Be careful what you wish for.

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Gap in U.S. Law Helps Chinese Companies, for Now

Noah Feldman is a Bloomberg View columnist. He is a professor of constitutional and international law at Harvard University and was a clerk to U.S. Supreme Court Justice David Souter. His books include “Cool War: The Future of Global Competition” and “Divided by God: America’s Church-State Problem -- and What We Should Do About It.”
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Foreign governments can't be sued in U.S. courts. Foreign companies can. What happens when China's state-owned companies claim to be part of the government?

Nobody knows because the law is confusing, but some U.S. courts are taking the Chinese claim seriously. The Foreign Sovereign Immunities Act isn't well drawn to address the complex situation of Chinese companies and their relation to the government entities that control them.

There's a lot at stake. If a Chinese company wins the legal immunity of a government, it would gain a big advantage over American and other competitors. But a victory could also backfire, especially in a U.S. election year when concern about Chinese competition has become a campaign theme. Seeking special treatment in U.S. courts is an invitation to Congress to change the law and abridge the legal doctrine on which the Chinese companies are relying.

Historically, nearly all countries agreed long ago that kings wouldn’t sue each other. That sovereign immunity became a norm of international law and was later extended to national governments.

The words of the sovereign immunity law, which puts that principle into effect, are straightforward. They say that a foreign state can’t be sued in U.S. courts -- subject to several exceptions.

The most relevant exception for Chinese companies has three parts. It says that immunity doesn’t apply if the foreign government is carrying on commercial activity in the U.S.; if the suit involves an act in the U.S. connected with the state’s commercial activity elsewhere; or if the suit involves a commercial act elsewhere that “causes a direct effect in the U.S.”

The idea is to level the playing field. If a foreign state is acting as a commercial business, it isn’t supposed to get the unfair advantage of immunity from lawsuits.

But these exceptions, designed to cover situations where a government does business itself, don't fit easily with the innovative way the Chinese government organizes its state-owned enterprises.

The exceptions are meant to draw a clear line between passive state ownership, which doesn’t create liability, and active managerial control, which does. China’s companies operate in a complex, opaque system where it’s often unclear who’s running the show.

Two recent U.S. judicial decisions show this mismatch in different ways.

One, decided last year by the U.S. Court of Appeals for the Sixth Circuit, involved the Aviation Industry Corp. of China, a state-owned aerospace company. It was sued by Global Technology Inc., a Michigan company, which charged that the Chinese had breached a contract in the course of creating a new subsidiary called Yubei to purchase another U.S. firm that the Americans also wanted to buy.

A federal district court found that the Chinese company was engaged in commercial activity in the U.S., and allowed the suit to go forward. But the Sixth Circuit sent the decision back to the lower court for more fact-finding. The Michigan firm alleged that Aviation Industry Corp. controlled Yubei. Aviation Industry replied that Yubei made all its own decisions. Some court documents said that Yubei was a wholly controlled subsidiary. Others were fuzzier, with one saying that “a subsidiary of a subsidiary of a subsidiary of AVIC owns at least a minority stake (49%) in Yubei.”

The appellate court told the district court to dig into the details and figure it all out – based on evidence to be provided by the Michigan plaintiff. That made the case much harder for the Americans to win.

As a matter of law this may possibly have been correct. There's a difference between a wholly owned subsidiary and an independent company in which one entity owns a minority share.

But the sovereign immunity law is a bad fit for the complex interrelationships between Chinese companies. It makes little sense for Aviation Industries, which functions as a commercial company, to be able to avoid being sued by forcing a plaintiff to untangle the relationship it has with its subsidiaries.

The other case involved China National Building Materials Group, a state-owned building-materials company. A lawsuit alleges that Chinese-made drywall caused injuries in the U.S. But China National didn’t make the drywall. It was being sued on the theory that it was the parent of the Chinese companies that did.

A federal district court in Louisiana dismissed China National from the suit on the ground that the plaintiff had only demonstrated its indirect ownership interest in the companies that made and sold the drywall. To go forward, the court said, the plaintiff would have had to show that the parent company exercised “extensive, day-to-day control over its subsidiaries.”

Again, this decision was probably correct, legally speaking. But there’s still something fishy about the result. The Chinese building-materials company, like other state-owned enterprises, appoints the boards of its subsidiaries. Legal precedent treats this relationship as insufficient to show effective control. The sovereign immunity law, however, is based on mechanisms of corporate control and design that exist in the U.S. It doesn’t recognize the extent to which a Chinese company can act like a commercial entity, not a state actor, by manipulating its subsidiaries.

When a law doesn’t fit a new circumstance, the ordinary solution is to amend it. That means going to Congress, which the Chinese have plenty of reasons to fear right now. It must seem appealing to Chinese companies to instruct their U.S. lawyers to take advantage of legal confusion to win in court. But good tactics aren’t the same as good strategy. China’s government-owned companies should rethink their approach, or they may see the law amended in ways they won’t like.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Feldman at nfeldman7@bloomberg.net

To contact the editor responsible for this story:
Jonathan Landman at jlandman4@bloomberg.net