If you are required to pay a deposit or make a prepayment before you can get the goods delivered by Chinese suppliers, then you need to beware of moral hazard. The best way is to find a trustworthy company and sign a good contract.

This post was first published in CJO GLOBAL, which is committed to providing consulting services in China-related cross-border trade risk management and debt collection.

This is because once you made the payment before getting the goods under the circumstance of no third-party guarantee, you are likely to face moral hazard from the supplier: the supplier may refuse to deliver the goods, delay the delivery, increase the price, or deliver the goods of lower quality.

In China’s business customs, when drafting the contract, the party in an advantageous position will be “Party A”(甲方, Jia Fang) and the party in a less favorable position will be “Party B” (乙方, Yi Fang). In daily communications, “Party A” generally refers to the strong party while “Party B” refers to the weak party.

In most transactions in China, the payer is “Party A”. Given there has always been an oversupply in the Chinese market, and the number of the party that makes the purchase and payment is relatively less than that of the opposite party, “Party A” is more powerful.

However, after payment but before delivery, the supplier will briefly become “Party A”, because it has the opportunity to commit fraud or breach the contract, or at least threaten the purchaser with the breach in order to modify the transaction terms or obtain additional benefits.

Especially when you are outside China and have no agent in China, some unscrupulous suppliers may take advantage of your inconvenience.

So, how to avoid the supplier’s fraud or breach?

1. Choose a trustworthy supplier

You can’t expect to choose a supplier who will strictly discipline itself and overcome the moral hazard. This is not what I call “trustworthy”.

What I mean is a supplier who keeps its promises driven by interests. Specifically, this kind of supplier “chooses” to abide by the contract because it will be most cost-effective for him.

Objectively speaking, in the Chinese market, there are few self-disciplined suppliers solely due to morality, whereas suppliers who keep their promises for interests are more likely to be found.

So, how can you figure out whether your supplier was the latter one?

Firstly, if the production and sales scale of your supplier is big, then it is very likely for the supplier to keep its promises for interests. Because in this case, it would be economically unwise for the supplier to earn any proceed from intentional breach of your “small orders”.

Secondly, when your supplier believes that you can continuously and stably place orders, they will abide by every order for the purpose of long-term cooperation. Therefore, if you can really bring them orders continuously, both of you will get a win-win situation.

Additionally, whichever type your supplier is, you are equipped with the ‘toolbox’ to counterbalance the supplier in case of intentional breaches. For example, you can present their bad records to other customers, or the pertinent industry association, or their marketing platform for business development (such as Alibaba). So, you’d better make good use of these means to prevent your supplier from breaching of contract.

2. Sign a contract to control moral hazard

This means that you should design a transaction structure that can control moral hazard and write it into the contract.

First of all, payment and delivery are the main control methods.

For example, the proportion of deposit or prepayment in the total purchase amount should never be too high. Besides, you should never pay the price in full in a lump sum before the supplier delivers the goods. The higher proportion of your prepayment in the total purchase amount, the more likely you will end up more like a “Party B”.

If possible, you’d better adopt the mode of the delivery batch by batch and payment for each batch delivered. This will procure the supplier to carefully complete the delivery of previous batches for the payment of later batches.

Of course, you can also use letters of credit to ensure payment security.

Secondly, the terms of the contract cannot be too detail-oriented.

In addition, you also need to specify every obligation of the supplier in the contract. This is because if the supplier finds any ambiguity, it will interpret and implement the clause most favorable to itself (possibly unfavorable to you).

You also need to describe the technical specifications of the product in detail so that when drafting the contract, you can even pretend that the supplier is an amateur. We have explained why in “How can I avoid being scammed on Alibaba: Take product nonconformity as an example”.

Finally, you need to ensure the enforceability of your contract.

You need to ensure that the terms of your contract can be upheld by the court whether the lawsuit is brought in China or in your country.

Finally, you’d better make clear in the contract that the dispute arising from the contract is under Chinese courts’ jurisdiction. If you win the case and the property of the supplier is in China, it will be most convenient to enforce a Chinese judgment in China.

We will introduce what kind of contract is enforceable in China in our following posts.

The Cross-border Trade Dispute 101 Series (‘CTD 101 Series’) provides an introduction to China-related cross-border trade dispute, and covers the knowledge essential to cross-border trade dispute resolution and debt collection.

Photo by Max Zhang on Unsplash

Contributors: Meng Yu 余萌

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