– Some New Rules on Sales Contracts Brought by China’s Civil Code
China’s new Civil Code and a series of corresponding judicial interpretations of the Supreme People’s Court have become effective since 1 January 2021. While they replace and reiterate plenty of earlier legal provisions and judicial interpretations, they are by no means just a simple compilation of existing rules.
The following are examples of new rules brought by the Civil Code that will impact the sales contract practice:
Determination of Quality Standard in Doubt
In contrast to the vague provisions of the repealed Contract Law, pursuant to Article 511 Item 1 of the Civil Code, where contractual quality requirements are unclear and cannot be determined with the help of a supplementary agreement, other relevant contractual clauses or trade custom, the contract shall be performed according to:
- the compulsory national standards (of China);
- in the absence of compulsory national standards, the recommended national standards (of China) shall apply;
- in the absence of recommended national standards (of China), the industry standards (of China) shall be followed;
- in the absence of national standards or industry standards, the contract shall be performed in accordance with general standards or specific standards in conformity with the purpose of the contract.
In practice, the contractual quality requirements are a key part of a sales contract. They should be carefully and clearly worded. Otherwise, if in doubt, the relevant Chinese standards could apply. This might not be fully consistent with the real contractual purpose (e.g. items bought for distribution in foreign countries where different quality standards than China’s apply).
Retention of Title
Similar to the repealed Contract Law, the Civil Code confirms the validity of an agreement on retention of title pending fulfilment of payment obligation or other obligations. However, pursuant to Article 641 Paragraph 2, where the seller retains ownership of the contractual subject matter but no registration of such retention of title has been completed, the retention of title as agreed by contract parties cannot be used against any bona fide third party.
As announced by the State Council, since 1 January 2021 retention of title can be registered with the platform (https://www.zhongdengwang.org.cn/) operated by the Credit Reference Centre of China’s People’s Bank. However, according to an enquiry with the platform operator, a foreign entity cannot yet conduct such registration by itself and can only entrust its Chinese subsidiary or other Chinese entity (e.g. the Chinese buyer or a law firm) with the registration. Should the Chinese buyer be entrusted with the registration or under the contractual obligation to complete the registration, it should be considered whether the delivery of the contract subject matter be preconditioned by buyer’s provision of the relevant document certifying the completion of the registration.
Formal Transfer of Title as Security
Through a new judicial interpretation, the Supreme People’s Court of China officially confirmed the validity of formal transfer of property ownership (not an actual transfer of ownership) as a security. However, when the debtor fails to perform his due obligation, the creditor cannot directly claim that he is the owner of the property formally transferred to him as a security. The creditor can instead request that the property be auctioned, sold off, converted into monetary figure (e.g. by evaluation) for repaying the debt with priority if the relevant publicity procedure for such formal title transfer (i.e. registration with the competent authority) has been completed.
In principle, since 1 January 2021 formal transfer of title (e.g. a machine or raw materials) as security should also be registrable with the platform (https://www.zhongdengwang.org.cn/) operated by the Credit Reference Centre of China’s People’s Bank. However, it is still unclear, how it shall be registered indeed. According to an enquiry with the platform operator, a foreign entity cannot yet conduct such registration by itself and can only entrust its Chinese subsidiary or other Chinese entity with the registration.
Privity of Contract vs. Third Parties’ Rights
The Civil Code explicitly confirms the privity of contract doctrine. Pursuant to Article 465 paragraph 2, unless otherwise provided for by laws, a contract lawfully concluded shall be legally binding only on the parties thereto.
On the other hand, the Civil Code recognises contracts for the benefit of third parties as an exception to the privity of contract doctrine. For instance, a sales contract between the seller and the buyer for delivering a machine to the end user entitles the end user to request delivery from the debtor directly.
Pursuant to Articles 522 paragraph 2, a third party is entitled to directly request the debtor to perform the contract obligations if
- it is so agreed upon by the contract parties or provided for by law; and
- the third party does not explicitly refuse such performance within a reasonable period.
Should the debtor fail to perform the obligations vis-à-vis the third party in accordance with the contract, the third party is entitled to request the debtor to bear liabilities for breach of contract. However, vis-à-vis the third party the debtor may avail itself of any defence it has against the creditor.
In practice, should a contract for the benefits of third parties be concluded, the relevant contractual clauses should unequivocally stipulate the involved parties’ rights and obligations (especially the third party’s rights and the debtor’s obligations). To avoid uncertainties, the debtor should try to obtain an explicit acceptance of its performance from the third party.
Method for Contract Interpretation
In contrast to the repealed Contract Law, the Civil Code explicitly provides for a rule for contract interpretation. Pursuant to Article 466 in conjunction with Article 142 Paragraph 1, the meaning of a disputed contractual clause shall be determined according to the literal meaning of words and sentences used as well as in combination with the relevant clauses, nature and purpose of the contract, customary practices, and the principle of honesty and credit (i.e. good faith).
If different language versions of a contract are equally effective but use different words and sentences, the meaning of a disputed contractual clause shall be determined according to the relevant clauses, nature and purpose of the contract, and the principle of good faith.
In practice, the wordings and contents of different language versions are oftentimes not fully consistent with each other. To avoid uncertainties, a prevailing language version should be contractually determined unless there is a mandatory requirement in this regard. If the prevailing language version is made in a language that one of the parties does not understand (e.g. Chinese for a non-Chinese party), this should be scrutinised by qualified professionals before signing. Not least, for interpreting potentially disputed contractual clauses, the negotiation process as well as the contract’s nature and purpose should be carefully documented.
Electronic Data Exchange and E-Mail as Written Form
The Civil Code reconfirms that a contract concluded by electronic data or e-mail exchange can be deemed concluded in writing. However, in contrast to the repealed Contract Law, they must be accessible for reference and used at any time.
In case of dispute, the people’s courts and arbitral tribunals in China usually demand conclusive documentary evidence for proving fulfilment of the above-mentioned legal requirements. The party bearing the burden of proof has to provide other supporting documents or even certification by a Chinese notary public to prove that the relevant electronic data or e-mail exchange has been kept complete and unchanged ever since its establishment and can be retrieved at any time. Therefore, we strongly recommend obtaining the contract version originally executed (or at least an executed confirmation by the contract parties) despite its previous conclusion through electronic data or e-mail exchange.
Regulations on General Terms and Conditions (“GTC”) Modified
In contrast to the repealed Contract Law, Articles 496 – 498 of the Civil Code have substantially modified the regulations on GTC as follows:
- The scope of GTC provider’s reminding and explanation obligations has been extended from the terms excluding or mitigating the GTC provider’s liabilities to all clauses that significantly affect the other party’s interests;
- Should the GTC provider fail to fulfil such reminding and explanation obligations and cause the other party not to pay attention to or understand the relevant clauses significantly affecting its interests, the other party may claim that such clauses do not constitute the contents of the contract. In such case, the other party does not need to apply to the competent people’s court or arbitral institution for revocation of such clauses, as was the case in the past;
Not all clauses excluding the GTC provider’s liabilities and increasing the other party’s liabilities shall be null and void, as provided for in the past by the repealed Contract Law. Now only clauses unreasonably exempting or mitigating the GTC provider’s liabilities, increasing the other party’s liabilities or limiting the major rights of the other party shall be null and void.
Extension of Scope of Contract Parties’ Confidentiality Obligation
In the course of concluding a contract, the contract parties have a statutory confidentiality obligation. Under the repealed Contract Law, such statutory confidentiality obligation was only limited to trade secrets. The legal term of “trade secret” under Chinese law refers to:
- technical information, management operation information or other commercial information
- that is unknown to the public,
- is of commercial value, and
- for which the right holder has taken corresponding confidentiality measures.
Now, Article 501 of the Civil Code has extended the scope of such confidentiality obligation from trade secrets to other information (e.g. personal information) that shall be kept confidential.
Contracts affected by Deficient Declaration of Intent
Pursuant to Article 508 in conjunction with Article 146 of the Civil Code, sham contracts based on a contract parties’ false declaration of intent shall be null and void.
Pursuant to Article 508 in conjunction with Articles 147 – 152 of the Civil Code, the contracts affected by material misunderstanding, fraud, coercion or by being obviously unfair (due to one party’s making use of the other party’s disadvantageous position) can be revoked by the competent people’s court or arbitral institution upon request of the affected party. If the affected party only wishes to amend such contracts, a private agreement with the other party should suffice. An application to the competent people’s court or arbitral institution for amendment as provided for by the repealed Contract Law is no longer required.
In contrast to the general one-year time limit provided for by the repealed Contract Law, now the revocation right based on material misunderstanding shall be extinguished if it is not exercised within 90 days from the date when the party concerned knows or shall have known the cause for revocation.
The one-year time limit for exercising the revocation right by the party coerced shall now firstly begin to run from the date when the coercion ceases.
Where the party concerned does not exercise the revocation right within five years from the date when the legal transaction takes place, the right of revocation shall be extinguished.
In general, the above-mentioned time limits for exercising the revocation right cannot be suspended, interrupted or extended (Article 199).
Regulation on Change in Contractual Basis Clarified
Under a former but now repealed judicial interpretation of the Supreme People’s Court, a party concerned can file a request for the modification or rescission of the contract with the people’s court, where:
- any major change in objective circumstances, that is unforeseeable when concluding the contract, and is not a business risk and is not caused by a force majeure event,
- such major change occurs after the conclusion of the contract, and
- the continuous performance of the contract is obviously unfair to one party or cannot realise the purposes of the contract.
This rule has played an important role against the background of the current COVID-19 pandemic. However, in practice, several ambiguities had to be clarified. For instance, will a major change in any objective circumstances suffice? Why such major change shall not be caused by a force majeure event? Shall the party affected at first try to negotiate a corresponding amendment to the contract with the other party?
Now, pursuant to Article 533 of the Civil Code a party can (only) apply to the competent people’s court or arbitral institution for amending or rescinding the contract, if:
- after a contract has been concluded, the conditions forming the basis of the contract have undergone a significant change;
- such change was unforeseeable for the parties when concluding the contract;
- such change does not belong to commercial risks;
- it is obviously unfair for one party to continue the performance of the contract; and
- the parties fail to reach an agreement based on renegotiation within a reasonable period of time.
In practice, if a party is affected by such material change in the contractual basis and wishes to amend or rescind the contract, such party should carefully collect relevant evidence and try to negotiate a solution with its contract partner at first. Only when such renegotiation fails, a request for amending or rescinding the contract can be filed with the competent people’s court or arbitration institution.
Default Interest Clearified
A revised judicial interpretation of the Supreme People’s Court now officially confirms the change of regulation on default interest. In the absence of a relevant agreement,
- if the default occurred before 19 August 2019, the benchmark interest rate for the same (or comparable) type RMB loan published by the People’s Bank of China in the same period and with reference to the overdue penalty interest rate standard may be used as basis for calculating the default interest;
- if the default occurred after 20 August 2019, the National Interbank Funding Center’s Loan Prime Rate (“LPR”) for one-year loan plus 30% – 50% may be used as the basis for calculating the default interest. The current LPR for one-year loan is 3.85%.
Exercise of Right to Rescind Contract
Regarding exercise of rescission right (e.g. due to material breach of contract by one contract party), Articles 564 and 565 of the Civil Code supplement the repealed Contract Law as follows:
- in the absence of relevant statutory or contractual provisions determining the time limit for exercising the right to rescind a contract, the rescission right shall be extinguished, if the right holder does not exercise such right within one year from the date on which the right holder knows or shall have known about the cause for rescission;
- a rescission notice can specify that if the debtor fails to perform his obligations within a certain time period, the contract shall be rescinded automatically. The contract will be rescinded upon expiration of such time period if the debtor fails to perform in time;
- not only the recipient of the rescission notice but either contract party can ask the competent people’s court or arbitral institution to determine the validity of the rescission;
- a contract can also be rescinded by filing a lawsuit or arbitration request. If the claim for rescission is supported by the competent people’s court or arbitral institution, the contract shall be rescinded upon service of the duplicate of the statement of claim or arbitration request on the other party.
In practice, the principle of “trust but verify” shall also apply to the performance of contract. Each breach of contract should be carefully documented, and its rectification should be required. Should a breach of contract be able to justify a rescission of contract and a rescission also be wished, the entitled party should exercise his rescission right in time to avoid being forfeited or causing the impression of tacit consent, approval or even waiver.
Consequences if a Non-Monetary Performance cannot be Required
Same as the repealed Contract Law, pursuant to Article 580 of the Civil Code, if either contract party fails to perform non-monetary obligations as agreed, the other party cannot ask performance under any of the following circumstances:
- the performance is impossible in law or in fact;
- the subject matter of the obligation is unfit for compulsory performance or the performance costs are too high;
- the creditor fails to request performance within a reasonable time limit.
In contrast to the repealed Contract Law, the Civil Code further confirms that if any of the above results in the impossible realisation of the contract, a party may request the competent people’s court or arbitral institution to end the contractual relationship. However, such ending ruled by the competent people’s court or arbitral institution does not affect the liabilities for breach of contract to be borne by the responsible party.
Debt Assumption vs. Suretyship
Pursuant to Article 552 of the Civil Code, the creditor may request a third party to bear joint and several liability for repaying a debt within the scope of debts assumed by the third party where:
- the third party agrees with the debtor on joining in the debt and notifies the creditor, or
- the third party expresses to the creditor his willingness to join in the debt, and the creditor does not expressly reject the joining within a reasonable period.
Such debt assumption shall be distinguished from suretyship (Articles 681 – 702 of the Civil Code). In the case of debt assumption, the third party will join in the debt and discharge the obligations as his own and no written form for debt assumption contract is required.
In contrast, under a suretyship contract, the surety shall perform the obligation for the debtor or assume liability when the debtor fails to perform the obligation on time or when circumstances agreed upon by the parties occur. A suretyship contract shall be concluded in writing by and between the surety and the creditor.
According to the new Supreme People’s Court’s judicial interpretation, if it is difficult to determine between debt assumption and suretyship, the relevant contract shall be deemed a suretyship contract.
Furthermore, pursuant to Article 686 Paragraph 2 of the Civil Code, in the absence of a clear agreement on the type of suretyship, the surety shall bear the liabilities according to a general suretyship. In the past, in such case the surety shall bear the liabilities based on a joint and several suretyship.
Under a general suretyship, with a few exceptions the surety can refuse to assume suretyship liabilities to the creditor until:
- a dispute concerning the principal contract between the creditor and debtor has been adjudicated or arbitrated; and
- the debtor has failed to perform his obligation despite enforcement against his property.
In contrast, under a joint and several suretyship, the creditor can require the debtor to assume liabilities or the surety to assume suretyship liabilities once the debtor fails to perform his obligation on time.
In practice, if a debt assumption or a joint and several suretyship is intended, the relevant contractual clauses shall be carefully and unequivocally worded. Otherwise, they could be deemed a general suretyship contract with weaker protection for the creditor.