the FIE's debt management.
Consistency Generally speaking, debt collection is not a one-off deal, but rather a process that requires ongoing management. The Chinese law firm must be able to provide consistent and uniform updates and reports throughout the debt-collection process. The importance of such documentation cannot be understated, as the progress often must be accounted for not only within China, but also at an FIE's parent office abroad.
The office A foreign investor can tell a great deal from a potential legal partner by viewing the law office and how it is run, so a visit is important. Companies should mee t the staff responsible for debt collection and have them explain the process thoroughly.

Don't settle for less

No business likes uncertainty, but it is often difficult to avoid, especially in China. Many bad debts were created years ago as a result of China's unclear commercial-law structure. Now that the laws are more transparent, businesses should consider how to minimize their debt exposure in China. If receivables are excessive, or if a business has a difficult time obtaining hard currency because of the new SAFE regulations, the firm should seriously consider debt collection. As there is no longer a stigma attached to collecting debt in China, companies that collect against bad debtors will not only find themselves in a better economic position, but also held in higher esteem by would-be and current business associates.

Edward E. Lehman and Brinton M. Scott are attorneys at the L & A Law Firm in Beijing.*

* Note: The L & A Law Firm has changed its name to "Lehman, Lee & Xu." Brinton M. Scott no longer works at the firm.

Last Updated: 1-Mar-99