Contract law in China

Contract law in China

William Gamble

February, 13, 2001

General Motors wanted to try again. Its first effort at producing a light truck in the city of Shenyang in 1990 failed. This time it had greater support from the local government and more management control. Most important, it relied on its tightly written contract with its local partner. Its lawyers had been instructed to make sure every “i” was dotted and every “t” crossed. No surprises. But the new plant was in China, where contracts are always filled with surprises.

Just before the launch, “In a complicated transaction involving two local investment firms, the owner of GM's joint-venture partner, First Auto Works (FAW), China's largest manufacturer of motor vehicles, is unloading most of its stake in Jinbei GM to China Brilliance, a Hong Kong-listed company. ‘We don't really understand all the reasons why FAW decided to sell their holding, and we don't know the new company all that well,’ said Philip Murtaugh, chairman of GM's China operations.”^{^[1]}

General Motors has just spent $230 million; built a 34,000 square meter factory; hired 700 employees; started an enterprise that is supposed to last for six years; and it doesn’t have the faintest idea, who its new partner is or even why it has a new partner. This is the type of surprise that contracts are supposed to prevent.

Contract law at its most basic is about the future. It is about the future economic expectations of the contracting parties. In very primitive (or illegal) situations, contracts are not necessary. Performance takes place simultaneously. Food is bartered for pots. Drugs are bartered for money. Both parties test quality prior to the exchange, and walk away with their obligations fulfilled. The parties assess the risk on the spot and take the appropriate action. Transparency is not an issue. There is no need to reduce the contract to writing. Courts, judges and lawyers will not help the efficiency of the transaction.

If performance of either party takes time, the deal could be subject to either opportunism or changed circumstances or both. Since neither party knows if the other is crooked or if circumstances will change, the parties try to put limits to their risk in two ways. First, they record their bargain, so as to remember what exactly what the future payoffs would be. Second, they rely on a legal framework to protect them from opportunism and to provide for unforeseen contingencies.^{^[2]}

Risk assessment is crucial to the whole contract process, because it forms one of the basic components of the value of the transaction. For example, Li has a cow. Both Yang and Bo

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wish to purchase the cow. Yang can offer $5 now, cash. The cow is more valuable to Bo. He knows someone who is willing to pay a premium for the milk. If Bo had possession of the cow today, he could milk it, sell the milk and in a week pay Li $10 for the animal. A has to assess whether the $5 premium is worth the risk of waiting a week. The cow could die. Bo could skip town. Bo might not sell the milk.

If Li can rely on a legal system that will help him predict his risk, he will sell the cow to Bo. Since Bo can put the cow to its most valuable use, the overall economic system is more efficient. Assets are allocated in the most productive manner. Li will value the $5 premium to include the likelihood of changed circumstances (dead cow), the likelihood of opportunism (departed Bo) and the cost of enforcing the contract (expensive lawyer).

What is crucially important to Lin is to have enough information to determine the risk premium. How the legal framework frame work allocates risks is relative. If Li knows that he can recover for the dead cow he will factor that in his analysis. If he cannot recover, he will factor that information in as well and bargain for a higher premium. How risk and liability are allocated is not significant to the efficiency of the system. What is absolutely paramount is that Li knows the rules and they do not change.

The eminent economist and Nobel laureate, Ronald Coase, in one of the most famous arguments of modern economics, pointed out that it did not matter what the law was. What was important was that the rights of the parties were clearly defined and that the transaction costs were low. If these prerequisites existed, then Li and Bo would negotiate their bargain voluntarily. If the distribution of rights and duties change during the transaction, then the parties have no idea what the costs are and cannot bargain. Without a contractual legal framework, neither party has sufficient information to bargain with certainty. Transaction costs go through the roof. The high transaction costs will require either an enormous risk premium or the parties will not go through with the transaction at all. This is what basically occurs in China.

In China the problem is that the rules change, because of the discretionary power of the state or more precisely the arbitrary power of the Communist Party. Prior to the post-Mao reforms of the late 70's, contracts were viewed as extensions of the economic plan. Their sole purpose was to govern transactions between State-Owned Enterprises (SOEs). As such, they created duties but not rights. Disputes arising out of performance of these agreements were not settled in court. They were resolved by mediation of ministerial committees, local economic committees or the State Administration of Industry and Commerce.

Like all planned economies, prior to reform, the Chinese economy experienced widespread shortages and oversupplies caused by bureaucratic rigidities. The bureaucrats could not “obtain or process all of the information needed to calculate an optimal allocation or put it into practice”^{^[3]} Also, in any large bureaucracy information is lost and distorted in proportion or the size of the bureaucracy. To deal with the miscalculations in the plan, SOE managers had to break the law. A barter trade developed outside of the plan often in violation of state regulations. Since there was risk of punishment, the managers had to rely on close personal relationships to reach goals and comply with the plan.

When the post Mao reforms were introduced after 1978, the leadership perceived the need for market forces to supplement the central economic plan. With the introduction of market forces, there were more transactions outside the plan. With the guidance and restrictions of the plan, there was a need for parties to transactions to rely on contracts and contracts required a contract law.

The first round of reform came with the passage of the Economic Contract Law of 1981. Although the law was an improvement, it direction was more concerned with the importance of carrying out the state economic plan. “Contracts could still be used as administrative devices to regulate enterprises.”^{^[4]} The law provides various means for policy makers to supervise commercial transactions. The office of Notary, which had ceased to function after 1959 found new life. With the rebirth of private contracts, notaries were called into service to investigate the contract. Their job was to determine if the contract was in compliance with all regulations, if it was “practical,” in “the spirit of ‘equality’ and ‘mutual benefit’”^{^[5]} Even after the contract was signed, notaries had to investigate to be sure that the contract was performed.

The law was revised in 1986 and 1993. The most important and most recent revision occurred in 1999 with the enactment of the Contact Law of 1999. The Contract Law of 1999 is a vast improvement. It owes some of its origins to “importation of rules consistent with the United Nations Convention on Contracts for the International Sale of Goods”^{^[6]}(CISG). China became one of the early signatories to the convention and it came into force in China in 1988. The CISG itself has origins in American contract law embodied in the Uniform Commercial Code (UCC).

Nevertheless, the Contract Law of 1999 suffers from two potential flaws. First, the law tends to be ambiguous. Second, it allows for substantial state supervision. For example, articles 3, 5 and 7 require parties to treat each other fairly. Article 3 states that “neither party may impose its will on the other.” ^{^[7]} Article 5 states that “The parties shall observe the principle of equity in defining each other's rights and obligations.”^{^[8]} Article 7 requires that the contracting parties “may not disrupt the socioeconomic order nor impair social and public interests.”^{^[9]} Ostensibly, these provisions are fairly innocuous. They have parallels in older American contract law. Unfortunately, allowing contract rules to be based on a vague notion of what is fair or what disrupts the public interest invites a judge or a bureaucrat to rewrite a contract that has been agreed to by the contracting parties. A large profit, for example, might “disrupt the public interest.”

Even more onerous are sections in the Contract Law and other laws, which allow direct state supervision of contracts. These include article 52, which declares a contract invalid if it impairs or damages a State “interest^{^[10]}.” Article 51 of the Economic Contract Law allows the State Administration of Industry and Commerce to carry out supervision and examination of relevant economic contracts^{^[11]}. The law in China on Chinese-Foreign Contractual Joint Ventures Article 3 gives the state the right to “supervise” joint ventures. Part of their supervision includes the right to determine if the contract or the performance of the contract “injures the public interest of China” whatever they may be.

It is paramount that the law is viewed in context. The legal infrastructure that gives it life is often more important than the isolated words. If the law is vague, much of the enforcement depends on judicial interpretation. In many legal traditions, the principal obligation of a judge it is to give all parties to a lawsuit an impartial interpretation of the law and the facts. In China the role of the judge is almost reverse. A judge in China is expected to promote the political agenda of the government.

First, few lawyers are recruited as judges. The prime candidate for a judge was considered to be a PLA officer because “they like police, had been engaged in enforcing proletarian dictatorship and possessed the appropriate ideological outlook on their work”^{^[12]} Rather than a font of legal knowledge or a wise arbiter of facts, the model for a judge was a warrior fighting for state.

Of course warriors do not necessarily need knowledge of the law. In 1994 “about half of the judges in the country have not reached the level of a university legal education^{^[13]}.” A judicial college was established in Beijing in 1997. The Judges’ law of 1995 has set standards, but there is no set time in which to attain them. A legal education is still not necessary as long as the candidates have “professional legal knowledge” and have graduated from an institution of higher learning. In fact before the law was enacted, the perfect candidate was one with a high school education and no education or experience in the law.

Even if the judge was inclined to be impartial, he or she would have enormous difficulties because of the effect of local protectionism. The local Party committees and their First Secretaries exercise enormous influence over the courts both directly and indirectly. The appointment of a judge involves the local Party committee and the Party committee of the court. They report to the local Party committee. The local Party committee controls their pay and housing. The judges often consult with the local Party Secretaries and solicit their opinions. Local party secretaries are in charge of the local legal infrastructure including the judges, courts, police, prosecutors. If there is a conflict between the offices, the Party secretaries will resolve it. They also continue the practice of reviewing cases.

Finally and most importantly from a commercial stand point, “officials of the local Party frequently seeks to influence outcomes either to prevent local enterprises from suffering losses that would reduce the revenue of the local government or to protect parties to the dispute with whom they have a personal or economic relationship.”^{^[14]}

Another problem with the judicial process is that the courts are not considered a coequal branch of government. The judiciary is part of the executive branch. It is considered to be another aspect of the bureaucracy like a bank or another regulator. Therefore, its orders are often ignored by other branches of the bureaucracy or local government.

The result of vague laws and arbitrary enforcement is, that contracts in China do not have the ability to protect the parties from opportunism and to unforeseen contingencies. Information, the basis of any economic choice, is proscribed. Utilization of law as a tool of risk management is impossible. Without a legal framework neither the size of the company nor the experience of the parties can prevent disaster.

For example, a McDonalds store in Beijing had signed a contract with the city for the rights to use a particular site for 20 years. Unfortunately, someone with better connections, in this case Hong Kong tycoon Hong Kong tycoon Li Ka-shing, wanted to build an office residential complex on the McDonalds site. Between the time inception of the lease and the time of Mr. Li’s development in 1994, the value of the McDonalds site had increased enormously. It was therefore in the in the city’s best interest to redevelop the property despite McDonalds prior claim. The city’s economic interest won.

Mr. Li denied any responsibility for the dispute, and “added that he did not use any special privileges or contacts to get his way. ‘We have an understanding with the mainland government authorities which will be responsible for clearing the site for us,’ he told participants at a trade and investment seminar.”^{^[15]}

Rather than trying to enforce the contract in court, McDonalds chose to negotiate with Mr. Li’s organization and the city government. Even in the unlikely event that McDonalds was able to prevail in court, the power of a court to censure the activities of local government is extremely limited. The local government threat to deny a company ability to do business has exceptional leverage. Without the protection of contract, McDonalds bargained for premium disappeared. Despite its past experience, McDonalds agreed to forgo the contractually promised present profits flowing from the contract in hopes of future larger benefits.

Hong Kong Business man T. H. Koo was not the president of a multibillion dollar corporation, but he felt that he had something else going for him. Born in Shanghai, he was educated in China during the 1950s. Fluent in Shanghainese, Cantonese and Mandarin dialects, he started his business in Hong Kong in 1977 pursue opportunities in China. In 1989, Mr. Koo’s company, Novelact, signed a contract with Xiamen Special Economic Zone International Trade & Trust Co. then a state-run enterprise. Under the contract Novelact was to deliver 5,000 tons of fish meal to Xiamen's port in southern Fujian province. Xiamen then refused the cargo to be unloaded until Novelact accepted a 20% decrease of the price stated in the contract.

Rather than allow the fish meal to rot, Novelact agreed to the decrease in the contract price. The product was unloaded. Novelact then began to try to negotiate for the full contract price. When this failed, rather than forego its profits like McDonalds, it sued in the local intermediate court. Novelact won! In December 1992, the court ordered Xiamen to pay Novelact the price provided under the contract plus interest.

Unfortunately, Novelact never collected. First, it had to wait until it received a favorable decision in Xiamen’s counter claim. In theory the court should have heard and decided the counter claim in seven days. Instead, it took four years. Second, its successful result was stymied by an appeal by Xiamen to a higher court. Worse, the lawyer who represented Novelact in the first case, changed sides to represent Xiamen during the appeal.

“Mr. Koos believed the delay resulted from well-connected Xiamen International Trade managers exerting political pressure on the court to act in their favor. Xiamen International Trade executives deny using political connections in trying to resolve the court case.”^{^[16]}

Even if Novelact ultimately wins there is still no guarantee that they will collect the judgement. Even in the United States, collecting a judgement can be a major problem. Debtors around the world have a predilection for hiding assets from creditors. In China the

operation is hindered by the lack of clearly defined property rights. Without clearly defined property rights, the infrastructure that protects those rights cannot exist. For example, in the United States there are state and federal registries that keep track of title for all types of property. These include registries of deeds and mortgages for real property, registries for motor vehicles, corporate information and financing forms on file with the local state, patents and intellectual property on file with the federal government and shareholder lists for most listed corporations.

This information can and is used to determine credit worthiness and to collect debts. Once the location and title to the property are determined, it is possible to get a court to issue an order and levy on the assets. Without this information, it is impossible for a court to issue an order even if one assumes that the order would be enforced. In China the result is predictable. “Chinese courts now handle three million or so civil cases a year, but in 1997 there was a backlog of two million unresolved cases to which were added nearly one million additional cases the following year. By June of 1999, China had 850,000 unenforced court verdicts, a third of the total, involving sums amounting to 259 billion yuan (U.S.$31 billion).”^{^[17]}

Since the courts are basically ineffective in enforcing judgments, many litigants take the law into their own hands and utilize self-help. “In Hunan province, were verdicts in 100,000 civil in commercial disputes remain unenforced, frustrated litigants had taken the law into their own hands: people have persuaded their relatives or friends and gangster figures to enforce court verdicts by themselves. They kidnap hostages, detained motor vehicles, threatened, blackmail and injured debtors.’^{^[18]}

The failure of a contractual legal framework does not by mean that business does not take place. A contractual legal framework, enforced by the impartial court, whose orders are respected by local authority is the most efficient method to produce the lowest transaction cost. It is not the only means of doing business. Commercial transactions predate law and even writing by thousands of years. To fulfill the basic functions of a contract by avoiding opportunism and providing for unseen contingencies, parties to a transaction fall back on an ancient device: personal relationships.

Doing business with someone you know is common in any culture. If you know someone, well enough disclosure is not necessary. The relationship takes care of transparency. Even in the United States with its almost obsessive reliance on law, personal relationships are still very important in creating and continuing any business transaction. In China they are especially important.

The Chinese diaspora throughout Southeast Asia has over the centuries created commercial networks that have been enormously successful. These networks have one thing in common. The members of the network can all trace their lineage back to a single village in China. In fact many have returned. “The Indonesian Chinese tycoon Mochtar Riady of the Lippo group who took out a lease on 14 square miles of coastline near his birthplace at Putian in Fujian province. Another Indonesian billionaire, Liem Sioe Liong is also building an new city industrial zone in his ancestral home in Fuqing.”^{^[19]} “Over the past 20 years, China has attracted nearly US$260 billion in utilized foreign investment, with over 70% of this investment coming from overseas Chinese, including those from Hong Kong, Macao and Taiwan.”^{^[20]}

In the walled city of Pingyao, there is a museum house of the Qiao family. “The House of Qiao was a commercial empire that included 18 businesses trading in oil and vegetables, 200 shops, several coal mines and a bank with 20 branches across China.”^{^[21]} To facilitate business relationships they staffed their organization with family members, who actually lived together. “At the peak of its glory 70 members of the clan lived in the house waited on by 170 servants”^{^[22]}

Even in the Communist era doing business with personal friends and family was a necessity. Before the reforms of 1978, the personal contacts between managers of state-owned enterprises were indispensable. It was impossible for the Communist bureaucracy (or any bureaucracy) to obtain and fully process all of the information necessary to organize the economic system. Worse, information necessary to make economic decisions was and still is tightly controlled. So shortages and rigidities often arose. In order to make process work, managers would barter to provide the basic materials essential for the functioning of their businesses. Since this type of collusion was in violation of state regulations, the managers would have bartered only with other managers with whom they would have had a close personal relationship.

The problem personal relationship as a substitute for a legal framework is the problem consistency. Doing business with someone you know works because you have developed a personal relationship based on trust. Unlike (at least the ideal) of law, personal relationships can be uneven. Trust can diminish overtime. In a recent paper, researchers asked subjects to play a game where the most efficient outcome required trust. As the game was replayed the researchers found that the level of trust diminished. In another study researchers found that trust diminished substantially between players of different races and nationalities. Taken together, it “seems that trust is a fragile thing, prone to break down altogether.”^{^[23]} An economic system based on personal relationships and trust can operate, but as time passes it becomes less and less efficient and trust diminishes along with choice.

Like Russian in the pre-reform Chinese Communist system, fear could be over come and trust could be built through covert relationships. The covert relationships do create a problem. The problem is transparency. Parties to the transaction did not necessarily know other parties within to the network. Without information, it is impossible to determine which party to contact and their relative power. You always run the risk that you’re contacting the wrong person with the wrong incentive. This is especially true even in present day China. For example, there was the case of Robert Chua.

Mr. Chua began producing television shows in Hong Kong in 1967. In 1974 he started his own production company. By 1979 he became the first foreigner to sell TV ads in China. In 1995 he began China Entertainment Television, CETV and began to broadcast his channel into China by satellite.

Mr. Chua was a strong believer in the Chinese methods of doing business. Based on personal connections, the concept of the guanxi is at the core of many deals. He was very careful to try and make the right connections within China. To ensure that nothing he or his channel did displeased any powerful individual in China, he did not broadcast any news, any sex or any violence. He even broadcast China’s National Day Celebrations in full.

When he started CETV “he offered advice to western broadcasters seeking to operate in China: ‘Most companies are sold on anyone who claims to be a China expert. They think they have a successful deal when they actually do not. They must check whether those people are respected in China”^{^[24]} Unfortunately, he was unable to heed his own advice.

The problem with CETV was that there was no way to determine the number of viewers. Although Mr. Chua claimed 33 million viewers, there was no reliable way to confirm the figures. In order to provide reliable numbers, it was necessary to get permission to send his programming over local cable channels into China. Unfortunately, Mr. Chua’s guanxi was not as great as he’d hoped.

The cable contract went to someone with far greater guanxi, Rupert Murdoch. Mr. Murdoch was and is the head of a media empire called News Corp. Despite his run-in with the Chinese authorities in 1993, he became the new best friend of Tung Chee-hwa, Hong Kong’s new Beijing appointed chief executive. Mr. Murdoch was able to get access to the cable system of Guangdong. His mandarin language channel, Phoenix, soon had 36 million viewers throughout China and advertising revenues to match. Mr. Chua was denied access.

He got nothing.

In order to get his television connection, Mr. Chua needed to jump start his guanxi with a Chinese partner. Through recommendations he found Mr. Kan. Mr. Kan was reputed to employ 6,000 people, was named one of the 10 best producers in China and had created more than a thousand television dramas. He also was said to own hotels and restaurants. Even better, he had connections with Yang Weiguang Vice Minister of China’s Ministry of Film, Television and Radio, head of CCTV and chairman of Chinese Television Artists Association. Mr. Kan, with Yang Weiguang as one of the investors, agreed to purchase CETV for $34 million. The contract was signed in October 1997.

By December the deal was dead, and Mr. Chua never knew why. Mr. Kan never explained nor signed a release to allow Mr. Chua to look for other partners. When Mr. Chua threatened to sue, Mr. Kan rebuked him. A law suit was not very Chinese. Mr. Chua’s personal relationships were never able to replace the need for a contract.

But even Mr. Murdoch’s guanxi met its match. In February 2000 a battle developed to control Cable & Wireless HKT, Hong Kong's dominant telecommunications group, Mr. Murdoch and his ally, Singapore Telecom, lost out to Mr. Li, the 33-year-old son of Li Ka-shing. With the support of the Bank of China and its government allies, Mr. Li was able to gain control of HKT and dispatch Murdoch with the same ease as his father had dispatched McDonalds.

Mr. Murdoch did learn his lesson. The next time he tried to gain access to the Chinese telecommunications market, he found the best quanxi available. Mr. Murdoch purchased a stake in China Netcom. Netcom connects 17 large Chinese cities with fiber optic cable and represents China’s most advanced telecommunications infrastructure. The best part about China Netcom is that it is backed by Jiang Mianheng eldest son of Jiang Zemin, China’s president. Jiang Mianheng who sits on Netcom’s board it was also courted by Sumner Redstone, chief executive of Viacom and Gerald Levin CEO of AOL Time Warner. Jiang began and is also deputy head of the ministry of railroads and a branch of the Shanghai government. “Chinese law does not permit direct equity participation by foreigners in domestic telecoms companies. Details of how this regulation has been circumvented were unclear.”^{^[25]}

Although Mr. Murdoch appears to have cornered the ultimate quanxi, he should be aware that the power of quanxi may be limited in time. Jiang Zemin’s term expires shortly. His son’ s power to circumvent regulations may expire as well. When Deng Xiaoping died in February 1997, Deng Pufang and his son-in-law Wu Jianchang both became the subject of the securities fraud investigation by the CSRC. When Jiang Zemin steps down, Mr. Murdoch may find that his deal is contrary to Chinese regulations after all.

Reliance on government connections rather than legal frameworks can create arbitrary results in a number of ways. Competition for government favors from private individuals and firms, leads to unpredictable outcomes especially when the government’s policy is inconsistent. This can occur in a number of ways. There can be problems of local government enforcing rules, laws, orders or regulations from another branch of government. Different agencies or bureaucracies can have conflicts. The most dramatic are conflicts at the very center of power. Some of these conflicts can have unexpected results.

Parco Productions, of Hong Kong has a contract with Air China, the Chinese national air carrier. Parco was to publish "Air China” an in-flight magazine and Air China was to carry it exclusively on its flights between China and Hong Kong. Civil Aviation Administration of China (CAAC), China's aviation regulator published a rule that required Air China had to carry the CAAC publication “CAAC Inflight Magazine", a rival Hongkong publication.

Parco sued Air China in the Beijing intermediate people’s court for breach of contract. Air China countered with a defense of Force Majeur, since they were required by an administrative agency of the government to break the contract. Parco won! The court held that the contract was valid. Air China’s defense was insufficient because the order of the CAAC was only an internal document and did not have the validity of administrative rule.

It appears that in enforcing the contract, the court was strengthening the validity of contract law in China. There was another possible explanation. “An analyst, who declined to be named, saw the court victory as a signal from the Chinese authorities not to be embroiled in any commercial dispute ‘even if it involved a regulatory giant such as the CAAC. The CAAC clearly has its hands in this mess. With the court decision, people in the Chinese aviation industry would want to see whether it would now back off”^{^[26]} This case shows that sometimes there are limitations to bureaucratic actions in China. However, those limitations are rarely based on the law. Usually, they are simply based on power.

Unicom was created in 1993. Since its original 13 shareholders included the ministries of electronic industry, railways and power, along with powerful state-owned firms like Citic and China Merchants, it was considered a sure success. In addition, the new company was midwifed by Vice-Premiers Zou Jiahua and Zhu Rongji. Unfortunately, it also had a very powerful enemy, the Ministry of Posts and Telecommunications(MPT)[in the 1998 reorganization the MPT became the Ministry of Information Industry or MII] the former telephone monopoly.

Unicom backers originally proposed originally the second carrier, because they contended that MPT/MII was so inefficient it could not keep up with demand. In order to stimulate competition and improve service of telephone service, the State Council approved the project over the strong objections of MPT/MII, who felt that any competition was unnecessary.

MPT/MII never forgot. In order to appear impartial, MPT/MII in 1996 spun off its telecoms activities into the supposedly autonomous China Telecom It was able to restrict competition with China Telecom by blocking Unicom’s access to its mobile phone network for two years and access to its fixed line service for three years. It wasn’t until the State Council delivered ultimatums to MPT/MII that it actually allowed Unicom to tap into its networks. Until then Unicom subscribers could only talk to each other.

Part of the problem with Unicom was that although it had powerful backers, each of its shareholders had a different agenda for Unicom and none of them wanted to upset their relationship with MPT/MII. The only thing they agree upon was that they wanted to use Unicom to get money from foreign investors. As always, the idea of a billion customers was an incentive that few foreign telecommunications companies could resist.

There was a problem. Foreign investment in the telecommunications industry was illegal. To get around the prohibition, Unicom created what it called China-China-Foreign (CCF), joint ventures with 43 foreign investors include Sprint International, Deutsche Telekom, Bell Canada International Inc., France Telecom, Siemens, Marubeni and NTT of Japan. Under these contracts, Unicom gave the foreign operator a revenue-sharing agreement with a fixed return on investment as high as 30% . In addition, the foreign operator may have a management consulting/training contract, which was paid for separately. There also may have been a fee paid for using the operator’s hi-tech equipment.

Unicom also sliced its projects into small units. They wanted to get around a rule that required State Planning Commission approval for any deal that costs more than $30 million. Since support for Unicom in the State Planning Commission was not universal, its approval was not guaranteed. Also, the the purpose of the CCFs was to give the impression of distance between the foreign company and the Unicom operation.

It didn’t work. In 1999, Wu Jichuan, the powerful minister of the MPT/MII took revenge on Unicom and its foreign backers. All of the contacts were ordered to be “revised”. Rather than receiving the expected 30% return, the foreign investors were told that their return would be only 6 to 8 %. Most companies decided to take the offer rather than be shut out of future deals. A few including Korea’s Daewoo, SIT from Singapore, Welcom and Lark Telecom Services threatened to take legal action.

The law suits never took place. To raise capital, Unicom planned an IPO. The disgruntled former partners threatened to block the offering. Rather than delay, Unicom reached tentative settlements with the claimants in early June. On June 21, 2000, Unicom was able to issue stock in an IPO in Hong Kong and New York and raised $5.6 billion.

So at the end of the day nothing works. Neither experience in China, government contacts, personal contacts, high government position, good lawyers, bribed judges, corrupt bureaucrats, there is no substitute for an effective legal framework. Without contracts and the infrastructure to enforce them, there is no way for the parties to protect themselves from opportunism and unforeseen contingencies. As McDonalds, GM, Sprint International, Deutsche Telekom, Bell Canada International Inc., France Telecom, Siemens, Marubeni, NTT, Mr. Chua and Mr. Koo discovered, without a contract framework transaction costs go through the roof. The high transaction costs will require either an enormous risk premium or the parties will not go through with the transaction at all, which is what has occurred.

As the Coase theorem predicts, the efficiency of the entire economy is diminished. “In spite of years of effort, the creation and subsequent dissolution of several foreign ventures in China, there is now only one Chinese-foreign project in one of the world's largest markets for telecoms services. And that, a value-added service venture between local authorities and AT&T in Shanghai's Pudong district, is not yet up and running”^{^[27]} Despite a booming export market fueled by a seemingly inexhaustible supply of inexpensive labor the lack of a legal infrastructure that protects contract is beginning to have a very definite effect. The transaction costs of doing business in China require an almost prohibitive risk premium. Eventually, businesses will decide that despite the size and potential of the market it is simply not worth it.