October 01, 2009

Guiding Opinions on Several Issues Concerning Trials of Civil and Commercial Contract Disputes Under Current Circumstances

Issuing Body: Supreme People's Court

Issuing Date: July 7, 2009

Effective Date: July 7, 2009

Months after issuing a wide-ranging interpretation of China's Contract Law—its first interpretation of that important law in a decade—the Supreme People's Court (SPC) has issued another key opinion to guide how courts handle contract disputes. The SPC released the Interpretations on Certain Issues Concerning the Application of the Contract Law of the People's Republic of China (II) (Second Contract Law Interpretation) in April. (See China Law Update, June 2009.) In July, the high court released the Guiding Opinions on Several Issues Concerning Trials of Civil and Commercial Contract Disputes Under Current Circumstances (Contract Dispute Guiding Opinions). As the latter's name suggests, the new interpretation specifically addresses issues that have arisen because of the global economic crisis.

The SPC's judicial interpretations play an important role in the Chinese legal system, providing often-detailed guidance to courts throughout the country about how to interpret existing laws. Written in response to a perceived need rather than to resolve a single case, interpretations function almost as laws or regulations, filling gaps and answering questions.

In this case, the SPC released the Contract Dispute Guiding Opinions specifically to address problems related to the economic crisis and the civil and commercial disputes that have emerged due to factors such as sharp fluctuations in raw material prices, dramatic changes in supply and demand, and significant cash shortfalls.

The Contract Dispute Guiding Opinions provide guidance on contract law issues such as the principle of a "change of circumstances," adjustment of liquidated damages and the calculation of loss of profit.

Application of the "Change of Circumstances" Principle

Under the Second Contract Law Interpretation, which became effective on May 13, 2009, if objective circumstances have materially changed since the signing of a contract, and such a change was unforeseeable by the parties to the contract when it was concluded, the parties may file a petition in court to modify or terminate the contract.

The types of changed circumstances that parties have been citing in current contract disputes tend not to happen so suddenly that neither party has time to take action and deal with the change; rather, they evolve in a gradual fashion. As a result, the Contract Dispute Guiding Opinions emphasize the need for courts to scrutinize closely the issue of foreseeability so as to avoid abuse of the "change of circumstances" principle. The opinions require courts to strictly examine a claim of unforeseeability, especially when the contract deals with a commodity (e.g., oil, coke, non-ferrous metal, etc.) or financial instruments (e.g, stock and futures) that have been volatile in the past 18 months.

To distinguish between an unforeseen change of circumstance and ordinary commercial risk, the Contract Dispute Guiding Opinions instruct courts to assess whether the risk was previously unforeseeable in an ordinary person's conception, whether the risk level was far beyond the reasonable expectation of an ordinary person, and whether the risk could have been controlled and/or prevented.

Adjustment of Liquidated Damages

According to China's Contract Law and the Second Contract Law Interpretation, if the agreed-upon liquidated damages in a contract are excessively high, a court may decrease the amount of liquidated damages to an appropriate level, upon one party's request, on the basis of the actual damages that were incurred.

Because many enterprises are experiencing financial difficulties in the current economic environment, properly determining liquidated damages—and avoiding excessively high damage awards—has taken on greater importance in contract disputes. When determining the amount of liquidated damages, the Contract Dispute Guiding Opinions say, courts should take various factors into consideration, such as the extent to which the contract was fulfilled, anticipated profits, the relative fault of the parties, the parties' relative position in concluding a contract and whether boilerplate contract language was used.

Recognition and Calculation of Expectation Damages

Under China's Contract Law, if one party breaches a contract and causes a loss to the other party, the breaching party should be liable for damages to the non-breaching party in an amount equal to the loss caused by the breach of contract, including gains that would have been expected if the contract had been fulfilled. The breaching party is not liability for damages exceeding the amount of loss caused by the breach that was foreseeable at the time the contract was concluded.

The Contract Dispute Guiding Opinions state that when calculating expectation damages related to the loss of potential profits, courts should deduct from the total the amount of the loss that was unforeseeable by the breaching party, amount (if any) of improperly increased loss due to the non-breaching party's actions (or failure to act), gains obtained by the non-breaching party due to the breach of contract, losses attributable to the fault of the non-breaching party, and necessary transaction costs.

In addition, the Contract Dispute Guiding Opinions reiterate that it is not appropriate to apply the remedy of expectation damages to operations that involve fraud, personal injury and "spirit" (mental) damages.

Conclusion

Although the Contract Dispute Guiding Opinions do not cover all key facets of China's Contract Law and only general enforcement rules are stated, the SPC has provided important guidance for resolving civil and commercial disputes under changed—and changing—economic conditions. This guidance should prove helpful in maintaining orderly markets, guaranteeing a fair investment environment, fairly resolving disputes and generally enhancing confidence in China's markets.

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