China Contract Damages Done Right

This must be China contract damages week. I say that because in cleaning up months of emails I came across three interesting emails on contract damages (similar to  liquidated damages under common law). Before I discuss those three emails, I will explain what contract damages are and why they are so important in just about all China contracts.

Contract damages refers to a contract provision setting out the damages for breach. The typical contract might have a provision saying if Party X breaches this contract, Party Y is entitled to $100,000 in contract damages. Some contracts we write will have more than one contract damages provision. For instance, we might write a distribution agreement that provides for $300,000 in contract damages for a distributor breaching the contract by stealing our client’s IP and another contract damages provision providing for 1% a month in contract damages for late payments.

Contract damages are an amazing and oftentimes essential element of a good China-specific contract.

In the standard commercial contracts, our China lawyers usually include a specific damage amount for certain (but not all) violations of the contract terms. We alway say that coming up with the right amount and the right combination of contract damages is an almost magical combination of experience and art, not a science. We vary the amount of contract damages each time, based on a combination of the amount at stake in the contract, the likely amount of damages if there is a breach, the location of the court in which disputes will be resolved, the moral culpability of the breach, the industry, the financial wherewithal of the Chinese party, the power/prestige of the Chinese company, and sometimes even the country in which our own client is based. The only constant is that we try to make the amount as high as we can, while at the same time erring on the side of keeping it low enough so that it will actually work to scare the Chinese company into not breaching the contract.

Our China lawyers need to ensure that the Chinese judge will not view this provision as a penalty, but rather an honest assessment of what real damages might result from the breach. Perhaps most importantly, this amount needs to be high enough to deter the Chinese counter-party from breaching the contract, yet also low enough so that it will actually sign the contract and so that a Chinese court will enforce it. Chinese courts will often simply invalidate or just ignore a contract damages provision if they deem it to be too high. Far too often foreign companies and their lawyers will put use such a high amount in their contract damages provision that the Chinese company will readily sign the contract, knowing it will never be enforced. They are trying to cover themselves for any potential lost profits they might lose from a breach, but in doing so they shoot themselves in the foot because no Chinese court will enforce it and knowing this, their Chinese company has no fear in breaching.

But done right, contract damages can be a near miraculous thing and our China attorneys love them for the simple reason that they work. Putting the right contract damages provision in your China contract does the following important things:

  1. Increases the likelihood your Chinese counter-party will not breach your contract.
  2. Increases the likelihood you will be able to avoid litigation if your Chinese counter-party breaches your contract.
  3. Increases the likelihood you will prevail quickly in litigation if you do end up needing to sue your Chinese counter-party.

Chinese contract law clearly provides for “contract damages” and Chinese judges tend to like them. Though contract damages are both permitted and encouraged, they cannot be used as a penalty and Chinese courts therefore usually will allow a defendant to argue that the contract damages are too high and the court should therefore ignore them and award a lower amount. The court is then free to accept this argument and award the lower amount.

Amazingly enough, the plaintiff also has the right to argue for an amount higher than the contract damage amount. That means that well-crafted contract damages can be used as a damages floor, but not a ceiling. Though this idea of allowing defendants to argue for less than the amount of contract damages set forth in a contract while also allowing a plaintiff to argue for more does obscure the concept of contract damage amounts, our China lawyers still nearly always include contract damages in the China contracts we draft. We do that for the following three reasons:

  1. We want a specific number for when we contact the breaching party to try to settle and having contract damages gives us a specific damage amount to discuss.
  2. We want a specific number for when we go to the court when suing for a breach of contract. This is particularly important for those situations where the amount of damages is not clear.
  3. Most importantly, we want a specific number to use for a prejudgment attachment of assets. One of the best ways to stop a Chinese company from infringing on your intellectual property rights (IPR) is with prejudgment attachment. But to to get that you need a reasonable standard for the amount of damage that will quickly set the amount to be attached. Contract damages provides that reasonable standard. Chinese companies know how easy it is to attach/seize their assets based on a contract damages provision and they fear this. This in turn makes them far less likely to breach a contract with a well-crafted contract damages provision.

Securing injunctive relief is difficult in China and  have an agreed contract damage amount in cases where the actual amount of damages is difficult/impossible to calculate. In these cases where there is no clear monetary damage (the classic common law injunctive relief situation), PRC courts generally have NOT allowed defendants to argue that no relief should be awarded when there is a contract damages provision.

Now about those three emails. The first was from one of our China manufacturing lawyers to a client regarding the amount of contract damages we had chosen to put into an NNN Agreement. I see this sort of email all the time and it was in response to a client complaining that the amount we had chosen as contract damages were too low:

I do not advise we increase the amount of contract damages we have written into your NNN Agreement. Note that this $350,000 per each event and note that it is intended to represent a fair estimate of your losses from each breaching event. When the amount of contract damages is too high, the Chinese side is unlikely to sign the agreement because it will think you are being unreasonable and or demonstrating your inexperience with how to conduct business in China. Equally importantly, a Chinese Court is unlikely to enforce a much higher amount because it will view it as not having a sufficient relation to the actual damages.

That said, there is nothing “magical” about the $350,000 we chose here for the contract damages amount. We came to this figure using various different factors we ordinarily use for calculating the best amount of contract damages for any specific contract. If you still believe our number is too low, let’s talk more about what your losses are likely to be and see whether we can come to a number we both like.

The second email also was from one of our China IP lawyers to a client involving an IP licensing agreement. In this matter, the Chinese side had stricken our contract damages provision entirely and our client was asking how to respond to that:

As for paragraph 8.2, the sentences they [the Chinese company on the other side of the deal] are seeking to remove are one of the core provisions of this licensing agreement because they provide for contract damages in a specific monetary amount for every act of breach. This sum certain amount (called contract damages) provides the Chinese court with the basis for a prejudgment seizure of the Chinese company’s assets (but it does not limit the court’s power to decide the amount of damages). In short, these sentences give your agreement real teeth and I would not accept the proposed change and would push back hard on this. The Chinese company knows this provision is powerful and will make its breaching your contract more risky to it and for that reason it does not like it. This is somewhat of a red flag regarding the Chinese company’s intentions and so we probably will want to draw a clear line on this issue.

The third email was from me to a company that wanted our China litigation/arbitration team to take its case and the contract damages part of this email went like this:

I also do not like the contract damages provision in your contract. It’s for $25 million dollars on a 2.5 million dollar deal and near as I can tell from what I have read and from what you told me when you spoke, your damages here are well under a 2 million dollars on a really good day and I do not see how anyone could ever have viewed them as being higher than this when the contract was signed. To be blunt with you, I do not even see how you get to $2 million dollars in damages under your analysis and under a U.S. damages analysis I have a hard time getting past $1 million in damages and I am skeptical a Chinese court would see even $750,000 in damages here. Your too-high contract damages provision is going to hobble us from the get-go. It is too high for us to use to try to freeze the Chinese company’s assets so we probably should just forget about that. Even worse, and based on what the Chinese company has told you and on how it is acting, it has zero fear of this happening and in fact, it plans to use this provision to paint you as the horrible exploitive Westerner (the potential client was from the Europe) trying to take advantage of a Chinese company. Not sure how far that will actually get this Chinese company, but it probably will to eat up more time.

So again, I really wish you had used a lawyer who knew what it was doing with Chinese contracts because if you had, you would be in a much better position right now and we might have been interested in taking on this case. But this, coupled with all the other flaws we see in your contract have convinced us that we are not the right law firm for this case. But just to be clear, I am NOT telling you that you have no case and I am NOT telling you not to pursue this case. What I am telling you is that we simply would not feel comfortable taking your money to handle this case nor are we interested in taking it on a contingency fee basis. I therefore urge you to find another attorney/law firm for this litigation and I truly wish both you and your company nothing but the best going forward. This Chinese company did not treat you fairly and I would hate to see it get away with that.

Bottom Line:  Contract damages can be a great thing in a China contract, but only if done right.