China Contracts: Writing the Contract Damage Provision

In our standard commercial contracts we almost always draft a damages provision that specifies the damage amount for certain (not all) violations of the contract terms. Our China lawyers work with our clients to ensure these provisions are not a penalty (which Chinese courts will not enforce), but rather an honest assessment of what real damages might result from the breach. This system has worked well in China and actually helps prevent litigation due to the certainty of result these contract damage provisions provide.

Common law lawyers often express concern about these contract damage provisions based on their general aversion to “liquidated damages.” This concern shows a lack of understanding of how China’s civil law system works regarding contact damages. The Chinese side will also often object but for very different reasons: they understand the effectiveness of such provisions in Chinese courts and they want to escape from this very real threat.

The term “liquidated damages” is a common law term without meaning in the PRC. PRC contract law provides for “contract damages.” Though contract damages are both permitted and encouraged, they cannot be imposed as a penalty. For this reason, in recent cases and under guidance from the PRC Supreme Court, Chinese courts have indicated that a defendant is free to argue that the contract damages are too high and the court should award a lower amount. The court is then free to accept this argument and award the lower amount. However, the presence of the contract damages provisions does not in any way serve to invalidate the contract or the basic notion of awarding contract damages.

Note also that under PRC law, the plaintiff always has the right to argue for an amount higher than the contract damage amount. That is, the contract damage amount is treated as a floor, not a ceiling. Though the concept is a floor from the plaintiff’s point of view, the Supreme Court recently held defendants are also free to dig a basement, allowing for an award lower than the contract damage amount. Though these recent interpretations obscure the concept of contract damage amounts, we still include contract damages in PRC contracts for two reasons: 1) We want a set number when we contact the breaching party and having contract damages allows give us a specific damage amount to discuss and 2) we want a specific number to use for a prejudgment attachment of assets. Also, law or no law, the contract damages does become the grounding to which Chinese courts will look.

We also provide for contract damages because though China has no law/equity distinction (unlike common law countries), injunctive relief generally does not work well in China. We therefore want to 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), the PRC courts generally have NOT allowed defendants to argue that no relief should be awarded. For this reason, though there is risk the PRC court will reduce the contract damage amount, the risk is for a lower award. The risk is not for no damage award at all or that the contract will be invalidated. Chinese courts very much prefer making a monetary award as an alternative to issuing an order (injunction) they know they cannot enforce.

The basic legal rules for dealing with China contract damages are as follows:

In accordance with PRC Contract Law, if the agreed contract damage amount is lower than the actual amount of damage, then the plaintiff can argue for a higher amount. On the other hand, if the agreed contract damage amount is substantially higher than the actual amount of damage, then the defendant can argue for a lower amount. (Article 14 约定的违约金低于造成的损失的,当事人可以请求人民法院或者仲裁机构予以增加;约定的违约金过分高于造成的损失的,当事人可以请求人民法院或者仲裁机构予以适当减少)

The plaintiff may always argue for an amount higher than the contract damage amount and that the contract damage amount is not a ceiling. Unfortunately for the plaintiff, the contract damage amount is also not treated as a floor.

Pursuant to Interpretation II of the Supreme People’s Court of Several Issues Concerning the Application of the PRC Contract Law (《最高人民法院关于适用〈中华人民共和国合同法〉若干问题的解释(二)》), if the defendant argues the actual damage is lower than the contract damage and thus should be lowered, the court will consider it on the basis of actual damage, and will take into account the parties’ actual performance, degree of fault, parties’ expectation, and other factors and will apply the principles of fairness and good faith in making a ruling. (Article 29 当事人主张约定的违约金过高请求予以适当减少的,人民法院应当以实际损失为基础,兼顾合同的履行情况、当事人的过错程度以及预期利益等综合因素,根据公平原则和诚实信用原则予以衡量,并作出裁决).

The threshold for “substantially higher (过高)” is 30%: if the contract damage amount is more than 30% higher than the actual amount of damage it is deemed to be substantially higher than the actual damages. In principal, the contract damage amount should only be lowered if it meets this “substantially higher” threshold. However, the situation is not that clear. Chinese judges fundamentally believe in doing “justice,” which means they will not necessarily follow the judicial interpretation strictly and may adjust the amount as they see fit. The plaintiff has the burden to prove its actual damage, and judges that are not satisfied plaintiff has met this burden may lower the amount even though the 30% threshold is not met. This is one of the many areas of uncertainty plaguing the Chinese litigation system.

Bottom Line:  Despite the risk the court may end up adjusting the amount, contract damages usually make sense in Chinese contracts. The key is choosing the right amount for your contract damages; one that is neither too high nor too low.