Shanghai Kai-Rong Law Firm

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1 Client Update July 2009 Shanghai Kai-Rong Law Firm By Jin Yu-Lai Supreme People s Court of PRC issued new interpretation on Contract Law Contents: Change of circumstances 1 Standard clauses 2 Compulsory provisions on 3 Effectiveness Approval or registration 3 Formalities Liquidated damages 4 The order of repayment for 4 Debts On April 24, 2009, the Supreme People s Court of PRC ( SPC ) issued the second judicial interpretation in respect of the 1999 PRC Contract Law, which took effect on 13 May The Interpretation 2 is deemed to be a counter-measure to the global financial crisis, which covers a wide range of issues relating to the conclusion, validity, performance, termination and breach of contracts. The Interpretations apply to disputes in relation to contracts entered into after the Contract Law took effect and in respect of which no final appeal has been concluded as of the effective date. Some important changes contained in this Interpretation are listed as below: Establishing the principle of Change of circumstances The principle of Change of circumstances was left out of the final version of Contract Law by PRC legislative body because it was concerned about the discretionary power of the judges in determining contract disputes. However, the absence of this principle had presented difficulty for courts in trying contract cases when a party's failure to perform the contract was caused by a significant change of circumstances. The Interpretations, in Article 26, purport to change the situation by clarifying that the court's right to vary a contract or declare a contract discharged extends to a situation where: (i) significant change occurs after the formation of a contract; (ii) the change could not be foreseeable at the time of the contract; (iii) the change is not caused by force change could not be

2 Foreseeable at the time of the contract; (iii) the change is not caused by force majeure and is not a commercial risk; and (iv) due to the change, continuous performance of the contract is obviously unfair to the other party or cannot realize the purposes of the contract. Many commentators view this article as specially dealing with circumstances caused by the present global financial crisis. To avoid courts abusing this principle and affect the order of market unnecessary, the SPC further stipulated in other interpretations that: a. if the dispute relates to some commodities actively traded in market and easily subject to price fluctuation for a long time, such as oil, coke, non-ferrous metals etc, or financial products relating to risk investment, such as shares, futures etc, the court shall be much more cautious in applying this principle; ; b the courts shall guide actively the relevant parties to re-negotiate and revise their contract, or, failing this, to settle through mediation; and; if eventually all the aforementioned efforts fail and a court is to apply this principle, it shall report level by level to a high people s court for approval, or even to the SPC. Clarifying the requirements for standard clauses Under Article 39 of the Contract Law, a party that provides standard form clauses has the obligation to draw the other party's attention to limitations and exclusions of liability and explain them on request. Article 6 of the Interpretations clarify how this obligation may be satisfied: Where, at the time of concluding a contract, the party providing the standard clauses adopted special characters, symbols, fonts and other signs sufficient to arouse the other party s attention to the content of the standard clauses regarding liability exemptions or restrictions in favor of the party providing the standard clauses, and made an explanation of the standard clauses according to the requirements of the other party, the people s court shall determine that the requirement of a reasonable way in Article 39 of the Contract Law has been satisfied. The party providing the standard clauses shall bear the burden of proof on its/his fulfillment of the obligation to make reasonable prompting and explanation. This clarification is a piece of good news for those companies providing standard clauses, such as insurance companies, banks, airlines, which may standardize their standard clauses in accordance with this requirement. It shall be noted that the obligation to draw the other party s attention is to be fulfilled when concluding the contract, 2

3 Client Update rather than any other time. Dividing compulsory provisions into compulsory provisions on administration and compulsory provisions on effectiveness As per articles 52 (5), Contract Law, a contract shall be null and void if violating the compulsory provisions of laws and administrative regulations. In practice, many courts abused this stipulation and nullified many contracts that should have been held valid and enforceable. To avoid this situation, SPC provides a further gloss on compulsory provisions, explaining that "compulsory provisions" can be divided into compulsory provisions on administration and compulsory provisions on effectiveness, and that "compulsory provisions" in the article 52 (5) of the Contract Law only refers to those provisions of PRC law which expressly provide that failure of compliance will render the relevant contract null and void. For example, under article 16 of the Company Law, if a company intends to invest in any other enterprise or provide guarantee for others, it shall be decided at the meeting of the board of directors or shareholders or shareholders' convention. This stipulation only relates to the internal governance of a company, the violating of which will not and shall not nullify an investment or a guarantee made by the company without such a procedure. Innovating the liability for Wrongs in Conclusion of Contract As per article 8 of the Interpretations, after the formation of a contract which does not become effective until it is approved or registered under a relevant law or administrative regulation, if the party which has the obligation to apply for going through the approval or registration formalities fails to apply for approval or registration under the relevant law or contractual provisions, such a failure shall fall within the scope of any other act in violation of the principle of good faith, and the people s court may, as the case may be and upon the request of the opposite party, rule that the opposite party shall go through the relevant formalities by itself; however, the other party shall be liable for compensating the opposite party for the expenses incurred therefore and the losses actually caused to the opposite party. This stipulation is an innovation for liability for wrongs in conclusion of contract, i.e., the doctrine of culpa in contrahendo (obligations in negotiation). 3

4 It is often found from past trials that after a contract was concluded, if the market had a large price hike (such as real estate market), the party which has the obligation to apply for going through the approval or registration formalities may refuse or postpone intentionally to apply for approval or registration, thus to prevent the contract from coming into effect. Such act certainly would cause damage to the other party, but as the contract had not been effective, the other party may no rely on the contract to ask the damaging party to bear relevant liability for breach of contract, but can only have the same bear liability for wrongs in conclusion of contract, which mainly are compensations based on actual losses. The Interpretations had taken into consideration such circumstance and stipulate that the other party may go through the relevant formalities by itself, which is an innovation. But as this stipulation relates to the powers and procedures of the departments in charge of the registration or approval formalities, its application remains to be seen. Fixing the standard for liquidated damages The Contract Law generally allows contracting parties to prescribe a fixed amount of liquidated damages or a method for calculating such damages. There are certain exceptions to this principle, including where the amount of liquidated damages agreed in the contract is lower or excessively higher than the actual losses suffered by the aggrieved party, either party may petition the court or arbitral tribunal to increase or reduce the amount to an appropriate level. Article 28 of the Interpretations determines how courts may exercise this power: (1) liquidated damages may only be increased up to the amount of the actual loss, and no further claim for losses may be allowed; (2) the Court may deem liquidated damages "excessively high" if they exceed the actual loss by 30%; and (3) when reducing excessively high liquidated damages, the Court must take the actual loss as its starting point, but must also consider other factors such as performance of the contract, the degree of each party's fault and expected profits, and make a decision "weighing the principles of equity and good faith." This provision makes the outcome of disputes over liquidated damages clauses somewhat more predictable than before. Elucidating the order of repayment for debts Article 20 of the Interpretations elucidates the order of repayment for debts as follows; 4

5 a. if there is any agreement between the creditor and debtor on the debts to be paid off or on the order of repayment to offset the debts, such agreement shall prevail; b. if no agreement, the repayment shall first offset a due debt; c. if several debts are all due, it shall first offset the debt for which no guaranty is provided to the creditor or the guaranty provided to the creditor is in the smallest amount; d. if the amounts of guaranty for the debts are the same, it shall first offset the debt with a heavier debt burden; e. if the debt burdens are the same, it shall offset the debts in the order of the dates of maturity of the debts; f. If the dates of maturity of the debts are the same, it shall offset the debts in proportion. Shanghai Kai-Rong Law Firm, a leading law firm specializes in international trade, shipping and aviation, insurance, finance and commerce, has been and will continue to be committed to serving clients both domestic and overseas with unmitigated zeal and great professionalism. For further information concerning this topic, please contact: Mr. Jin Yu-Lai / Managing Partner Tel: Fax: jinyulai@skrlf.com This newsletter is intended to provide general information on issues which may be of interest. It is not intended to provide specific legal advice. Further advice should be taken before relying on the contents of this summary. 5