July 2003
China's "New Contract Law"
A Practical Overview
by Gordon J. Liu
In March 1999, the Chinese People's Congress enacted the unified Contract Laws of the People's Republic of China (the New Contract Law), which went into effect on October 1, 1999. Simultaneously, previous laws governing business and commercial contracts, such as the Economic Contract Law of the People's Republic of China, the Law of the PRC on Economic Contracts Involving Foreign Interests, and the Law of the PRC on Technology Contracts, were repealed.
Chinese and foreign legal experts believe that the New Contract Law provides users with a more consistent and coherent set of statutes closely paralleling international business contracting principles. The New Contract Law sets forth—with a higher level of clarity—the essential elements of a contract, forming and performance of a contract, and parties' rights and obligations under the contract. It is an evident attempt by Chinese lawmakers to close the gap between Chinese business practices and international standards, in anticipation of China's membership in the World Trade Organization.
This article summarizes the New Contract Law while aiming to pinpoint the areas that require special attention from American companies in contract negotiations with their Chinese counterparts. It also provides an interesting contrast between familiar U.S. contract-law principles and those of an increasingly powerful global-market participant seeking to integrate its own social and business principles into a regime for doing business with the world.
General Provisions
As in many other laws of the People's Republic of China, the New Contract Law contains some general provisions at the outset of the text. The general provisions are meant as guidelines with general applicability to more specific provisions of the law. Although the drafting authorities do not specifically state it, the general provisions serve as a public-policy framework with which the interpretation of a particular section of the law must be consistent.
The New Contract Law is enacted to "protect contracting parties' legal rights, maintain social economic order, and improve the construction of socialist modernization." The stated purpose of the law reflects China's extreme sensitivity to social and economic stability, and China's national policy focus on the Four Modernizations.1
In furtherance of the stated purpose, the general provisions require that a contract not interrupt social-economic order or harm public interests, and that the contracting parties be honest and trustworthy, and respect societal ethics.
The general provisions specifically state that the New Contract Law does not apply to marriage, adoption, or guardianship matters, establishing it as a law principally governing business, commercial, and related activities.
Although the general provisions are rarely emphasized by contracting parties, sometimes they serve to void a contract if a third party can prove that the contract disturbs social-economic order or causes harm to the public. The general provisions force contracting parties to be aware of public policies and restrict their covenants within the confines of the grand social-economic framework. This is different from the United States, where functions of interpreting public policies are generally left to the court; therefore, it is advisable for the contracting parties to adopt a cover-all clause mirroring the language of the general provisions in the beginning of their contract.
Formation of a Contract
A valid contract can be in written, oral, or other form. Written contracts include telegram, telefax, facsimile, digital-based exchanges, e-mail, or other tangible forms of expression. A written contract is required if (1) other laws or regulations mandate the contract to be in writing; or (2) the parties agree to use a written contract.
Although content of a contract is subject to negotiation by the parties, a contract generally should include the following items: (1) the parties' names and addresses; (2) the contract price; (3) the contract quantity or amount; (4) the quality of the product or service; (5) payment or compensation terms; (6) the time, location, and method of performance; (7) liabilities for breach; and (8) a method of resolving disputes. (See Article 12.)
Contracts are formed with an offer and acceptance. To be valid, an offer must be (1) specific and definite, and (2) binding upon the offeror. An invitation for an offer is an expression of hope for an offer. Under Article 15, a mailed price list, auction announcement, bidding announcement, stock-placement brochure, or commercial advertisement may all be deemed an invitation for an offer. If its content satisfies the elements for an offer, a commercial advertisement may also be considered an offer.
An offer becomes effective when it "reaches" the offeree. (See Article 16.) The New Contract Law is not clear about whether the word "reaches" means that the offeree must actually receive the offer. For contracts in digital or electronic format (the recipient having specified the system through which such digital or electronic text may be transmitted), an offer is deemed to have reached the offeree when it has entered into that system. (See Article 16.) An offer may be withdrawn before it reaches the offeree, or simultaneously upon reaching the offeree. An offer may be cancelled after the offer reaches the offeree, but before the offeree accepts. However, an offer may not be canceled if (1) the offeror specified a timeframe for acceptance or (2) the offeree has reason to regard the offer as noncancelable, and has prepared for performance of the contract. The New Contract Law is unclear on what reasons are sufficient or what preparation for performance is required. (See Articles 17, 18, and 19.)
Under Article 21, acceptance of an offer must be made known to the offeror through notice, except where acceptance may be made through conduct of the offeree if the offer so specifies, or established through industry customs. Acceptance must reach the offeror within the time fixed in the offer. If the offer does not fix a timeframe, then acceptance must be made immediately if it is an oral offer, or within a reasonable time if the offer is not oral. Acceptance may be withdrawn before the acceptance reaches the offeror, or simultaneously upon reaching the offeror.
A new offer, or counteroffer, occurs when the offeree makes substantive changes to the content of an offer. Under Article 30, "substantive changes" means changes to the price, quantity or amount, quality, payment or compensation, performance time, location, method, liability for breach, or method of dispute resolution. It is notable that the New Contract Law treats dispute resolution as an essential element of a contract. Contracting parties must be specific about the method they wish to utilize to resolve any dispute, such as the selection of jurisdiction or venue, choice of law, or, if the parties decide on arbitration, the arbitrating organization. Ambiguity or failure to be specific may cause the court to invalidate the dispute-resolution provision and assert the court's own discretion on dispute resolution. This point is especially important for international transactions, and for companies hoping to avoid litigation or dispute resolution in the Chinese courts or before a Chinese forum.
Under Article 32, the location where a contract is formed is the location where acceptance becomes effective. If a contract is made through digital or electronic means, the recipient's principal place of business shall be the place where a contract is made. If the parties contract through formal written agreement, the location where both parties sign or seal the document is the location of contract.
A potential conflict exists pertaining to the time when a contract becomes effective. Article 25 states that a contract is formed when the acceptance becomes effective. However, Article 32 states that if the parties adopt a formal written agreement as the form of contract, the contract is formed when all parties sign or seal the contract. Article 33 states that when letters, digital transmission, or other forms are adopted, a party may request that the other party sign a confirmation letter, and the contract will be formed when the confirmation is signed. Obviously, questions exist as to how to synchronize the application of Articles 25, 32, and 33. Is signature or seal the only form of acceptance recognized by the New Contract Law? Or how should the confirmation letter be worded for it to be deemed an acceptance? Is the confirmation part of the contract, or is it an independent contract? What is the difference between signing on the confirmation, and signing on digitally or electronically transmitted correspondence? The New Contract Law is silent on these questions.
The New Contract Law adopts a modified version of the principle of "equitable estoppels": where written contract is required by law, regulation, or agreement of the parties, but the parties fail to use a written contract, a contract is formed if one party performs according to the terms of the contract and the other party accepts the performance. If the parties agree on a written contract before the contract is signed or sealed, and one party substantially performs and the other party accepts the performance, the contract is formed. (See Article 36.)
Under Article 54, a contract or part of a contract may be declared void or modified upon application by a contracting party if (1) the contract is formed due to a substantial and major misunderstanding; (2) the contract is obviously unfair and unjust in its formation; or (3) the contract is formed based on fraud, duress, or other circumstances where a contracting party enters into the contract involuntarily. However, a contracting party loses his right under this article if (1) he fails to act within one year from the date he knew, or should have known, the basis for application to have the contract declared void or modified; or (2) he expressly states, or through his own action indicates, that he has abandoned the right to apply.
Under Article 53, a disclaimer of liability in a contract is invalid and ineffective if (1) a contracting party causes personal injuries on the other party or (2) a contracting party intentionally or with gross negligence causes the other party property damages.
If the contracting parties conspired through the formation of a contract for purposes of personal gains at the expense and in harm of national, collective, or third-party interest, the gains resulting from the contract shall be condemned and returned to the government, collective entity, or such third party.
Contract Performance
In performing a contract, the parties may use a supplemental agreement to clarify certain provisions in the contract if such provisions are unclear. In the event the parties cannot reach a supplemental agreement, these provisions may be interpreted in accordance with other provisions in the contract, or trade and industry customs.
Under Article 62, if interpretation based on trade and industry customs cannot resolve the issues, the New Contract Law provides the following interpretation guidelines: (1) in case of unclear provisions on quality, the national or industry standard shall apply; if there is no such national or industry standard, then customary standard or special standards which are consistent with the purpose of the contract shall apply; (2) if the price or compensation provisions are unclear, then the market price at the location of performance shall apply; or if the local government regulates such price, then the government's regulation applies; (3) if the location of performance is unclear, the payee's location in payment of money transactions, or the location of real property in real estate transactions, or the location where the contract is actually performed, is controlling; (4) if the time for performance is unclear, the debtor may perform at any time and the creditor may demand performance at any time, provided that the creditor gives the debtor reasonable time for preparation; (5) if the method of performance is unclear, a method most suitable for materializing the contractual purpose shall be adopted; and (6) if the responsibility to bear the cost of performance is unclear, the performing party shall bear the cost.
Article 64 provides for the basic principles of transfer of contractual obligation and indemnity. If the contracting parties agree that the debtor shall perform his obligation in favor of a third party and the debtor fails to do so, the debtor remains liable to the creditor for breach of contract. By the same token, if the contracting parties agree that a third party should perform the debtor's obligation to the creditor and the third party fails to do so, the debtor remains liable to the creditor for breach of contract.
Under Article 68, a performing party to a contract may stop performance if he has confirmed evidence that the other party (1) is in a seriously deteriorating operating condition; (2) transfers assets, or cashes out to escape debts and liability; (3) has lost commercial credibility; or (4) has lost or faces the possibility of losing the ability to perform under the contract. However, if a party does not have confirmed evidence but nonetheless stops performance, he shall be liable for breach of contract. (This is a major red flag: the New Contract Law is not specific as to the type of evidence required under this article, or the definitions for "deteriorating operating condition," "commercial credibility," or the "possibility of losing the ability to perform." Without clear definitions of these phrases, a party seems to have a subjective right to stop performance in anticipation of the other party's difficulties in performance.)
Articles 73 and 74 provide for the interesting scenario wherein a debtor owns a future right and fails to exercise such right upon maturity, which harms the creditor's interest. Under these articles, the creditor may petition the court for authority to act in the debtor's place to exercise such right. However, the creditor's right of substitution is limited to the debtor's right, and the creditor shall bear the cost of enforcing the right. Furthermore, if the debtor abandons his right or sells assets at unreasonably low prices to the creditor's detriment, and the buyer of said assets has knowledge of the situation, the creditor may also petition the court to declare such sales void. The creditor must file such petition within one year from the time he knew, or should have known, the causes for the petition, or the creditor's right ceases to exist after five years from the time of the actual sale.
Once a contract is formed, change of the parties' names, entity, executive, manager, etc., shall not be basis for nonperformance.
Contract Modification and Assignment
Modification of a contract must be consented to by the contracting parties. However, the New Contract Law does not provide for the form of consent or method of modification. It states only that if the modification is unclear, there will be deemed no modification. (See Articles 77 and 78.) This creates a substantial likelihood for confusion. For example, the New Contract Law does not require written consent on modification of a contract, which implies that oral agreement is allowable. But if the contracting parties orally agree to modify the contract, and one party performs under the modified contract and the other party does not, have the parties modified the contract? Under these circumstances, the parties will almost certainly dispute whether the modification is clear. What is the standard governing the clarity of modification?
Under Article 79, the creditor under a contract may transfer all or part of his contractual rights to a third party, except where (1) the nature of the contract is nontransferable; (2) the parties have agreed not to transfer the contract; or (3) the contract is nontransferable under other laws and regulations.
Upon transfer, the transferee of contractual rights shall have subrogated rights in relation to the contract, unless such rights cannot be separated from the transferor. Once the debtor receives notice of the transfer, he may raise any and all issues with the transferee. Vice-versa, the creditor may raise any and all issues with the debtor's transferee. (See Articles 81 and 82.)
Under Article 83, if the creditor's transferee owes an obligation to the debtor, and the debtor's contractual obligation matures before or at the same time as the transferee's contractual right, the debtor may request that his contractual obligation be offset against the transferee's contractual right.
A debtor under the contract must first obtain the approval of the creditor before he can transfer all or any part of his contractual obligations. If the debtor transfers his contractual obligations, the transferee must assume the debtor's obligation transferred to him, except where such obligation is inseparable from the debtor.
Under Article 90, if a contracting party merges with another entity, the legal person or the entity resulting from the merger shall succeed, and continue to perform under the contract. If a contracting party is divided, the legal person or the entity emerging after the division shall continue to perform under the contract unless the contracting parties agree otherwise.
Termination of Contractual Rights and Obligations
Under the New Contract Law, Article 91, the rights and obligations in a contract are terminated if any of the following events occurs: (1) the debt under the contract is paid in full; (2) the contract is cancelled; (3) the debt under the contract is offset entirely; (4) the debtor delivers the goods that are the subject of the contract; (5) the debtor is rid of his debt under the contract; (6) the contractual rights and obligations are consolidated into one person; or (7) the contract is terminated under the law, by agreement of the parties, or under other circumstances.
A contract can be terminated by agreement of the contracting parties. The contracting parties may also agree on a contingency, the fulfillment of which will trigger the termination of the contract. After the contract's termination, the contracting parties should act in honesty and good faith in giving notices, providing assistance, or maintaining confidentiality, etc., according to industry customs. (See Article 92.) The New Contract Law makes no further provisions concerning Article 92, which, by its language, invites the question of whether a contract is really terminated.
Under Article 94, a contracting party may cancel the contract when any of the following events occurs: (1) there is an occurrence beyond the parties' control that prevents further performance of the contract (force majerus); (2) one of the contracting parties indicates either expressly or through his actions that he will not perform major obligations under the contract; (3) one of the contracting parties delays performance of major obligations and fails to redeem his performance after receiving reasonable notice and request for performance; (4) a contracting party delays performance of major obligations or breaches other provisions of the contract, making it impossible to fulfill the contractual purpose; or (5) other events as required by law occur.
To cancel a contract under Article 94(2), stated above, the canceling party must provide notice to the other party. The contract is cancelled at the time the notice reaches the other party. However, the right to cancel under Article 94 may be terminated if the contracting parties do not exercise such right within a reasonable time. (See Article 95.)
After the contract is cancelled, the contracting parties are absolved from further performance of the contract. However, based on the nature of the contract, a contracting party may demand to be restored to its original financial condition, or demand payment for damages or other compensatory measures for performance already completed. (See Article 97.) Furthermore, the fact that a contract is cancelled does not affect the validity of the accounting and disposition provisions of the contract. (See Article 98.) Obviously, Article 98 seems to be in conflict with Articles 94 and 95, in that it keeps part of the contract valid even though the contract is legally cancelled.
If a contract is cancelled, the contracting parties may agree to offset each other's obligations by delivering to each other the subject of the contract or collaterals securing such obligations. However, a contracting party may deposit the subject of the contract in the following circumstances: (1) the creditor unreasonably refuses to accept; (2) the creditor cannot be located; (3) the creditor is deceased, or becomes incompetent without the appointment of a guardian; or (4) other events allowed under the law occur. If the subject of the contract is not suitable for deposit, or the costs of deposit are unreasonably high, the debtor may sell the subject by lawful auction and retain the proceeds that legally belong to him.
Liabilities for Breach of Contract
A contracting party is liable for performance, undertaking remedial efforts, or compensating for losses and damages when he fails to perform under the contract or if his performance does conform to the contract. When a contracting party expressly indicates, or by his own conduct indicates, that he will not perform under the contract, the other party may enforce the contract before the contract term expires. (See Articles 107 and 108.)
Under Article 110, a contracting party may demand specific performance if the other party fails to perform obligations that are nonpecuniary, or his performance does not conform to the contract, provided that the contracting party may not demand specific performance, if (1) the obligation cannot be legally or factually performed; (2) the subject of the contract is not suitable for specific performance, or the costs of such performance are unreasonably high; or (3) the creditor does not demand specific performance within a reasonable time.
The New Contract Law allows damages beyond the contract price stipulated in the subject contract. For example, Article 112 states that if the breaching party takes action to mediate but is unable to mediate the entire damages, the unmediated damages should be awarded. Article 113 provides that "lost profit" is recoverable upon breach of a contract, but such recovery is limited to the profit which is reasonably foreseeable, or damages which should have been foreseeable, at the time of breach.
The New Contract Law contains mechanisms for the parties to self-regulate in performing under the contract. Article 114 states that the contracting parties may enter into agreement that, in the event of a breach, the breaching party may pay a "breaching fund" to the other party; or the parties may agree on the method of calculating damages in the event of a breach. If the breaching fund is less than the loss caused by the breach, the nonbreaching party may petition the court or an arbitrator for additional compensation. On the other hand, if the breaching fund is excessively more than the loss, the breaching party may petition the same court or arbitrator for a reduction. If a breaching party delays paying the breaching fund according to agreement, it shall be liable for the payment of the breaching fund in addition to liability under the contract.
Article 115 states that the contracting parties may stipulate that one party pay the other party a "guaranty fund" according to China's law of guaranty. When the debtor performs under the contract, the guaranty fund shall be returned or used to offset the contract price. Upon breach, the breaching party shall not be allowed to demand the return of the guaranty fund. But if the party receiving the fund fails to perform, it shall be liable for double the amount of the guaranty fund. If a contract contains provisions for both a "breaching fund" and a "guaranty fund," the nonbreaching party shall have a choice as to which provision to proceed upon.
The New Contract Law also contains several provisions based on force majerus, or "Act of God." The term used therein is "irresistible force," which is defined as "an objective event which is unforeseeable, unavoidable and cannot be overcome." Upon occurrence of an irresistible force, the contracting parties may be excused of part or all of contractual obligations, except where the irresistible force occurs while a party delays performance of its obligations or if the law provides otherwise. If an irresistible force makes performance of the contract impossible, the nonperforming party must timely notify the other party to reduce such party's damages, and provide the other party with evidence of the occurrence of the irresistible force. (See Articles 117 and 118.)
Miscellaneous Provisions
Under Article 125, any dispute over interpretation of contract provisions should be resolved according to the terms used in the contract, other contract provisions, industry custom and usage, and based on fair dealing and good faith. If a contract is prepared in two or more languages, provided each version has equal force and effectiveness, then any disputed term shall be interpreted consistent and in accordance with the contract.
Under Article 126, a contract involving foreign parties may provide for choice of law applicable to the contract. If the contract involving foreign parties does not provide for choice of law, then the law of the country to which the contract is most closely related shall apply. Contracts governing China–foreign-equity joint ventures, and cooperative joint ventures and contracts on joint exploration of natural resources that are performed within the Chinese territories, are governed under Chinese law.
Article 127 states that local business-administration or other governmental entities may exercise their regulating authority within their respective jurisdictions concerning contracts that harm China's national interest and social welfare.
Article 128 provides that a foreign contracting party may apply for arbitration before a Chinese or foreign arbitration forum according to the contractual-arbitration clause. If the contract does not contain an arbitration clause or if the arbitration fails, any party may commence suit in Chinese court. Upon application, the court may enforce an arbitration award.
Article 129 contains a statute of limitations that limits the time to sue or arbitrate to four years on disputes over contracts dealing with the international purchase and sale of goods, or technology export and import. The statute of limitations begins to run when the contracting party knew, or should have known, the cause of action.
Conclusion
The New Contract Law is certainly a step in the right direction in bringing China's business contract law on par with international standards. However, there are still inconsistencies and loopholes. Moreover, application of the New Contract Law is subject to local interpretation and enforceability. Companies contracting with Chinese entities must be keenly aware that China is just beginning to implement a business-legal infrastructure which is compatible with WTO requirements. Confusion in interpreting the law is bound to occur. Foreign companies should carefully study the New Contract Law and use it to their own advantage, but it is important to understand that having a good contract is just one aspect of ensuring that business in China goes smoothly.
Gordon J. Liu is of counsel to the law firm Bullivant Houser Bailey, PC. He practices extensively in the areas of business, international, and commercial law, especially in connection with China, Taiwan, and Hong Kong. He can be reached at gordon.liu@bullivant.com.
NOTE
1. The Four Modernizations (modernization in industrial, agricultural, science, and national defense) are a national goal set by the Chinese leader Deng Xiaoping (1902-97) more than two decades ago.
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