China: News In Chinese Contract Law

Interpretation of the Supreme People's Court addresses limitation of liability in standard terms, liability for unauthorised agent actions, frustration of contract, limits on liquidated damages and settling debts

The Supreme People's Court ("Court"), the highest legal authority in China, issued its second Interpretation of Several Issues Concerning the Application of the Contract Law, effective as of 13 May 2009 ("Interpretation"). The importance of the Interpretation is related to the widespread applicability of the Contract Law, and we discuss below the legal issues addressed in the Interpretation that are most important to businesses in China.

1. Limitation of liability in standard terms and conditions

Standard terms and conditions face especially strict legal scrutiny, as they can potentially affect a large number of contracts and are often used in situations where one party is in the position to impose its terms on the other party. And it is wrong to assume that merely supplying the other side with completely one-sided terms is a good strategy. Prudence dictates that the supplying party provide terms that are fair to the other side and make sure that the other side also understands them.

In the Interpretation, the Court selected limitation of liability clauses as a type of standard term that requires special graphic treatment in a contract. The Court notes that Article 39 of the Contract Law requires special marking for any limitation of liability and suggests doing so by using text, punctuation and typeface. We believe that choosing a conspicuous colour, a bigger font size or another graphic marker should also be acceptable ways of ensuring that the limitation of liability stands out from the rest of the terms.

Upon the other party's request, the party who supplies the standard terms is obliged to explain them. The Court places on the party who supplies the terms, the burden of proof for the provision of the requested explanation. If your company receives any queries about your standard terms and conditions, document your replies so that you can demonstrate your fulfilment of this obligation should the matter go to court.

Chinese law does not recognise limitations of liability for bodily harm or damage caused by intentional or gross negligence.

2. Liability of an agent without power of attorney

Article 49 of the Contract Law holds that a contract concluded by an agent without an adequate power of attorney is valid as long as the other party had reason to believe that the agent was authorised to represent the principal. That means your company will have to honour a contract that may have been signed by an unauthorised representative. While the Interpretation confirms this principle, it asserts that the agent will be liable to the principal for losses incurred due to the agent's misrepresentation.

In theory, this will allow you to recoup losses incurred because of such misconduct. In practice, because the agent may abscond or simply lack funds to cover the loss, it may be difficult to pursue such claim. Therefore, you should make sure to have employees and other representatives return any documents regarding their power of attorney when they are no longer necessary for their work. In addition, you should strictly control the use of the company seal since in China such seal has the same effect as the signature of the legal representative. Also, if your representative oversteps his or her authority, rather than simply honour the contract, indicate to the other party that, although you intend to fulfil your obligation, the representative lacked the authority to represent you in the manner or to the extent presented. This will help to avoid creating the false impression that you authorised the representative's actions.

3. Frustration of contract and material change

The Interpretation for the first time officially confirms the concept of frustration of a contract due to changed circumstances. While this possibility had previously only been discussed in light of Article 4 of the General Principles of Civil Law and Articles 94 and 117 of the Contract Law, the legal basis remained unclear. The Interpretation now lays out the conditions under which a court may change or rescind a contract that has been rendered obviously unfair or can't be realised at all because of a change in objective circumstances which

• was unforeseeable for the parties at the time of conclusion of the contract;
• was not caused by force majeure; and
• can not be attributed to the commercial risks of either party.

The court will remedy such a situation with regard to the principle of fairness and actual conditions.

It remains to be seen how this will actually be implemented by Chinese courts. While the Interpretation seems to set relatively tight requirements as preconditions for finding material change, it also confirms the practice of Chinese courts to use the concept of fairness to reach a verdict they consider equitable to both parties. It also remains to be seen what kind of contracts will be considered "obviously unfair" by the courts.

Although the Interpretation explicitly excludes "commercial risks", it is likely that parties whose business model is damaged by unforeseen risks will claim frustration of contract. Courts generally, for example, refuse to honour a party's attempt to modify contract terms unilaterally in the face of even a dramatic change of a commodity price because such instability is considered a customary business risk. However, one can expect such claims to be made and it will be interesting to see how courts react to them.

4. Thirty-percent threshold for liquidated damages

The Contract Law addresses "unreasonably" or "excessively" high or low payments of liquidated damages for breach of contract. Article 114 of the Contract Law, for example, allows a court to raise or lower liquidated damages agreed between the parties if such damages are less than losses sustained or excessively high compared to the actual loss. The Court has now set a threshold of 30% above or below the actual loss to determine if a court should intervene.

While it is welcome that the Court now has provided a clear numerical threshold, the 30% threshold may be inadequate for some situations. In addition, liquidated damages are generally agreed upon to relieve the party that benefits from them from the obligation to evidence its actual losses, or in situations where losses are very hard to determine. Having to evidence liquidated damages that are between 70% and 130% of actual damages reintroduces the necessity to determine actual losses—a hassle the parties may have originally sought to avoid. It's also unclear whether courts will conform the agreed damages to the acceptable threshold or award the actually evidenced damages.

Still, the Interpretation's thresholds may serve as a guideline for the interpretation of other indefinite terms of other articles of the Contract Law and can guide drafters when determining what liquidated damages to put into a contract.

5. Order of fulfilment of debts

Especially in strained economic times, not all debtors will be able to fulfil their obligations. Under the Interpretation, in absence of other agreements between the parties on the order of debt settlement, a debtor's payments shall be set off against outstanding obligations as follows:

The Interpretation also provides that when payments are insufficient to discharge all debts, costs and interest have priority over the principal debt. So, for example, the necessary costs of a lawyer retained to claim outstanding amounts as well as court and enforcement fees will be covered by any payments received before they are set off against the principal debt unless the parties agreed otherwise.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.