Preventing risk in overseas project subcontracts

By Wang Jihong and Zhao Huiqi, Zhong Lun Law Firm

With the gradual promotion of the Belt and Road Initiative(BRI), Chinese enterprises are intensively and extensively “going out” to participate in international engineering contracting projects. As Chinese contractors tend to subcontract projects to other Chinese companies, what are the risks in the design of subcontracts between Chinese enterprises in overseas project contracting? Is it possible to avoid regulation requirements of foreign laws by applying Chinese laws? Based on the design of subcontract arrangements between a Chinese contractor and a Chinese subcontractor, this article will list some common risks in subcontract arrangement between Chinese companies.

Wang Jihong
Zhong Lun Law Firm

Company A undertook an engineering, procurement, and construction (EPC) project overseas. According to the design, the general contractor will be composed of company A, company A’s local branch (A branch) and company A’s group company (the group company), and their roles are clearly split onshore and offshore. Among them, A branch is responsible for onshore work, company A is responsible for offshore work, and the group company provides guarantee for the overall project.

For the onshore part, company A intends to subcontract the main work to company B, another Chinese company. In order to reduce tiers of subcontracting of onshore work, company B will carry out construction in the name of company A, and subcontract the relevant work to other Chinese companies or local companies for project management. All contracts between Chinese companies were signed in the PRC, and PRC law was intended to be the applicable law.

Zhao Huiqi
Zhong Lun Law Firm

The above-mentioned subcontracting structure is very common among Chinese companies, especially among construction enterprises in the same group, and its purpose is generally: (1) to isolate risks; and (2) for tax planning. In reality, however, the main risks of this subcontracting arrangement are as follows:

Risk of contract invalidity from illegal subcontracting. Article 10 of the Regulations on the Administration of Foreign Contracted Projects (Revised in 2017) (Decree No.527 of the State Council) clarifies the situation of illegal subcontracting of overseas contracted projects, including: (1) subcontracting projects to units that do not have the qualifications prescribed by the state; (2) subcontracting to domestic construction enterprises that have not obtained work safety permits according to law; and (3) subcontracting or re-subcontracting.

The regulations require that “the subcontract shall clearly stipulate that the subcontracting unit shall not subcontract or re-subcontract the project, and shall be responsible for supervision”. In the above-mentioned contract structure design, in fact, company A subcontracted its overseas projects to company B, and then company B subcontracted them. Will the subcontracting of company B lead to the invalidity of the contract due to the violation of the strong prohibitive provisions?

In the dispute between Jianghe Chuangjian Group (formerly Beijing Jianghe Muqiang), Xinghongda Group, and the Xuzhou Chengzhong branch of China Construction Bank in 2017, the court of first instance found the contract invalid on the grounds that the contract involved in the case constituted sub-subcontracting.

Although the court of second instance later held that the contract involved in the case did not constitute sub-subcontracting, and therefore the contract was valid, the court of second instance still accepted the prohibition of sub-subcontracting in principle, as to whether the sub-subcontracting contract would be deemed invalid in the case where the contract constitutes sub-subcontracting. At the same time, according to the authors’ search, in other similar cases most courts have held that if the contract constitutes sub-subcontracting, it violates the prohibitive provisions of the regulations, and is thus invalid.

Ignorance to laws and regulations of the country where the project is located. Because subcontracts between Chinese companies often stipulate that PRC law is the applicable law of the contract, and that Chinese institutions are the go-to dispute resolution institutions of the contract, local laws and regulations are often ignored. Article 41 of the Law of the Peoples Republic of China on Choice of Law for Foreign-related Civil Relationships stipulates that: “The parties may choose by agreement the law applicable to the contract.”

But at the same time, the law has special provisions and requirements for the legal capacity, capacity of conduct, real property rights, labour relations and tort liability of civil subjects in foreign-related civil relations. In addition, some countries also have mandatory provisions on the application of law in construction contracts. Therefore, for overseas project contracting, the application of PRC law is not set once and for all, and Chinese companies must pay attention to the relevant laws and regulations of the country where the project is located.

Two sets of contracts at home and abroad. In similar subcontracting design, the project is often implemented through two sets of contracts at home and abroad. That is, company A will enter into an overall construction and subcontracting agreement (including onshore and offshore work) with the applicable PRC law in China, and the local branch of company B will select the local sub-subcontracting company abroad, and then A branch will enter into a tripartite construction and subcontracting contract with the local branch of company B and the local construction company.

In the form of contract, company A / A branch subcontracts the same project twice, forming a domestic and foreign dual contract, which will bury hidden dangers to the implementation of the whole project.

To sum up, the current subcontracting arrangements between Chinese enterprises show that there is still a huge gap between Chinese enterprises and advanced international concepts, means and practices in project management. When Chinese enterprises contract overseas projects, they should give up the idea of sealing the deal first and considering execution later, but consider the contracting structure and contract structure of the project in advance in the bidding process, which should be reflected in the bidding documents.

Wang Jihong is a partner and Zhao Huiqi is an associate at Zhong Lun Law Firm.


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