08 August 2018

Global M&A: Know the differences btw PRC & foreign law contracts

This article was written by Yong Kaichang (International Partner) and Jackie Yu (Associate).

In cross border transactions, there is sometimes a misconception amongst both PRC and foreign parties that all contracts are by and large the same, whether governed by PRC law or foreign law, and that the key to a good contract is just proper drafting. Whilst it is true that the key to a good contract is good drafting backed by proper experience and expertise, different legal systems have inherent conceptual differences and as such, there are fundamental differences between PRC law-governed contracts and foreign law-governed contracts. These differences affect the interpretation, construction and adjudication of a contract – and will impact parties’ rights, obligations, remedies and liabilities under it. In this article, we briefly compare some key general differences between PRC law-governed contracts and common law-governed contracts.[1] 

Consideration

Common law requires that consideration must be given in return for a promise to form a binding contract (with a notable exception of a deed). In contrast, under PRC law, a contract is formed at the time when a promisor’s promise becomes effective[2]. This means that, a promise for which no consideration has been given, e.g. a promise to give a gift, would be unenforceable under common law but could be enforceable under PRC law. As such, to address doubt about whether there is consideration in place in a common law-governed contract, market practice typically creates a legal fiction (e.g. a “1 dollar” consideration), which would be legally considered as sufficient. Note that the common law court would not examine the adequacy of the consideration (i.e. its monetary value against the market value of the subject matter being purchased). 

However, under common law, a promisee who has not given any consideration is not without protection – for example, the principle of promissory estoppel would protect a party who has relied on and acted upon a promise to his detriment. For example, if Party A offers Party B to live at his property rent-free for certain period of time, as a result of which Party B sells his own house and spends a substantial amount of money on the restoration of the property, then Party A may not be able to revoke that promise. Even though there is no consideration provided from Party B, the common law court may consider it unconscionable and unfair to allow Party A to depart from his own promise as Party B has relied on the promise to his detriment.

Pre-contractual Obligations

PRC law, in line with civil law influences, imposes a duty of disclosure on the parties to a contract to disclose information that is material to that contract at the pre-contractual stage[3]. Under common law, save in exceptional circumstances, a party does not ordinarily owe a general duty to disclose to the other party – each party should take care of its own interest by making necessary inquiries. This difference can be illustrated by a simple example of the sale of a second-hand car: Under PRC law, the seller is obliged to inform the buyer of any major defects or any other condition that may materially affect the price of the car that he knows or ought to have known. If the seller fails to so disclose, the buyer may claim damages for the loss he suffers as a result of such failure. Whereas under common law, the buyer has the responsibility to inspect the car and make the necessary inquires as to the condition and fitness of the car, and the seller responds to the buyer’s questions (i.e. via representations). Under common law, if a party to a contract (representor) makes a false representation with regards to a fact to the other party (representee), and the representee relies on and is misled by the representation, then the representee may claim “misrepresentation” and seek damages and/or rescission. 

It is generally easier to establish “misrepresentation” under common law than “breach of pre-contractual obligations” under PRC law. This is because a representor who has made a misrepresentation negligently or innocently could still be liable for misrepresentation under common law; whereas under PRC law, culpability on the part of the representor is needed to establish breach of pre-contractual obligations (i.e. there has to be an element of fraud/dishonesty or a breach of the principle of good faith).[4] Say, in the same example of the sale of the second-hand car, the buyer inquires about the condition of the car engine, and the seller, having neglected to serve and inspect the engine, makes an untrue statement that the engine is in good condition. Under PRC law, the buyer will need to prove that the seller kept quiet about the engine defect while having knowledge, or intentionally gave incorrect information. In contrast, under common law, if it cannot be established that the seller made a fraudulent misrepresentation, the buyer can still claim negligent misrepresentation (i.e. the seller breached its duty of care to provide accurate information), or innocent misrepresentation (i.e. no intention to misrepresent, but note that the existence or absence of culpability will affect the availability of damages). 

One point to note is that “representation” is different from a “warranty” in common law. The difference is especially relevant in a common law-governed M&A contract, as the choice of term will affect the remedies available in the event of breach. A comparison table briefly outlining the key differences of the two concepts is enclosed:

  Representation  Warranty 
Meaning  A representation is a statement of fact or opinion.  A warranty is a contractual promise that a certain statement is true. 
Nature of claim for breach  Tort claim (misrepresentation)  Contract claim (breach of contract) 
Right to terminate/rescind contract?  Generally yes.
The effect of rescission is to put parties in the position they would have been in prior to entering into the contract
 
Generally no. 
Damages  To put the plaintiff in a position as though the representation had not been made (i.e. contract may no longer be valid).  To put the plaintiff in a position as though the warranty is true and the contract is performed (i.e. contract is still valid). 
Illustration   In the same example of a second-hand car sale, say the buyer pays $10,000 for the car, and the seller makes a representation and warranty that the car has no defects and is worth $10,000. However, there are in fact engine defects, and the car is only worth $6,000 due to such defects:
A successful claim of misrepresentation will entitle the buyer to rescind the contract and obtain refund of the $10,000 purchase price. Alternatively, the buyer could affirm the contract and obtain $4,000 in damages.   A successful claim of breach of warranty will entitle the buyer to claim the difference between the price paid as warranted ($10,000) and the actual value of the car ($6,000), being $4,000 in damages. 

Liquidated Damagesand Penalties 

“Liquidated damages” is an amount contractually stipulated to be payable in the event of non-performance or breach of contract. It is intended to measure damages that may be difficult to prove once incurred, thereby providing parties with certainty and allowing parties to expedite the process of recouping losses. 

Under common law, liquidated damages typically have to be a genuine pre-estimate of a quantifiable loss caused by a breach, and not an amount that is designed to punish a party in breach. As such, an amount that is extravagant, unconscionable or unreasonably large may be struck down by the common law court. For example, an amount that goes beyond what can be the greatest loss conceivable at the time of entering into the contract, or an amount payable even where the breach does not incur pecuniary losses, would be considered punitive and consequently be found invalid. 

PRC law does not prohibit the stipulation of a “penalty” in contract, but seeks to narrow its scope. Under PRC Contract Law, liquidated damages cannot be “excessively higher” than actual losses[5]. In practice, an amount that is more than 30%[6] of the actual losses suffered by the aggrieved party may be considered as “excessively high” and may be mitigated by the PRC court which will look into the actual losses incurred and award a reduced amount. To briefly summarise the differences of the two approaches:  

Nature of liquidated damage  Allowed under common law?  Allowed under PRC law? 
Genuine estimate of losses flowing from a breach  Yes  Yes 
A punitive sum stipulated as to deter potentially offending party from defaulting  No  Yes but with limitation (generally cannot be more than 30% of actual losses) 

The concept of liquidated damages is also important to break fees and reverse break fees in merger and acquisition transactions. Under common law, where a (reverse) break fee does not represent a genuine pre-estimate of the losses suffered by the party not in breach in the failed deal, such a term may be unenforceable. Conversely, under PRC law, such a term would generally be enforceable as long as the agreed fee is not “excessively higher” than the actual loss suffered. 

Due to the difference in the interpretation of the term “liquidated damages”, some of the provisions that are considered common and acceptable in a PRC law-governed contract may be unacceptable in a common law-governed contract. A PRC law-governed contract may elect to use language such as “penalty fee” or ‘for the purpose of penalising”, but use of such terms would generally be considered prima facie evidence of a “penalty” in common law jurisdictions. As such, lawyers who have enjoyed greater freedom in drafting liquidated damages clauses in PRC law-governed contracts may need to narrow down the scope of such clauses in common law-governed contracts so as to preserve the validity of such clauses.  

Specific Performance and Damages

Common law and PRC courts have very different approaches in their choice of remedies. In PRC law, specific performance (继续履行)[7] is one of the main remedies for breach of contract.[8] In common law, specific performance is exceptional and is only complementary to monetary damages; specific performance is awarded only where it is just and equitable to do so, and where damages are not an adequate remedy. The common law court will also take into account a number of factors and exercise discretion in awarding specific performance, including, e.g. the nature of the unperformed obligations, existence of hardship or unfairness in performing these obligations etc. 

Due to differences in approach, PRC courts and common law courts may arrive at different conclusions for the same case. For example, in a contract for the supply of steel, the seller refuses to deliver steel at the agreed price and asks for a higher price arguing that the market price has gone up recently, thereby committing a breach. A PRC court is likely to order the seller to perform the contract if that is what the buyer seeks. In contrast, a common law court generally will award damages to put the buyer in a position as if the contract has been performed (i.e. order the seller to pay the difference between the agreed price and the price the buyer paid for securing replacement steel). 

In practice, however, whilst the starting basis of the two approaches is very different, the practical effect between them may not be as significant as it seems – the availability of specific performance under PRC law is also subject to limitations. The PRC courts will not order performance where such performance is impossible or inappropriate, the expenses of performance are too high, or the plaintiff does not seek performance within a reasonable time.[9] Say, in the above case in a contract for the supply of steel, if the seller at the time of trial suffers fire at its plant and cannot deliver, performance will not be possible from the view of both the common law courts and the PRC courts because the seller would incur undue hardship in performing the contract (i.e. to deliver the steel).

Conclusion 

While there are many differences between common law and PRC law, this article only covers a few key conceptual differences that arise more often in practice for both PRC parties and foreign parties. If you are a PRC party investing overseas and your contract is governed by common law or other foreign laws (or vice versa for a foreign party), and a term of the contract has implications on your rights, obligations, and liabilities, the best practice would be not to assume that the term carries the same meaning and legal implications as you would understand it under the laws of your own country. Seek appropriate advice from a qualified and experienced lawyer to ascertain the meaning and implications of such term so as to best protect your rights and interests.


[1] The discussion of common law and PRC legal principles in this article is in broad and general terms in order to assist readers to acquire a basic understanding of the subject matter in question. The discussion of common law legal principles here is based on the more traditional and common approaches adopted among common-law jurisdictions. This article does not discuss exceptions to the general rules, or the less common approaches adopted in some jurisdictions that have departed from the traditional approaches. Readers should always consult a lawyer qualified in the jurisdiction whose law governs the contract at hand.

[2]Section 26 of the PRC Contract Law.

[3]ection 42 of the PRC Contract Law.

[4]Ibid.

[5]Section 114 of the PRC Contract law.

[6]Section 29, Interpretation II of the Supreme People's Court of Several Issues concerning the Application of the Contract Law of the People's Republic of China, High Court [2009] No.5.

[7]A literal translation of the PRC Contract Law remedy that requires parties to perform their outstanding obligations under a contract is “continued performance” (继续履行), which overlaps with, and differs from, the common law remedy of “specific performance”. For ease of reading, we will still use “specific performance” or “performance” to refer to the PRC law concept of “continued performance”.

[8]Section 107 of the PRC Contract Law.

[9]Section 110 of the PRC Contract law.

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