Formation, Enforceability and Liability Issues Under the Contract Law

February 4-5, 2001
Beijing, China

By Ron (Rongwei) Cai

I. FORMATION

The formation of contracts is an important subject matter in the Contract Law. Parties should not wait until problems or disputes actually occur to try to find a resolution, as the parties' conflicting interests will make it difficult for them to come to a consensus at this juncture. It is crucial to contemplate potential problems that might arise during performance of contract at the time the contract is negotiated, and to incorporate specific provisions covering the different types of problems that may be involved in special circumstances. Once a dispute occurs, the parties' rights and obligations can be clarified on the basis of the contract's provisions. The significance of the formation of contracts lies in the fact that the parties' rights and obligations are clearly spelled out. A properly formed contract is the condition precedent to the performance of it. A contract with specific, clear provisions will facilitate the resolution of any possible contract disputes.

This chapter focuses on the following topics:

• contract format;
• content of an offer;
• the parties' stipulations vs. mandatory provisions;
• liability for breach; and
• standard clauses.

1.1 Contract Format

According to Article 7 of the Foreign Economic Contract Law, a "contract is formed when the clauses are agreed in written form and signed by the parties". When China signed the United Nations Convention on Contracts for the International Sale of Goods, it made a reservation on the provisions regarding the format of a contract. Currently, PRC law requires all international trade contracts to be in writing. China was still in the early stage of economic liberalization and had little experience with foreign trade when the Foreign Economic Contract Law was promulgated in 1985. The legal concept of contract was also underdeveloped and many people entering into contracts had no clear idea of whether or not their contract should be in writing. A foreign economic contract may involve tens of thousands and even tens of millions of dollars and a careless mistake in the formation of contract may result in serious loss.

During the drafting of the Contract Law, there were two different opinions regarding the formats of contracts. Some legal experts believe that written contracts can help to avoid mistakes and provide a solid basis for courts in their adjudication; therefore, emphasis should be placed on the written form. Others believe that law should not overly restrict the format of contracts. Whether or not it is in writing should depend on the situation, with consideration given to the nature of the contract and the amounts of money involved. Matters concerning the relationship between the parties should be left to the parties themselves.

Article 10 of the Contract Law stipulates:

The parties may conclude their contract in written, oral or in another form.

If a law or administrative regulation stipulates that it be in writing, then it shall be in writing. If the parties agree that it be in writing, it shall be in writing.

There are two major principles in the Contract Law concerning the form of contracts. First, consideration must be given to practical necessity. The Contract Law is applicable to both domestic and foreign contracts, and to contracts between enterprises as well as those between individuals and between enterprises and individuals. It could be very inconvenient if all contracts are required to be in writing as this increases the cost of transactions. For instance, it is impractical to put in writing those issues that can be easily resolved by a telephone call. Oral and written contracts each have their own advantages and disadvantages. The parties should decide the conditions under which to opt for an oral or written form of contract based on practical circumstances. Article 10 of the Contract Law does not prohibit oral contracts. If a contract is the first transaction between companies involving large sums of money, then of course it would be preferable to have the contract in writing. However, if the parties have dealt with each other for a long time, have enjoyed a good relationship and have never had a dispute before, it would be normal for a purchase order to take place over the telephone. If the order is urgent, a written contract would unnecessarily delay delivery and production.

Article 10 provides that a contract can be in a form other than writing, meaning that a contract can be formed by action. For example, a bus stopping at a bus stop is actually an act of offer as it essentially offers a ride to potential passengers. When a passenger comes on board, it is an act of acceptance. The passenger and the public transport company reach a transportation contract. This type of implicit contractual relationship also exists among companies. For two companies that have been dealing with each other for a long time, it may not be uncommon for one party to telephone the other and ask for immediate delivery of goods. Under such circumstances, the contract is formed when certain action commences.

The second principle under Article 10 of the Contract Law is to encourage the parties to use a written form. Except in some individual cases, contracts should be concluded in writing. Agreements reached orally should be subsequently supplemented by a written contract. In addition, comprehensive contract provisions make it easier to resolve future disputes that could arise. The first paragraph in Article 10 provides three different ways of forming a contract. A deliberate hierarchy of preference is implicit in this clause. The first way of forming a contract is in writing. It represents legislative attempt to encourage the use of written contracts.

Contracts in other forms are only used in unusual circumstances. Between written and other forms of contracts, the Contract Law devotes more provisions regulating the written form. The intent is to encourage parties to substantiate contracts in writing.

A related issue is how to deal with situations where parties fail to contract in writing despite their earlier agreement to do so, or where parties fail to contract in writing despite such a requirement by law. What would be the legal consequence of such failure? When parties fail to contract in writing despite such requirement by law, there are four possible legal consequences. First, the contract will be deemed as not being formed. Second, the contract though formed will have no legal effect. Third, the contract is effective but cannot be enforced; that is, the parties may perform solely on a voluntary basis. The courts cannot enforce the contract on a party to protect the interests of the other party. Fourth, a subsequent written contract will prove the effectiveness of the previously formed contract.

The Contract Law Drafting Committee had adopted the fourth approach, making written forms effective evidence a legally formed contract. Article 45 of the Contract Law (Draft) provided that where parties failed to conclude a contract in writing which is required by law to be written, it would nevertheless be effective if the parties could prove that they had agreed to the contract terms. This provision was subsequently deleted because of the desire to encourage parties to adopt the written form of contract. There is another reason for this deletion. In the early stages of the drafting, the drafters had only considered situations where the parties failed to conclude a contract in writing despite the legal requirement to do so. Subsequently, they also considered the situation where the parties agreed to conclude in writing but eventually failed to do so. For example, where a party proposes during negotiations that the contract must be written and signed; oral agreements in such a situation would be ineffective. Based on international practice, there will be no contract before the execution of a written contract. According to the new Contract Law, a contract has not been formed unless it is in writing if a law or administrative regulations requires such a contract to be written. However, Article 36 of the Contract Law also provides that:

If laws or administrative regulations stipulate or the parties have agreed that their contract be concluded in writing but the parties did not do so, a contract is nevertheless formed if one of the parties has already performed his main obligations and the other party accepts the performance.

1.2 Content of an Offer

Article 14 of the Contract Law states:

An offer is a party's declaration of his intent to conclude a contract with another party. The declaration shall comply with the following provisions:
(1) its content shall be specific and definite; and
(2) it shall indicate that the offeror will be bound by it upon its acceptance by the offeree.

Once there is an offer from one party and its acceptance by the other party, a contract is formed. The offeror will be bound by the terms of its own offer. Offer and invitation to make an offer are two distinct concepts. An invitation to make an offer is an invitation to another person to make an offer to oneself. An offeror, on the other hand, wishes the recipient to accept the offer and enter into a contract.

A salesman promoting his goods states to the other party that the sale will have to be approved by the general manager, or evidenced by a written and signed contract. In the above situation, the salesman's act is not final; it is merely an invitation to make an offer because the salesman's words are not conclusive. An offer conveys the idea that the provisions suggested by the offeror are conclusive and that a contract will be formed as soon as the recipient party agrees to them.

When one party wants to engage in trade with another party, it has to provide certain terms of trade. In other words, the content of an offer must be specified as stated in Article 14 of the Contract Law. A "for sale" sign together with the contact telephone number at the back of a car does not constitute an offer, it is merely an invitation to make an offer. The sale of a car would involve other matters such as the condition of the vehicle, years of operation, price and available date. If the content of contract is unspecified, there is no contract even if the other party agrees. In reality, offer and counter-offer may occur several times during the process of forming a contract. Simple transactions may be complete in one process of offer and acceptance. Most business transactions, however, may involve an initial offer from one party and a counter-offer from the other party. For instance, a party offers to sell a certain amount of steel to the other party at a specified price. While the offeree agrees to the offered terms, he also suggests a delivery date. The delivery date is deemed a counter-offer and the original offeror now becomes an offeree. If the offeree agrees to the delivery date, a contract will be formed. If not, the parties have to continue negotiations. Therefore, in real life, the status of the offeror and offeree may be constantly switching. In general, a party becomes an offeror whenever it makes a new proposal regarding the terms of contract or raises a new issue. Acceptance is an indication of agreement to the terms of the offer.

According to Article 12 of the Foreign Economic Contract Law:
Contracts should generally contain the following items:
(1) the corporate or personal names of the contract parties and their nationalities, and addresses of principal place of business or residence;
(2) date and place of signature of the contract;
(3) type of contract and the kind, scope of the subject matter of the contract;
(4) technical conditions, quality standard, specifications and quantities of the subject matter of the contract;
(5) time limit, place and method of performance;
(6) terms of price, amount and method of payment, and various additional charges;
(7) whether the contract can be assigned or conditions for assignment;
(8) compensation and other liabilities for breach;
(9) ways for settlement of disputes in case of disputes arising from the contract; and
(10) languages to be used in the contract and their effectiveness.

In judicial practice, some judges in their adjudication of contract disputes reach anomalous decisions that contracts are void simply because one of the terms provided in law was missing in the contents of the contracts in question. This is inconsistent with the principle of Contract Law.

The content requirements in the Foreign Economic Contract Law and the new Contract Law are both suggestive in nature. The objective is to encourage the parties to enter into comprehensive and carefully considered contracts. It does not mean that each of these terms is mandatory. The drafters of the Contract Law considered whether the Contract Law should include a list of all the items which should be included in an offer but subsequently decided against it because the subject of contract can vary and involve vastly different amounts or types of subject matters. The relationship between the parties may also differ, depending on whether they were involved in previous transactions and how frequently they have dealt with each other. Some foreign countries' laws and some international treaties have tried to deal with this problem. Under the US Uniform Commercial Code, an offer with a specified subject matter and quantity is sufficient to support the formation of a contract. The United Nations Convention on Contracts for the International Sale of Goods requires an offer to specify the subject matter, quantity and price. As long as these three items are definite, the formation of contract will not be affected. The Contract Law abandons the concept under both the Uniform Commercial Code and the United Nations Convention on Contracts for the International Sale of Goods with respect to the content of an offer. The Contract Law drafters felt that neither approach answers the question as to what must be included in the content of an offer. Additionally, they felt that certain leeway should be allowed in some individual cases. The drafters opted for the approach of the International Code of Commercial Contracts. While it is clear that the content of an offer must be specific enough, the types of information required in an offer which would support the ultimate formation of a contract would have to be analyzed in the context of the circumstances of each case. Therefore, the provision in Article 12 of the Contract Law is of a suggestive nature. It suggests to the parties the type of information that should be included in the contract. The parties can of course include other information as well. Article 12 of the Contract Law speaks in general terms. It differs from Article 12 of the Economic Contract Law, which stated that "an economic contract shall contain the following clauses", and also from Article 12 of the Foreign Economic Contract Law which stated that: "contracts should generally contain the following items". The phrase "should generally contain" has been changed to "in general, ...shall include", to emphasize the suggestive nature of this clause in the Contract Law. Thus, under Article 12 of the Contract Law, the omission of one or more items in contracts does not result in a void or ineffective contract.

Whether a contract is properly formed depends on whether the parties reach a consensus after negotiation. If there is no consensus, no contract has been formed. If there is no negotiation process, a contract is nevertheless formed as long as the contract contains essential terms and conditions. Issues unspecified in a contract can be resolved by relying on Articles 61 and 62 of the Contract Law and other provisions. A contract in which the main or basic terms are missing is indicative of a very limited agreement between the parties. A contract has not been formed where necessary issues have not been discussed and no other provisions can be relied on to resolve unspecified matters.

1.3 Parties' Stipulations vs. Mandatory Provisions

Parties entering into a contract will generally specify matters such as the subject, the performance period and liability for breach. The Contract Law contains provisions on the above matters. If there is a dispute between the parties with regard to the contract and it is submitted to a court or arbitration tribunal, the court or the arbitration tribunal should resolve the matter by first relying on the contract terms instead of the provisions in the Contract Law.
Contract terms take precedence over the provisions in the Contract Law for the following reasons.

Complexity of contracts

A contract may involve a multitude of issues, a variety of subject matters and contract amounts, and circumstances are different in each case. The complexity of real life, the existence of an endless possibility of variables and the combination of these factors mean that only the parties themselves are in the best position to protect their interests. It would be impossible for the law to provide for every single possible situation and the means to handle each situation. The law must defer to the parties in this regard.

Contract right is a form of civil right

A person has the discretion to decide whether or not to exercise his civil liberty, as long as it is within the confines of the law. If Party A suffers a loss in a transaction with Party B, A has the discretion to decide whether or not to claim against B as long as it is permissible under the law. Of course, A may consider his longstanding relationship with B and decide against any claim or reduce the claim amount in order to avoid jeopardizing their future business. Such discretion is permissible under law.

Legal provisions are either voluntary or mandatory

While the objective of the law is to regulate behavior, violation of the law might not always be penalized. Violation of a mandatory provision of the law will lead to punishment. Compliance with voluntary provisions of the law, however, is on a completely voluntary basis.

Mandatory legal provisions usually involve public interest, such as tax administration and business registration. Mandatory legal provisions can be further categorized into coercive and prohibitive provisions. Coercive provisions direct persons to take certain actions such as registering a business or paying taxes. Failure to do so under the requisite situation will be subject to administrative penalties and even criminal punishment in some cases. On the other hand, prohibitive provisions proscribe certain activities. For instance, the PRC Law Against Unfair Competition prohibits businesses from engaging in fraudulent practices, selling counterfeit goods, conducting misleading advertising or infringing upon others' trade secrets.

The majority of the provisions in the Contract Law are voluntary in nature and may be exercised at the discretion of the parties themselves. It means that the parties can choose whether or not to apply these voluntary provisions. Notwithstanding the voluntary provisions, it is also possible to be specific in the contract according to the agreement of the parties. The Contract Law has a limited number of mandatory provisions. These include provisions on the effectiveness of contracts, such as Article 52, which states that a contract that functions as a malicious conspiracy to harm the interests of the State is void. When parties enter into a contract, they cannot exempt themselves from such mandatory provisions despite their consensus to the contrary. Even if they agree among themselves that their contract, which functions as a malicious conspiracy to harm the interests of the State, is effective, the law will prevail over the parties' agreement. Parties must abide by the mandatory provisions of law and cannot set their own standards.

Therefore, as a general rule, the parties' agreement should be given prior consideration over the provisions of the law. If the parties' agreement is not explicit on certain terms, the parties can either supplement such particulars or rely on trade practice. Article 61 of the Contract Law provides that:

After a contract enters into effect, the parties may agree to supplement such particulars as quality, price or remuneration, place of performance, etc. which were not stipulated or were not explicitly stipulated in the original contract. If no supplementary agreement can be reached, the particulars shall be determined in accordance with the relevant clauses of the contract or usage of trade.

If the parties still cannot resolve their differences, the Contract Law provides its clauses as the last resort. The provisions in the Contract Law are meant to supplement particulars concerning the parties' rights, obligations and means of resolving disputes.

Liability for bad-faith negotiation

Articles 42 and 43 of the Contract Law contain new concepts concerning liability for negotiation in bad faith. The traditional concept of the law on contract is that it governs the period from when a contract is made until when it is extinguished. However, a more developed contract law would provide that the law also reaches retroactively to the time when the parties begin negotiations until the time when the negotiation breaks without reaching any agreement. It is possible for a party to incur "pre-contractual" liability under certain situations during such time. Articles 42 and 43 describe the pre-contractual liability recognized under the Contract Law. These liabilities are incurred before contracts are made, generally because one party suffers damages because of the other party's fault.

It is important not to confuse the right to negotiate with bad-faith negotiation. If the parties fail to reach a contract, they are not liable to each other. There is no contractual liability when there is no agreed-upon contract. The good-faith principle provides a good indicator of whether there may be any pre-contractual liability. A person who violates the good-faith principle causing damage to the other party will be liable. If there is no violation of the good-faith principle, there is no liability even if one party suffers damages.

Article 42 of the Contract Law provides that:
A party which causes loss to the other party is liable for damages if during the course of concluding the contract he:
(1) negotiated in bad faith under the pretext of concluding a contract;
(2) deliberately concealed an important fact relevant to the conclusion of the contract or provided false information; or
(3) engaged in another act counter to the principle of good faith.

The first and second items are instances that violate the good-faith principle. Negotiation in bad faith refers to the situation where a party who has no intention whatsoever of entering into a contract nevertheless conducts negotiation with the other party in order to keep such party engaged to prevent him from taking other available business opportunities or to cause damage to third parties.

Party A who owns an electrical appliance store engages in negotiation with Party B for the transfer of ownership interest in the store. Party C, who owns another electrical appliance store on the same street, does not want B to be his competitor. C tells A that he is willing to pay a higher price to buy A's store. A then starts negotiations with C. C's true intention is not to acquire A's store but to prevent B from entering into the market in the same area as C. In such a situation, A can claim its cost of negotiations and all other damages against C.

Some cases in other countries involve over-exaggeration or empty promises resulting in damages to the other party. For instance, Party A and Party B are planning a joint venture but have not entered into a definite contract. A requires B to level the site and connect utilities before proceeding further and promises to pay its share of the capital in the mean time. B relies on A's promise and levels the site and connects the utilities. Despite B's work, A does not pay according to its promise. In such a situation, B may have a claim against A for its loss. The lack of a contract will not be a defence for A.

Article 43 of the Contract Law concerns trade secrets. Two companies negotiating for a contract will unavoidably exchange certain proprietary information, including trade secrets. Regardless of whether or not a contract is formed, neither party may disclose trade secrets or use such information improperly. Otherwise, the disclosing party or the party who uses the information improperly will be liable for any damages suffered by the other party. Article 43 of the Contract Law provides that:

Trade secrets learned by a party during the course of concluding a contract may not be disclosed or improperly used, regardless of whether or not the contract is formed. If a party causes loss to the other party through the disclosure or improper use of such trade secrets, he is liable for damages.

Contracts using standard clauses

The 1995 PRC, Insurance Law is the first law in the PRC to touch on the subject of contracts using standard clauses. Articles 39, 40 and 41 of the Contract Law provide further guidelines. Contracts with standard clauses refer to those contracts that are usually not the result of negotiation between the parties. They are usually typed in advance by one party and presented to the other when the occasion calls for such a contract. Contracts with standard clauses are the result of the fast-paced economy and society. They are convenient to contractual parties and lower transaction costs. Passengers on trains and aeroplanes do not need to negotiate contracts with railroad companies and airlines before their trips. However, these standard contracts also have their disadvantages. Large businesses or industrial associations usually prepare such contracts which generally protect their interests at the expense of the interests of small and medium businesses and individual consumers. Standard contracts might contain latent pitfalls that ordinary, relatively inexperienced individuals who are under time constraints might find difficult to detect. In the event of dispute, small and medium businesses and individual consumers are usually at a disadvantage.

Provisions in the Contract Law concerning contracts with standard clauses provide special protection for small and medium businesses and individual consumers. Articles 39, 40 and 41 stipulate certain special protection available, such as:

• the party providing the standard clauses is obligated to draw the attention, in a reasonable manner, of the other party to clauses which exempt or limit his liability, so that the other party can be aware of such clauses and consider them carefully before signing the contract. The "reasonable manner" can be satisfied by, for instance, using different fonts or colors to highlight these clauses to the attention of the other party;
• certain standard clauses are void. According to Article 40 of the Contract Law, clauses which exempt the party providing them from liability, increase the liability of the other party or deprive the other party of a major right are void if the providing party breaches its obligation to draw the attention of the other party to such clauses; and
• special provision concerning interpretation of standard clauses. Article 125 of the Contract Law is applicable in the interpretation of all contracts including contracts with standard clauses. Article 41 of the Contract Law states:

  If a dispute arises over the understanding of a standard clause, the clause shall be interpreted in accordance with the usual understanding of such a clause. If there are two or more interpretations of a standard clause, the clause shall be interpreted in a manner that does not favor the party that provided the said clause. If there is an inconsistency between a standard clause and a non-standard clause, the non-standard clause shall prevail.

"Usual understanding" refers to the common understanding of those persons who may enter into such a contract. Article 41 is a special provision applicable to the interpretation of contracts with standard clauses only. It signifies the special protection that this legislation provides to small and medium businesses and individual consumers.

II. PERFORMANCE

Part 4 of the Contract Law deals with performance of contracts. It contains a total of 17 articles that regulate matters such as:

• the principles of performance;
• acknowledgement of contract content;
• contracts concerning third parties;
• right to suspend performance if the party with concurrent obligation fails to perform;
• right to suspend performance if the party with prior obligation fails to perform;
• right to suspend performance in an anticipatory breach situation;
• early performance of debt obligation;
• partial performance of debt obligation; and
• subrogation and right of annulment.

Articles 61 and 62 of the Contract Law provide the answer on how to deal with the situation where a contract does not have explicit terms such as quantity, price or compensation, or place of execution, and the contracting parties fail to reach any supplementary agreement. Similar provision is found in Civil Law General Principles.

This chapter discusses the following issues:

• right to suspend performance in an anticipatory breach situation;
• subrogation and right of annulment; and
• frustration of contract.

2.1 Right to Suspend Performance in Anticipatory Breach Situation

After a contract is formed, the parties are required to perform their respective obligations according to contract terms. Problems arise if one party discovers that the other party will not perform. Contracts are usually mutually beneficial and the parties' obligations correspond to each other. If one party cannot perform, the other party will suffer loss, then should the other party be allowed to take measures to avoid such loss or should he deal with it only after he suffers the inevitable loss?

To combat fraudulent contracts and to protect creditors' interests and the social and economic order, Article 17 of the Foreign Economic Contract Law provided that:

[A] party may suspend performance of his obligations temporarily if it is proved by conclusive evidence that the other party cannot perform his obligations. However, the party who suspends performance should promptly inform the other party. When the other party provides a full guarantee of performance of the contract, the party shall perform the contract. The party who suspends performance of contract, in case of no conclusive evidence for proving the other party is not able to perform the contract, shall be responsible for breach of contract.

This provision is theoretically sound and has reached good results in practice. The Contract Law has adopted the spirit of this article, making it applicable to domestic as well as foreign contracts.

Article 68 of the Contract Law stipulates that:
The party which is to perform his obligation first may suspend performance if he has conclusive evidence that:
(1) the other party's business circumstances have significantly deteriorated;
(2) the other party has transferred assets and/or surreptitiously withdrawn funds in order to evade his obligation;
(3) the other party has lost his goodwill; or
(4) there are other circumstances which have led or may lead to the other party's losing his ability to perform his obligation.
If a party suspends performance without definite evidence, he is liable for breach of contract.

Article 69 of the Contract Law provides that:
If a party suspends performance in accordance with the provisions of Article 68 of this Law, he shall in a timely manner notify the other party thereof. If the other party provides adequate security, performance shall be resumed. After suspension of performance, the party which has suspended performance may terminate the contract if the other party does not recover his ability to perform his obligation and fails to provide adequate security within a reasonable period of time.

Articles 68 and 69 follow the principles in the Foreign Economic Contract Law and take it one step further in the following ways.

First, these articles answer the question as to the circumstances under which a party can suspend performance. The rule under the Foreign Economic Contract Law was that suspension of performance was permitted when there was "conclusive evidence that the other party cannot perform his obligations". Under the Contract Law, the requirement is that there must be conclusive evidence that:

• the other party's business circumstances have significantly deteriorated;
  
• the other party has transferred assets and/or surreptitiously withdrawn funds in order to evade his obligation;
  
• the other party has lost his goodwill; or
  
• there are other circumstances which have led or may lead to the other party's losing his ability to perform his obligation.

Loss of goodwill refers to either of the following situations - where a contracting party is known for defrauding other people numerous times or where a contracting party has previously defrauded other contracting parties.

Second, Articles 68 and 69 of the Contract Law provide guidelines on dealing with the situation after the party with prior obligation suspends performance. The Foreign Economic Contract Law was silent on this matter.

2.2 Subrogation and Right of Annulment

Contracts regulate the rights and obligations between contracting parties and usually have no direct impact on third parties. Except under certain circumstances, third parties may not request performance by either contract party and may not assume the obligations of either contracting party due to lack of privity to contract.

Subrogation and annulment are the exceptions.

Assuming there are two separate creditor/debtor relationships: one between Party A, the creditor and Party B, the debtor, and the other between B the creditor and Party C, the debtor; under normal circumstances, these two relationships are independent of each other. Under specified circumstances, however, A may himself, on behalf of B, request C to perform his obligations. In other words, A may be subrogated in his own name and exercise B's right as a creditor against C. Article 73 of the Contract Law sets out the condition for exercising the right of subrogation: "If the obligor neglects the exercise of his own matured claim, thereby causing damage to the obligee…," then the obligee has the subrogation right.

Subrogation and right of annulment have the same objective in securing the creditor's rights and the realization of such rights. From the creditor's perspective, the condition for exercising both subrogation and the right of annulment is the same; that is, there must be damages to the obligee. From the debtor's perspective, though, subrogation and the right of annulment have different purposes. Subrogation deals with the situation where "the obligor neglects the exercise of his own matured claim". Right of annulment deals with the situation where "the obligor waives his own matured claim or assigns property without consideration and thereby causes damages to the obligee", or "the obligor assigns property at a price which manifestly is unreasonably low, thereby causing damages to the obligee, and the assignee is aware of such circumstances…"

Take the following example.

Party A owes Party B Rmb200, 000. Other than an automobile, A has no other significant assets. To avoid paying off his debt, A transfers his car to a trust fund without consideration. According to Article 74 of the Contract Law, B can petition the court to nullify A's gift to the trust fund.

There is a problem with title over assets obtained as a result of exercising subrogation or right of annulment. Is the title vested with the subrogee or the person exercising the right of annulment, or is it vested with the obligor who neglected the exercise of his own matured claim, or with the obligor who assigned property without compensation? It would not be fair to allow the subrogee and the person exercising the right of annulment to have title. In the earlier example, the real creditor/debtor relationship exists between B and C. It is C who owes B money. A is merely subrogated to exercise B's right against C in order to realize A's creditor's rights since B fails to exercise his claim against C himself. Based on the nature of the right of subrogation, assets acquired as a result of subrogation should belong to B, the owner. In addition, if A's right is an ordinary creditor's right and if B has other obligations toward other creditors, A cannot receive payment ahead of the other creditors. Considering the potential existence of other creditors, the assets should not be paid to A directly but should go to B instead. This will ensure that A and all other creditors receive their fair distribution.

If B and C have an arbitration agreement, A should still be entitled to petition the court to exercise B's right as a creditor and participate in the arbitration against C. The arbitration agreement between B and C should not limit A's right of subrogation. Any result to the contrary will defeat the purpose of subrogation under the Contract Law to protect the creditors' right. A may petition the court to claim against C only when B fails to exercise his right as creditor. The arbitration agreement between B and C is ineffective to A. On the other hand, if B decides to exercise his right as creditor before A's petition, then A will lose his right of subrogation and B can resolve his dispute with C based on their arbitration agreement.

Subrogation and right of annulment will work to protect the creditors' interests and preserve the social and economic order. In practice, one should pay attention to the following issues. First, the neglect or waiver of an obligor's matured claim should not be broadly interpreted. Similarly, damages to the obligee should be narrowly construed. Our opinion is that the right of subrogation and annulment should be strictly and narrowly construed. Otherwise, the consequences might contravene the legislative intent of the Contract Law.

2.3 Frustration of Contract

The frustration of contract provisions in the Contract Law were the source of many debates during the drafting process. Extraordinary circumstances, which were unforeseeable and uncontrollable by the parties at the time when they concluded the contract, might arise after the contract is formed. If these extraordinary circumstances have the effect of upsetting the basic assumptions of the parties when they entered into the contract and seriously disrupting the parties' interests, then under such circumstances, some legal experts believe, it would be unjust and unreasonable to strictly enforce the terms and conditions of the contract. A more equitable solution would be to allow the parties to negotiate new terms and conditions based on the new circumstances. If the parties fail to reach an agreement, then they can petition the court for alteration or termination of the contract. Other experts who opposed the inclusion of frustration of contract provisions in the Contract Law believe that it is inherently difficult to differentiate between frustration of contract and normal commercial risks and worried that frustration of contract might become an excuse for non-performance.

No legal system in the world has as yet offered mature experience in dealing with frustration of contract. On March 15 1999, the eve of voting for adoption of the proposed Contract Law, the PRC judicial branch suggested deletion of the frustration of contract provisions from the draft Contract Law. Based on China's experiences in domestic and international trade, it was finally agreed that China should not codify frustration of contract in this legislation. Extraordinary circumstances causing serious disruption in the parties' interests can be handled according to the principles of fairness and good faith.

III. TERMINATION OF CONTRACTUAL RIGHTS AND OBLIGATIONS

The timing of terminating a contract and the contracting parties' rights, obligations and liabilities associated with such termination, are among the most litigated areas of contract law. The Contract Law attempts to provide some detailed guidelines to such subject matters.

This chapter focuses on three of the conditions for termination:

• termination;
  
• offset; and
  
• lodgment.
  

3.1 Termination

According to Article 91 of the Contract Law:
Contractual rights and obligations are discharged when:
(1) the obligation has been performed as agreed;
(2) the contract is terminated by a party;
(3) the obligations are mutually offset;
(4) the obligor lodges the subject matter in accordance with the law;
(5) the obligee releases the obligor from his obligation;
(6) the claim and obligation become vested in the same person; or
(7) other discharge circumstances stipulated in the law or agreed upon by the parties arise.

Note that the above provision on termination is much more comprehensive than a similar provision in the Foreign Economic Contract Law. Article 31 of the Foreign Economic Contract Law stated that:

A contract should be terminated if one of the following situations occurs:
(1) The contract has already been performed in accordance with the agreed conditions;
(2) The arbitration body or the court decides to terminate the contract; or
(3) The parties agree to terminate the contract through consultations.

Contracts can be terminated either according to the parties' agreement or according to law. Article 93 of the Contract Law permits termination of contracts according to the parties' agreement:

The parties may terminate their contract upon reaching a consensus through consultations.

The parties may agree upon conditions under which a party is entitled to terminate the contract. If a condition for termination of the contract is fulfilled, the party with the right of termination may terminate the contract.

Termination according to law usually occurs when the parties are involved in dispute. This type of termination is stated in Article 94 of the Contract Law:

A party may terminate the contract if:
(1) an event of force majeure makes the objective of the contract unachievable;
(2) before expiration of the time limit for performance, the other expressly states or through his conduct indicates that he will not perform his main obligations;
(3) the other party has delayed the performance of his main obligations, and still fails to perform them within a reasonable period of time after having been reminded;
(4) the other party has delayed the performance of an obligation or committed another breach of contract which makes the objective of the contract unachievable; or
(5) other circumstances stipulated in the law arise.

The conditions for termination of contract according to law are basically the same in both the Contract Law and the Foreign Economic Contract Law. Article 29 of the Foreign Economic Contract Law provided that:

A party is entitled to inform the other party to cancel the contract if one of the following situations occurs:
(1) the other party infringes seriously the expected economic interests by the breach of contract;
(2) the other party fails to perform within the time limit agreed upon in the contract, and fails again within a reasonable period of time allowed for delayed performance;
(3) the whole obligation of the contract cannot be performed due to the occurrence of a force majeure event; or
(4) the conditions agreed upon in the contract for cancellation of the contract have arisen.

Termination due to anticipatory breach, subject to certain limitations, is a new concept under the Contract Law. This provision is found in Article 94(2) of the Contract Law, which states that if before the expiration of the time limit for performance, the other party expressly states or through his conduct indicates that he will not perform his main obligations, then the party is entitled to terminate the contract.

Once a contract becomes effective, it binds the parties to its terms and conditions. Discharge of the parties' rights and obligations under the contract can have severe consequences and must be handled carefully. Article 99 of the Contract Law specifies several situations where a contract can be discharged. The general rule is that a contract maybe terminated if continuing performance of the contract becomes futile and no longer fulfils the parties' intended objectives when they first entered into the contract. This is similar to the concept of "material breach" in the English and American legal traditions. In other words, if the breach does not amount to material breach, it should be resolved by methods such as taking remedial action or providing compensation, but the contract should not be terminated. Whether the innocent party can terminate the contract in anticipation of the other contract party's breach will depend upon the extent of the consequence of the anticipatory breach. It is only when a party states explicitly or otherwise indicates by his behavior that he will not perform certain material obligations, that the other party will have the right to terminate the contract.

Article 96 of the Contract Law concerns discharge of contract:

If a party wishes to terminate the contract in accordance with the second paragraph of Article 93 or Article 94 of this Law, he shall notify the other party. The contract is terminated upon the notice of termination reaching the other party. If the other party objects to the termination, he may petition a people's court or an arbitral institution to confirm the validity of the termination.

The nature of the notice under this provision was debated during the drafting of the Contract Law. Some legal experts believe that if one party decides to terminate the contract, he should notify the other party. As long as the other party has no objection, the contract can be terminated. If the other party objects, the contract cannot be terminated simply by notification. In such cases, it is for the court or an arbitral institution to decide whether the contract can be terminated.

Other experts believe that a party must satisfy the grounds for termination as specified in the second paragraph of Article 93 or Article 94 before he can send the termination notice pursuant to Article 96. Since there are grounds for termination, the contract should be discharged on the date the notice is received. If the recipient party thinks that the notifying party has not fulfilled the condition in Article 94 of the Contract Law, he should submit the issue to the court or an arbitral institution. If the court or the arbitral institution decides that the notifying party has satisfied the condition for termination, then the contract shall be discharged on the date the notice is received. If the notifying party has not satisfied the conditions for termination, then the contract continues to be effective. The notifying party is liable for any loss suffered by the other party as a result of wrongful termination. Article 96 adopts the latter opinion.

Concerning the legal consequence of the termination of a contract, Article 97 states that:

After a contract has been terminated, any executory portion is discharged. As concerns the performed portion, a party may, depending on the status of performance and the nature of the contract, demand a return to the status quo ante or resort to other remedies and have the right to claim damages.

There is no doubt that parties are no longer required to perform the executory portion of a contract after it is discharged. The question remains as to how to deal with the obligations and rights, which have already been performed.

Article 97 addresses this problem. "Return to the status quo ante", means returning to the same situation as when the contract was entered into; for example, goods delivered should be returned. This implies that the contract has never taken effect. This is just one of the legal consequences of termination. However, a return to the status quo is not necessarily applicable in all cases of termination.

A tenant, who has been paying his rent for two years, defaults in the third year of the lease. If the landlord demands termination of the lease contract on such basis, the lease for the previous two years does not become invalid simply because the tenant fails to pay rent in the third year. The termination only concerns the remaining portion of the lease contract.

Therefore, a return to the status quo may only be sought "on the status of performance and the nature of the contract", especially in long-term contracts where performance is fulfilled in stages. The parties may, instead of seeking a return to status quo, terminate only that portion of the contract which is yet unperformed and the portion which has already been performed will remain in effect.

3.2 Offset

Offset is one of the situations for termination. This occurs between two independent legal relationships.

Party A owes Party B Rmb1 million based on a loan contract, and B owes A Rmb1 million in a purchase and sale contract. A can request that B's debt be offset by A's payment obligation to B. The two parties' rights and obligations will be discharged by the offset.

The Contract Law permits offset in two situations:

• unilateral offset; and
  
• offset by mutual consent.
  

Unilateral offset

Unilateral offset must satisfy two conditions. First, the parties must owe each other an outstanding and due payment obligation. The critical point is that both obligations are due. One party cannot use its own obligation which is due and outstanding to offset the other party's obligation which is not yet due. On the other hand, most academics believe that a party can use its obligation, which is not yet due, to offset the other party's due and outstanding obligation.

Party A owes Party B Rmb500,000, which is due on April 1. B owes A Rmb500,000, which is due on June 1. On April 15, B suggests that its own Rmb500,000 obligation, which is not yet due, be offset by A's obligation of Rmb500,000 to B. Under such circumstances, B waives its own interest in the unexpired term of the loan without damaging A's interest.

The second condition is that the due obligations must concern the same subject matter and quality. Contracting parties may be obligated to perform certain acts, such as developing certain new products, providing technical training services, or providing live performances. They may also be obligated to provide certain goods, such as steel or cement. Generally, unilateral offset may only apply to obligations to provide certain goods but not obligations to perform certain acts. In addition, products subject to offset must be of the same type and quality. Obligations to perform acts generally cannot be offset since it would be difficult for two acts to be of the same type and quality. Therefore, unilateral offset is most appropriate where the obligation is payment in currency. A party can propose unilateral offset as long as the above two conditions are met.

When a party proposes unilateral offset by way of notice, the offset takes effect as soon as the other party receives notice from the party advocating unilateral offset indicating his intention. The parties' rights and obligations are discharged immediately. If the recipient party believes that the party advocating offset has not met the two conditions, they may resolve their differences in an amicable way. If they fail to reach an agreement, the matter can be submitted to a court or an arbitration tribunal for resolution. With regard to unilateral offset, Article 99 of the Contract Law provides that:

If each party owes a matured obligation to the other, and the subject matter of their obligations are of the same type and quality, either party may offset his obligation against that of the other party, unless the law or the nature of the contract does not permit such setoff.
If a party wishes to effect a setoff, he shall notify the other party. The notification enters into effect upon reaching the other party. The setoff may not be made subject to any condition or time limit.

Offset by mutual consent

The other type of offset is by mutual consent. Unlike unilateral offset, offset by mutual consent is not subject to any conditions. As long as the parties agree to it, they can offset their obligations. As stated in Article 100 of the Contract Law:

If each party owes an obligation to the other, but the subject matters of their obligations are not of the same type or quality, they may still offset their obligations after reaching a consensus through consultations.

Offset by banks

During the drafting of the Contract Law, there was some research conducted on whether banks may unilaterally offset contractual obligations. In the implementation of civil procedure, some judicial officials had requested banks to allocate the account balance of a debtor but were rejected by the banks, because the debtors still had loan amounts outstanding with the bank. Those who objected to the exercise of unilateral offset by banks pointed out that banks are in a unique position that allows them to withhold and dispose of funds. As such, they should not possess the right to offset on a unilateral basis. In particular, if the debtor has several creditors, unilateral offset by the bank may negatively affect the other creditors' interests because after the bank exercises unilateral offset, the debtor's remaining funds may be insufficient to repay other creditors. The PRC Commercial Banking Law of 1995 does not make an explicit statement on this matter due to conflicting opinions.

The authors support the arguments for the exercise of unilateral offset by banks on the following grounds:

• banks are legal persons. The law should treat the rights and obligations of all legal persons equally;
  
• the majority of bank capital is customers' deposits. Protection, at least similar to those offered to other commercial customers, should be accorded to medium- and small-amount individual accounts;
  
• banks can be required to meet certain conditions before they can exercise the offset right on a unilateral basis; and
  
• practical problems which may exist in the exercise of such right, such as when banks try to offset their own claims which are not yet due, protection of other creditors' interests and fair allocation of debtor's assets among all creditors, can be resolved by implementation guidelines.
  

3.3 Lodgment

What is the obligor's legal right when the obligee, without a valid reason, refuses to accept the obligor's performance of his obligation? Lodgment is one way by which the relationship between the obligor and the obligee can be discharged. If the subject matter is ordinary merchandise, the obligor can transfer it to a third party and seek damages from the obligee. If the subject matter is special merchandise produced solely for the obligee, the obligor might have no use for it if the obligee refuses acceptance. Even though there is default in performance (due to the obligee's fault), the obligor still has remaining obligations and the contract is not yet discharged.

Lodgment is a legal device that allows the obligor to constructively perform his obligations when the obligee makes it difficult for the obligor to perform his contract obligations.

Article 101 of the Contract Law provides several situations under which an obligor may lodge the subject matter:

The obligor may lodge the subject matter if the performance of his obligation is made difficult by any of the following circumstances:
(1) the obligee refuses to take delivery without a justifiable reason;
(2) the whereabouts of the obligee are unknown;
(3) the obligee has died without designating an heir or has lost the capacity for civil acts without designating a guardian; or
(4) other circumstances stipulated in the law.
If the subject matter is not suited to being lodged or the cost of lodgment would be excessively high, the obligor may auction or sell it according to law and lodge the proceeds.

Several issues related to lodgment, such as the obligor's notice requirement, damages to the subject matter, liability of loss, the right of the obligee to take delivery of the subject matter and the time limitation for taking delivery are provided in Articles 102 to 104 of the Contract Law.

The Contract Law is silent on matters such as the government department responsible for handling lodgment, application procedures, administration, and taking delivery. In most counties, the courts handle lodgment. China has yet to determine an appropriate authority for administering lodgment and to develop corresponding detailed implementation rules.

IV. LIABILITY FOR BREACH

Chapter 3 of the Foreign Economic Contract Law sets out the duty of contracting parties to perform and the parties' liability in the event of breach. Based on the experience gained from the implementation of the Foreign Economic Contract Law and other 1aws, the Contract Law attempts a more comprehensive approach towards liability for breach in order to encourage performance, preserve the social and economic order, compensate the party that suffers loss because of the other party's breach, and protect the lawful interests of contracting parties.

This Chapter focuses on four issues:

• liability for anticipatory breach;
  
• specific performance;
  
• liquidated damages; and
  
• scope of damages.
  

4.1 Liability for Anticipatory Breach

"Anticipatory breach" is a new concept introduced by the Contract Law. Article 108 of the Contract Law provides that:

If a party expressly states or through his conduct indicates that he will not perform his contractual obligations, the other party may hold him liable for breach of contract before the time limit for performance has expired.

This situation is known as "anticipatory breach". In other words, anticipatory breach occurs when there is a confirmed default in performance even before the term of performance has actually expired.

As a general rule, liability for breach only occurs after the term of performance expires. For instance, Party A and Party B agree, in the form of a sale and purchase contract, that A will deliver on May 1. A's term of performance expires on May 1. B does not have any legal basis to demand that A deliver before that date. The most B can do is to inquire or remind A of the May 1 delivery. So long as A delivers before the close of business on May 1, A is performing according to contract. However, if it is certain that the obligor cannot fulfill his obligation, is the obligee required to wait until the term of performance expires before he can negotiate with the obligor for a resolution? Can the obligee claim damages from the obligor before the expiry of the term of performance? The concept of anticipatory breach is intended to help the parties resolve such situations in a timely manner and preserve a stable social and economic order.

During the drafting of the Contract Law, some legal experts proposed that anticipatory breach entitle the non-breaching party to terminate the contract but without claims for liability. This was proposed out of concern that the obligor might subsequently decide to perform after the obligee claimed liability for breach upon the obligor's indication of his unwillingness to perform. However, this proposal was not adopted.

A prerequisite for anticipatory breach is that the non-performance must be confirmed. There may be two types of scenarios. One is where the obligor clearly indicates that he will not perform his obligations. Another is where there is clear evidence that he will not perform his obligations. For instance, a deve1oper undertakes to complete the construction of a real estate project on August 1. But on July 1, the foundation has not yet been laid. Based on these circumstances, it is impossible for the developer to perform as contracted by August 1. This is a situation where a party states through his conduct that he will not perform his contractual obligations (Article 108, Contract Law). Where anticipatory breach is based on a party's conduct rather than statement, the general interpretation is that the circumstances must clearly show that the obligor will not perform his obligations. Under such circumstances, there should be no problem in allocating liability for breach.

Some other legal experts proposed something slightly different from the above approach. They suggested that anticipatory breach only prompt termination but not constitute a basis for claiming damages. The Drafting Committee rejected this proposal as well, as it would be impractical to allow termination of contract but deny liability for anticipatory breach. It would lead to anomalous results if parties can discharge their rights and obligations but not seek damages for anticipatory breach. The fundamental principles of contract law will be undermined if an obligee can only demand termination of contract but not seek damages before the expiry of the term of performance when an obligor either states or through his conduct indicates that he will not perform. Therefore, Article 108 of the Contract Law states that a party may hold the other party liable for anticipatory breach.

4.2 Specific Performance

If a party breaches the terms of contract, the other party may request the court to issue an order requiring the breaching party to perform according to contract. Specific performance is generally sought when damages alone are not adequate.

In a planned economy, contracts are used as a tool to facilitate economy-planning. Specific performance is perhaps the most important form of remedy for breach. The objective of economic reform in China is to establish a new market economy. Considering the change in China's economy, there does not seem to be the need to overemphasize the function of specific performance as a remedy for breach.

Article 110 of the Contract Law states that:

If a party fails to perform a non-monetary obligation or performs a non-monetary obligation in a way other than is agreed upon, the other party can demand performance unless:

(1) performance is impossible in law or in fact; the subject matter of the obligation is not suited for specific performance or the cost of performance would be excessively high; or

(2) the obligee has failed to demand performance within a reasonable period of time.

This provision adopts the relevant regulations in the Principles of International Commercial Contracts, published by the International Institute for the Unification of Private Law (Unidroit). Article 110 embodies two major principles. First, when one party defaults on a non-monetary obligation, the other party can usually demand specific performance. Second, in some limited cases, it may not be appropriate for the obligee to request the obligor to perform specifically. In such situations, the obligee can only seek monetary damages.

Article 110 identifies several situations where specific performance is inappropriate or impossible. First, where legally or factually it is impossible to perform, the obligee cannot demand the obligor to perform according to contract. An example of legal impossibility is where the law prohibits or limits the trading of certain goods. An example of factual impossibility is where the subject matter of the contract is damaged or lost, or where the subject matter cannot be preformed due to technical failure.

Second, where the subject matter of the obligation is not suited for specific performance or the cost of performance would be excessively high, the obligee should not seek specific performance. Subject matters that are unsuited for specific performance generally refer to those non-monetary obligations that call for a specific act. For example, a performer who cannot perform according to a stage-acting contract cannot be required to give specific performance. A more appropriate remedy for breach would be payment of damages. The cost of performance, on the other hand, refers to the enforcement costs of the courts, and not the cost of specific performance by the obligor. It is inappropriate to have specific performance if it would be excessively costly for the court to enforce such specific performance.

Third, where the obligee fails to demand specific performance within a reasonable time period, he would be deemed to have waived his right to claim specific performance. The obligee would then have to seek remedy through other legal means. The easiest way to find out when the demand was actually made is to determine if a demand was made within a reasonable period of time. Other factors can also determine the "timeliness" of a demand, such as whether the obligee still requires the goods that are the subject matter of the contract, or the ways by which the obligee seeks his remedy. If the obligee demands monetary damages only, it will generally be interpreted to mean that he has waived his right to demand specific performance.

If one party defaults on a non-monetary obligation, can the other party demand specific performance assuming that it is relatively easy to obtain the same kind of goods in the market? Some legal experts believe that as the subject matter of the contract can be easily obtained in the market, the obligee should have no problem purchasing it on its own. In such a situation, the obligor should be liable for the difference between the contract price and the market value. In other words, the obligee cannot demand specific performance. Others believe that the obligor has the obligation to purchase the goods from the market and deliver that to the obligee in order to remedy his own default. In other words, the obligee can demand specific performance from the obligor. The final version of the Contract Law adopts the second opinion and the provision in the draft of the Contract Law, which prohibited parties from demanding specific performance when the subject matter of the obligation could be easily obtained in the market, was deleted.

4.3 Liquidated Damages

Liquidated damages are another significant legal remedy under the Contract Law. In China, many contracts specify that the defaulting party must pay the other party a fixed amount in damages. The benefit of liquidated damages is that they give the breaching party a distinct conception of the consequences of its breach; that is, the cost of breach. It also allows the parties to promptly resolve their disputes arising from such breach.

It was difficult for the drafters of the Contract Law to reach a consensus on the provision for liquidated damages. The issue of dissension was whether liquidated damages should be punitive. Some argued that the amount of liquidated damages does not necessarily have to be limited to the amount of the actual loss. If the parties had mutually agreed to an amount higher than the actual loss, then the court should not interfere. Additionally, introducing a punitive element into the concept of liquidated damages would help to deter the parties from committing breach, thus improving the overall performance of contracts and preserving the social and economic order.

Other experts argued that the real issue is whether the breaching party could petition the court to reduce the liquidated damages if these were considerably higher than the amount of loss suffered by the other party. If the breaching party could not petition the court to reduce the amount, then the other party could potentially reap a windfall. Such gain would be unfair. It would be contrary to the basic principle of contract law; that is, a contract is between two equal parties and one party should not have the right to punish the other. If a party could benefit more from the other party's breach than from his performance according to contract, then such a party may actually wish that the other party did not perform. In some cases, punitive liquidated damages may provide the incentive for one party to entrap the other to default. Such liquidated damages would not help to materialize the intent of the parties when they entered into the contract, and would also harm the social and economic order. Therefore, liquidated damages should be limited to compensation for actual loss due to breach.

There were some conflicts among the previous PRC laws on the issue of liquidated damages. Article 31 of the Economic Contract Law stated that:

If one of the parties concerned is in breach of an economic contract, it shall pay previously agreed upon damages to the other party. In a case where breach of contract causes the other party to incur losses which exceed the previously agreed upon damages, the party in breach of the contract shall pay additional compensation to make up the balance. If the other party requests continuation of the contract, it shall be continued.

Article 20 of the Foreign Economic Contract Law provided that:

The parties may agree in a contract that a certain amount of liquidated damages will be paid to the other party if one party breaches the contract; and may also agree upon a method for calculating the damages arising over such a breach of contract. The above-mentioned liquidated damages shall be regarded as compensation for the loss caused by breach of contract. However, if the liquidated damages agreed upon in the contract are significantly more or less than the loss, the parties may request an arbitration body or court to decrease or increase it appropriately.

Provisions on liquidated damages in the Foreign Economic Contract Law and the Economic Contract Law diverged in several ways. First, the laws differed on whether liquidated damages could be sought in conjunction with other remedies. Under the Economic Contract Law, a non-breaching party could request liquidated damages and specific performance of contract at the same time so that such party could be entitled to double remedies. Under the Foreign Economic Contract Law, parties generally could not demand liquidated damages and specific performance of contract at the same time. Upon payment of liquidated damages, the contract dispute was resolved and the non-breaching party could not request the breaching party to continue performance.

Second, the relationship between the amount of liquidated damages and the actual amount of loss caused by the breach were treated differently. The Economic Contract Law provided that the innocent party could request additional compensation if the actual loss exceeded liquidated damages. However, it was silent on the situation where liquidated damages exceeded actual loss. On the other hand, while the Foreign Economic Contract Law recognized liquidated damages as compensation for loss caused by breach of contract, it nevertheless allowed a party to petition for the adjustment of liquidated damages if it was significantly more or less than the loss the party had incurred.

Article 114 of the Contract Law states that:

The parties may stipulate that the party in breach shall pay the other party a definite measure of liquidated damages, depending on the circumstances of the breach, or they may stipulate a method for calculating the measure of damages arising from breach.

If the liquidated damages stipulated are lower than the loss incurred, a party may petition a people's court or an arbitral institution to increase the amount. If the liquidated damages stipulated grossly exceed the loss incurred, a party may petition a people's court or an arbitral institution to reduce the amount appropriately.

If the parties have stipulated liquidated damages for late performance, the party in breach shall nevertheless perform his obligation after paying the liquidated damages.

The Contract Law's provision on liquidated damages builds on the Foreign Economic Contract Law and the Economic Contract Law and yet departs from these laws in certain ways. Structured into Article 114 of the Contract Law are two different types of liquidated damages for two different breach scenarios.

First, if a party commits a fundamental breach or if the parties have agreed to a general liquidated damages provision, then according to the Contract Law, a party may petition the court or an arbitral institution to increase the liquidated damages amount if it is lower than the loss incurred. In other words, the breaching party may have to make additional compensation if the liquidated damages are insufficient to cover the loss suffered by the other party. This is similar to the provision in the Economic Contract Law. On the other hand, a party may petition a court or an arbitral institution to reduce the amount appropriately if the liquidated damages stipulated grossly exceed the loss incurred. In other words, if liquidated damages slightly exceed the actual loss; the breaching party would have to pay according to the stipulated amount. If the liquidated damages grossly exceed the actual loss, these may be reduced as is appropriate. This is similar to the provision in the Foreign Economic Contract Law.

However, it should be noted that once a party enforces liquidated damages after a fundamental breach occurs or pursuant to a general liquidated damages clause in the contract according to Article 114 of the Contract Law, such party will generally be barred from seeking specific performance or additional compensation. In other words, payment of liquidated damages effectively excludes other remedies such as specific performance or other damages.

Second, if the parties have stipulated liquidated damages for delayed performance, the breaching party is still obligated under the Contract Law to continue performance after paying the liquidated damages. Under this situation, liquidated damages are considered to be compensation for late performance so the non-breaching party can, in addition to the liquidated damages, demand continued performance but generally not additional compensation.

It appears that liquidated damages under the Contract Law do not contain a punitive element. This is covered under Article 113 of the Contract Law on the measure of damages, which states:

If a party fails to perform his contractual obligations or performs his contractual obligations in a way other than agreed upon, thereby causing loss to the other party, the measure of damages shall be equal to the loss incurred as a result of the breach of contract, including the benefits which could have been obtained after performance of the contract. However, such damages may not exceed the loss, which the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract as a possible consequence of the breach of contract.

In addition, Article 116 of the Contract Law prohibits contract clauses that have simultaneous provisions of liquidated damages and a deposit. It states:

If the parties have stipulated both liquidated damages and a deposit and one of the parties breaches the contract, the other party may elect to apply either the liquidated damages clause or the deposit clause.

Article 91 of the Security Law, restricts the amount of deposit as follows:

The size of a deposit shall be decided by the parties and shall not exceed 20% of the value of the subject matter of the principal contract.

These provisions show that PRC law has not affirmed a punitive element in civil liability.

4.4 Scope of Damages

When one party breaches the contract, thus causing damage to the other party, what kinds of liability should the breaching party be subject to? In the past, it was especially uncertain whether a breaching party could be liable for the other party's expected gain from performance of the contract; that is, indirect damages. Neither the Civil Law General Principles nor the Foreign Economic Contract Law provides any guiding principle on this issue. In practice, most judges deny indirect damage awards.

To protect the parties' lawful interests and to ensure full compensation in the event of breach, Article 113 of the Contract Law specifies, with regard to the extent of damages that:

If a party fails to perform his contractual obligations or performs his contractual obligations in a way other than that is agreed upon, thereby causing loss to the other party, the measure of damages shall be equal to the loss incurred as a result of the breach of contract, including the benefits which could have been obtained upon performance of the contract. However, such damages may not exceed the loss, which the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract as a possible consequence of the breach of contract.

Article 113 raises two points. First, the compensatory benefits may already be covered under certain methods of dispute resolution and therefore need not be individually assessed. Individually assessed compensatory benefits occur only in some cases of contract disputes.

For example, Party A fails to deliver goods by the specified date according to a sale and purchase contract it has with Party B. If their contract has a liquidated damages provision, then the dispute can be resolved accordingly. If their contract does not have a liquidated damages provision, the dispute can be resolved by compelling A to continue performance and to compensate B's loss due to his late performance, or by B purchasing substitute goods in the market and demanding that A pay B the difference between the contracted price and the market price. Both resolutions will allow B to be compensated, and thereby implicitly include the benefits that he could have obtained if the contract were performed. Therefore, there is no need to individually asses the amount of compensatory benefit.

On the other hand, take the example of a construction company that contracts to complete a department store renovation project by September 25 so that the department store can reopen for business on a public holiday three days later. If the construction company delays the renovation, making it impossible for the department store to open on schedule, thereby causing the department store to find a substitute warehouse for its inventory, then not only does the construction company have to compensate the department store for its warehouse charges but also for the expected benefits had it opened as scheduled.

Article 113 also states the maximum limit of damages; that is, the damages may not exceed the loss, which the breaching party foresaw or ought to have foreseen at the time of concluding the contract as a possible consequence of the breach of contract. In other words, the breaching party is not liable for loss it cannot foresee. The measure of damages, including what can or cannot be compensated, depends neither on the non-breaching party's assessment nor its actual loss, but rather on whether the breaching party foresaw or could have foreseen the damages at the time when the contract was concluded.

Party A has a contract with Party B to provide 500 tons of steel and B has a resale contract with C for the same goods. In the contract with C, B undertakes to pay liquidated damages of 0.1% of the value of goods if it delays delivery. If A delays its delivery to B causing B's default with C, then depending upon whether A knew or should have known the content of the contract between B and C, A may or may not be liable for B's liquidated damages to C. If A had knowledge of or should have foreseen such agreement when it entered into the sale and purchase agreement with B, then A would be liable for B's liquidated damages to C. If A had no knowledge and had no reason to know, then it would be exempted from this portion of B's loss. In the latter case, B can only demand compensation according to the provisions in its contract with A or the measure of damages commonly used in similar type of disputes.

V. SPECIAL PROVISIONS FOR FOREIGN-RELATED CONTRACTS

One of the major accomplishments of the Contract Law is the establishment of a uniform and comprehensive law of contract applicable to both domestic and foreign contracts. October 1 1999, the day the Contract Law becomes effective, marks the end of an era when contracts were treated differently under law based on whether there was the presence of a foreign party in the contract in question.

During the early stage of economic liberalization in China, it was necessary to have different legislation, the Economic Contract Law and the Foreign Economic Contract Law, to separately regulate domestic and foreign contracts. The means of economic management under the planned economy in China at that time were vastly different from those practiced by the international business community. After two decades of economic reform, government-directed business transactions are now mostly limited to the sale and purchase of a small number of strategic products. As China progresses towards a market economy, it is appropriate to introduce uniform legislation on contracts.

The majority of provisions in the Contract Law are equally applicable to domestic as well as foreign contracts. Among the 428 articles in the Contract Law, only Articles 120, 129 and 355 contain special provisions for contracts with a foreign element. Also, the articles on lease-finance contracts and the section on multi-modal transportation contracts would be more applicable to foreign contracts since such arrangements usually involve foreign parties. However, these provisions also apply to contracts between domestic parties.

This chapter focuses on the following three major issues in the application of the Contract Law:

• choice of governing law in foreign-related contracts;
  
• statute of limitations for filing judicial or arbitral claims based on foreign-related contracts; and
  
• import-export activities through foreign trade companies in China.
  

5.1 Choice of Governing Law in Foreign-related Contracts

Article 126 of the Contract Law stipulates that:

Parties to a contract with a foreign element may choose the law to apply to the handling of disputes, unless otherwise provided by law. If the parties to a contract with a foreign element have not made a choice, the law of the State with the closest connection to the contract applies.

In the case of Sino-foreign equity joint venture contracts, Sino-foreign cooperative joint venture contracts and contracts for Sino-foreign cooperative exploration and exploitation of natural resources performed within the boundaries of the People's Republic of China, the law of the People's Republic of China applies.

This article conveys the following meanings.

• First, Sino-foreign equity joint venture contracts, Sino-foreign cooperative joint venture contracts and contracts for Sino-foreign cooperative exploration and exploitation of natural resources which are performed within China must exclusively apply PRC law. The parties to any of these contracts are not free to stipulate the governing law for the following reasons. To begin with, all these contracts are concluded on the basis of PRC law and the business entities set up according to these contracts are subject to the examination and approval of relevant Chinese governmental authorities. In addition, the basic rights and obligations of the parties involved in these contracts are performed in China.
  
• Second, unless otherwise provided by law, parties to other contracts with foreign elements can stipulate governing law, including Chinese law, law of foreign jurisdictions or international treaties.
  
• Third, contracts without a governing law provision should apply the law of the country with which it has the closest connection.
  

It should be pointed out that Article 126 refers specifically to the applicable governing law in the handling of disputes. During the drafting of the Contract Law, there was a suggestion to change "parties to a contract with a foreign element may choose the law to apply to the handling of disputes" in the draft to "parties to a contract with a foreign element may choose the law applicable to the contract" .This suggestion was not adopted.

Applicable governing law with regard to issues which are not in dispute functions to fill in certain gaps in the contract, such as place of performance and quality of subject goods, which the parties may have neglected to stipulate in the contract. Article 12 of the Contract Law states that:

The particulars of a contract shall be agreed upon by the parties.

Such agreement includes choosing standard clauses used in any industry or any statutory provisions of any country. Therefore, Article 12 already provides the guideline for determining missing terms and details that are not in dispute. The choice of governing law should be applied primarily in resolving contract disputes, including disputes over content of the contract, the effectiveness of contract and liability for breach.

If the parties do not stipulate governing law in handling disputes, then they would have to apply the law of the country with which the contract has the closest connection. The Supreme People's Court, Issues Regarding the Applicable Law in Resolving Disputes Involving Foreign Economic Contracts Notice, states that:

If the parties fail to stipulate the applicable law, the people's court shall adopt the "closest connection" principle in determining the applicable law with regard to the following types of foreign economic contracts;

(1) Contracts for international sale of goods shall apply the law of the seller's place of business at the time the contract is concluded. However, if the contract is negotiated and concluded at the place of business of the buyer, or the contract is concluded primarily pursuant to the terms and