Crafting Contract Damages in China: Experience, Art, and Prudence
As I was going through my overflowing email inbox last weekend, three emails about contract damages really jumped out at me. But before I dive into those emails, I will first seek to demystify the concept of contract damages and explain why it’s so important for your China contract.
Decoding Contract Damages
Contract damages are provisions that set forth the amount of money one party has to pay the other for breaching the contract. A typical contract might state that if Party X breaches the agreement, Party Y would be entitled to $650,000 as contract damages. Most of the ones the China lawyers at my law firm draft contain multiple such provisions, reflecting various scenarios.
These stipulated damages in contracts with Chinese companies are invaluable. They are a crucial instrument in conveying both the importance of the contract terms and the potential consequences of a breach. Getting the contract damages provision right is the most important thing we lawyers do when drafting certain types of contracts for China. No exaggeration.
The Art and Science Behind the Contract Damage Numbers
Figuring out the right dollar amount for contract damages involves more than just pulling a number out of thin air. It’s a blend of legal expertise, extensive China-world experience, and the delicate art of negotiation. Our China legal teamcollaborates extensively when determining these figures and we engage deeply with our clients (and even the opposing party) to ensure the chosen amount accurately represents the stakes involved.
In trying to arrive at a number, we frequently account for the overall amount at stake, the potential damages from a breach, the prestige of the Chinese company, and even the location of the court. Our overarching goal is to come to an amount that’s high enough to deter a breach, yet reasonable enough to ensure the contract is both signed and enforceable by the Chinese courts.
The Balancing Act with Chinese Courts
Our lawyers are always conscious of the fine line that separates contract damages from penalties. An excessively high figure might lead a Chinese court to dismiss it, viewing it as punitive measure rather than a compensatory one. Many foreign companies, in their quest to shield themselves from potential losses, set the bar way too high, unwittingly making enforcement a challenge.
Chinese companies are well-acquainted with contract damages and they often prefer signing contracts with excessively high damages, knowing full well that Chinese courts may deem them unenforceable. I know this because many Chinese lawyer friends have told me.
However, when done right, contract damages can be a game-changer. They can serve as deterrents, facilitate faster dispute resolution, and even provide a basis for prejudgment attachment of assets.
Chinese companies are terrified of well-crafted contract damages provisions and such provisions scare them into abiding by contracts.
Contract Damages in the Chinese Market: Lessons from the Field
Back to those three emails:
1. An NNN Agreement
Background: NNN Agreements safeguard intellectual property for businesses venturing into China. After drafting one for a client, feedback emerged: the client was convinced that our contract damage amount was way too low. The client said that if his company’s IP were in fact stolen, the damages would “easily go into the millions of dollars.”
Significance: Excessively high damage figures can appear opportunistic, jeopardizing enforceability. What is excessively high for a Chinese court is no big deal for a U.S. lawyer, but it is the Chinese court that matters.
Resolution: The email explained how in this situation, the damages amount is more important as a deterrent to breach than as the amount to realize at trial. We also explained how if there were a breach and a lawsuit, we could still argue to the court for additional damages. After some discussions, a mutually satisfactory figure was agreed upon, one that resonated with our client and with what would work best with a Chinese court.
2. Over-the-Top Damages
Background: A U.S. company came to us with their “template international technology licensing contract” it had already used in multiple other countries. This contract contained what our China lawyers viewed as a strikingly high contract damages amount for China.
Significance: An inflated damages amount is not only likely to be viewed skeptically by a Chinese court, but it could also be seen by this company’s Chinese counterparty to offer it a free pass to breach the contract, knowing that the inflated contract damages would almost certainly complicate and slow down any litigation.
Resolution: Drawing from personal expertise, we counseled the company to reconsider the clause. They insisted that it was more important to them to be consistent on the damages amount in their licensing agreements (they had multiple other agreements with companies in other countries), so they did not want to change it only for China. We again tried to convince them otherwise, but we eventually drafted the provision as instructed.
3. An IP Licensing Standoff
Background: IP Licensing Agreements enable businesses to make money by licensing their innovations or brand names to Chinese firms In this instance, our client was facing strong pushback by the Chinese company on including a contract damages provision within such an agreement. The client said he didn’t really care about having such a provision because the amount was “not that high anyway.”
Significance: The contract damages provision is crucial. It specifies repercussions for potential breaches, and it greatly facilitates quick court action and asset seizures. Most importantly, it is terrific deterrent to a breach of a contract by a Chinese company.
Resolution: One of our China IP lawyers emphasized to our client the strategic importance of this provision and our belief that the strength of our contract would be greatly weakened without it. The client was convinced to fight for inclusion of this clause, and its Chinese counterparty eventually agreed to it.