On 13 May 2009, the Supreme People's Court's Interpretation on Several Issues Concerning the Application of the Contract Law (II) ("Interpretation") came into effect. The Interpretation sets out further rules explaining the Contract Law and related legal remedies. This article highlights some of the key provisions of the Interpretation which relate to:

• Liability for bad faith in negotiations;
• Post-contract substantial change in circumstances;
• Modification of liquidated damages; and
• Creditors' rights to invalidate debtors' actions.

Although there is no system of binding court precedent in the PRC, this Interpretation will have significant persuasive effect on courts considering related issues.

Key changes introduced by the Interpretation

Liability for bad faith conduct during negotiations

Article 42 of the Contract Law provides that a party is liable for loss caused to the other party during the course of concluding a contract if it: 

• negotiated in bad faith under the pretext of concluding a contract;
• deliberately concealed an important fact relevant to the conclusion of a contract or provided false information; or
• engaged in an act counter to the principle of good faith.

Under relevant PRC laws and regulations, some types of contract, for example, share transfer contracts, are concluded upon the signing of a contract but only become effective upon approval or registration by the relevant government authority. In circumstances where a party refuses or delays its part in an approval or registration process and therefore prevents the effectiveness of the contract, it has previously not been clear whether Article 42 applies and, if so, what the remedy may be.

The Interpretation clarifies that a deliberate refusal or delay in obtaining government approval violates the principle of good faith under Article 42 of the Contract Law. It provides that the People's Court can direct that the other party proceed to apply for the approval or registration; and that the party violating the principle of good faith shall be liable for actual damage and costs of the other party caused by its misconduct. The Interpretation does not provide any guidance on calculating actual damage and it remains to be seen whether loss of profit is included.

Change of circumstances

The Interpretation introduces the concept of "change of circumstances" which appears similar to the common law doctrine of frustration of contract. Parties will be allowed to apply to the People's Court to modify or terminate the contract where:

• after the contract is concluded, a substantial change of circumstances occurs;
• the change of circumstances is unforeseeable when the contract is concluded;
• the change of circumstances is not caused by force majeure (which situation is dealt with by separate statutory provisions in the PRC);
• the change of circumstances is not a commercial risk; and
• it is obviously unfair to a party or the purpose of the contract would be frustrated if the parties continued to perform the contract.

The Interpretation further provides that the court shall decide whether the contract shall be modified or terminated according to the principle of fairness on a case by case basis. Recent adverse economic circumstances may well lead to claims of this nature. The extent of change required to trigger relief remains uncertain, and the power to adjust contracts will, no doubt, be a factor raised in a number of attempts to renegotiate contracts.

Modification of liquidated damages

Article 114 of the Contract Law provides that a party may petition the People's Court or an arbitration commission to increase the amount of liquidated damages if the sum stipulated in the contract is lower than the loss incurred. Similarly, if the amount of liquidated damages stipulated grossly exceeds the loss incurred, a party may petition the People's Court or an arbitral institution to reduce the amount as appropriate.

The Interpretation provides guidance on the application of this rule and states that:

• liquidated damages of 30% more than the actual loss incurred can be considered to grossly exceed the loss incurred triggering the courts power to reduce the amount of the liquidated damages;
• if the liquidated damages amount is lower than the actual loss, the court can increase the amount of the liquidated damages up to the amount of the actual loss. After the modification of the liquidated damages, the aggrieved party cannot seek any additional compensation for its loss.

In deciding on how to modify the amount of liquidated damages, the Interpretation provides that the court will consider the following factors:

• actual loss;
• circumstances surrounding performance of the contract;
• fault;
• anticipated profit or interest; and
• principles of fairness and good faith.

This feature of PRC law is sometimes surprising to companies used to common law rules. Emphasis on drafting the damages provisions and calculating estimated losses can lessen the impact of this approach. It also reinforces the need to keep appropriate contemporary records to prove actual loss.

Certain third party transactions invalidated

Article 74 of the Contract Law provides that a creditor can petition the People's Court to invalidate the following transactions if the act caused the creditor to suffer damage:

• the debtor waives his debts which are due and payable;
• the debtor assigns property without consideration to a third party; or
• the debtor assigns property at a price which is unreasonably low, and the assignee is aware of such circumstances.

The Interpretation identifies additional areas of conduct which can be invalidated by the People's Court including:

• the debtor waives debts not yet due and payable;
• the debtor waives the security for his debts;
• the debtor deliberately delays collection of due and payable debts; or
• the debtor purchases property from a third party at a price which is unreasonably high.

The court will decide whether the price of the transaction is unreasonably low or high by considering the standard of ordinary business operators, guide price of the local government, market price and other relevant factors. If the price of the transaction is lower than 70% of the guide price or market price, this is considered unreasonably low. If the price of the transaction is 30% higher than the guide price or market price, this is considered unreasonably high. Parties making purchases need to be conscious of this risk. Obtaining appropriate valuations at the right time would also be a prudent precautionary step.

 

 

Supreme People’s Court issues Direction on dealing with several issues in civil and commercial contract disputes

On 7 July 2009, the Supreme People’s Court issued its Direction on Dealing with Several Issues in Civil and Commercial Contract Disputes (“Direction”). The Direction provides practical guidelines for the lower courts when applying the Contract Law and the Supreme People’s Court’s Interpretation on Several Issues Concerning the application of the Contract Law (II) (“Interpretation”) which became effective from May 2009 (see our previous Client Alert of June 2009).

In this alert we highlight some of the key issues covered by the Direction.

These relate to:

• Post-contract substantial change in circumstances;
• Modification of liquidated damages;
• Loss of profit; and
• Validity of contracts violating mandatory provisions under PRC laws.

Key changes introduced by the Direction

Change of circumstances

The Interpretation provides that if there is a “change of circumstances” after the contract is concluded, the parties are allowed to apply to the People’s Court to modify or terminate the contract. The change of circumstances should be unforeseeable.

The Direction confirms that the courts are required to take a strict view when applying the principle of “change of circumstances”. If the nature of the contract indicates that the parties should have foreseen the change of circumstances, the principle cannot be applied. Specifically, if the subject of the contract includes products such as petroleum,  coal or minerals which attract fluctuating market prices, or financial products such as stock and futures which are high risk investments, the principle of “change of circumstances” should generally not be applied.

If a court considers that the principle of “change of circumstances” should be applied, it is required to seek the approval of the local Higher People’s Court or Supreme People’s Court.

Modification of liquidated damages

Under the Contract Law, a party may request the court or arbitration commission to modify the amount of liquidated damages if the sum stipulated in the contract is lower or grossly higher than the loss incurred.

The Direction provides that where the party in breach of the contract does not request the court to reduce a ‘high’ amount of liquidated damages, the court itself can raise the possibility. This would encourage parties to request reduced liquidated damages and will likely increase the number of adjustments to be considered by the courts. As that process involves proving actual losses, contemporary records are essential and should be maintained.

Loss of Profit

In the past, there have been different views on the scope of loss of profit and its calculation. The Direction provides some further guidance identifying recoverable types of loss of profit which include:

• loss of profit in production, e.g. the buyer’s (manufacturer) loss of profit due to the seller’s failure to deliver equipment or raw material for the production;
• loss of profit in operation of business, e.g. loss of profit due to breach of lease or breach of contract of providing service or labor; and
• loss of profit of resale, e.g. the buyer’s loss of profit in the anticipated resale due to the seller’s breach of the sales contract.

When calculating loss of profit, the courts are also required to apply the following rules save where the parties have agreed on how to calculate the loss of profit or for certain disputes such as fraudulent operation of business and personal injury.

• The loss of profit should be limited to the loss which the party in breach could foresee or should have foreseen when the contract was concluded. The damaged party bears the burden to prove that the loss was foreseeable by the party in breach of the contract.
• After a party breaches the contract, the injured party must take appropriate measures to mitigate the loss. Increased losses caused by failure to mitigate are irrecoverable.
• Any benefits gained by the injured party should be set off against the loss of profit.
• The loss of profit should not include the loss due to the injured party’s fault.

This guidance implies that loss of profits will be increasingly supported by PRC courts. However, proof of foreseeability of the loss and the amount of loss will be required and  could prove challenging. This can be addressed, and the impact lessened, during drafting of the damages provisions and in communication of estimated losses.

Validity of contracts in violation of mandatory provisions under PRC Law

The Contract Law provides that a contract in violation of mandatory provisions under PRC law is invalid.

The Direction further explains that if the contractual act under the mandatory provisions will harm state or social interests, the contract will be invalid for violating mandatory provisions. However, if the mandatory provisions are to regulate certain “market access” qualifications or certain acts for performing a contract, the court has discretion to decide whether a contract is valid depending on the specific circumstances of the case. This allows some contracts to remain valid despite having violated mandatory laws. Recent decisions handed down by the Supreme People’s Court provide useful insights in this area. For example, a transportation contract signed by a carrier without a carrier qualification required by mandatory regulations was concluded to be valid. Similarly, a building contract, where a mandatory prerequisite of at least 25% of the total investment in a development was not satisfied (but which was subsequently fulfilled by the time the court had tried the case), was also decided to be valid. Such an approach is welcome as it upholds those contracts which have been effectively entered into and in the event of a breach of contract, parties would be able to seek redress as appropriate within the contractual terms and/or the Contract Law.