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Enforceability of Liquidated Damages Provisions
in China
By Allen
Clark and Yuping
Wang
[April 2004]
A great majority of international hotel operators ("Hotel
Operators") conduct business in China by means of hotel management
contracts ("Management Contracts"). In fact, the value
of these Management Contracts is today the Hotel Operators' major
asset in China. Thus, the enforceability of the terms and provisions
of such contracts is extremely important. This article discusses
the enforceability of one of those terms and conditions, namely,
liquidated damages.
Management Contracts normally have a term of 10 to 20 years and,
in the past, have not permitted no-fault termination by hotel owners
("Hotel Owners") prior to the end of the term. However,
a growing number of Hotel Owners have started to demand early termination
rights. The Hotel Operators have responded by demanding that liquidated
damages provisions be inserted in the Management Contracts. In the
event of an early termination of Management Contracts, Hotel Operators
generally expect to be compensated for an amount substantially equal
to the income they would have earned had the Management Contracts
been completely performed. Hotel Operators negotiate vigorously
to include such amounts in Management Contract as liquidated damages.
However, Hotel Operators should be aware that such provisions, while
legal in China, may not be 100% effective. Such provisions may be
contested by Hotel Owners at the enforcement stage and, depending
upon the circumstances, a judge or arbitrator may modify the amount
of liquidated damages set forth in the Management Contracts.
Liquidated damages are permitted in the PRC Contract Law ("Contract
Law"). Article 114 of the Contract Law provides that parties
may either stipulate the exact amount of liquidated damages or set
forth a method for the calculation of liquidated damages. Thus,
Article 114 appears to encourage a meeting of the minds between
the parties. However, Article 114 also permits a court or an arbitration
tribunal, upon request of one of the parties, to modify the amount
of liquidated damages under certain circumstances. Where the amount
of liquidated damages is lower or significantly higher than that
of actual losses, Article 114 allows the judge or arbitrator to
modify the amount of liquidated damages to bring it closer to the
amount of actual loss incurred by the non-breaching party.
By thus equating liquidated damages with actual losses, Article
114 not only shows a disfavor toward punitive contractual provisions,
but also may eliminate the effectiveness of the liquidated damages
provisions. At the very least, Article 114 brings uncertainty to
the enforceability of liquidated damages provisions.
Furthermore, while the Contract Law gives the judge or arbitrator
the right to increase or decrease the stipulated amount of liquidated
damages in light of actual losses, it fails to provide specific
mechanism or any guidance as to how the adjustment is to be made.
Will the liquidated damages provisions in the contract be totally
disregarded? Will the judge or arbitrator simply arrive at an amount
in the middle of the amount of liquidated damages and that of actual
losses, i.e., split the difference? In fact, in certain published
judicial cases, the courts totally disregarded the liquidated damages
provisions in the contract.
A recent development providing guidance to a judge or arbitrator
in the adjustment of liquidated damages is contained in the Several
Issues Concerning the Application of Law in Trial of Dispute Cases
Involving Commercial Real Estate Sales and Purchase Contracts Interpretation
("Supreme Court Interpretation"), which became effective
as of June 1, 2003. Article 16 of the Supreme Court Interpretation
provides that, if a party requests a reduction in the amount of
liquidated damages on the ground that it is substantially higher
than the amount of actual losses, the amount of liquidated damages
may be reduced to a level which is 30% above the amount of actual
losses. In addition, if a party requests an increase in the amount
of liquidated damages on the ground that the liquidated damages
are lower than the amount of actual losses, the amount of the liquidated
damages shall be increased to the amount of the actual loss.
Thus, Article 16 of the Supreme Court Interpretation for the first
time sets forth a quantifiable standard for modifying the amount
of liquidated damages in commercial real estate sales and purchase
contracts. However, it is not clear whether Article 16, or even
the principles contained in Article 16, applies to Management Contracts
and commercial contracts other than commercial real estate sales
or purchase contracts.
To maximize the ability to enforce liquidated damages provisions
in Management Contracts, it would be advisable to take the following
approach:
- The Management Contracts should carefully set forth the rationale
for using a liquidated damages provision and the method used in
the calculation of liquidated damages. This will provide the judge
or arbitrator with the background for and intention of the parties
in using the liquidated damages provision. It will hopefully make
the judge or arbitrator less inclined to modify the liquidated
damages provision when it is clear that the parties knew and understood
the purpose and effect of that provision. It will also make it
more difficult for a party to the Management Contracts to later
argue a position that is contrary to the rationale stated in the
liquidated damages provision.
- The parties should acknowledge and agree that the amount of
liquidated damages (either fixed or to be calculated) is in fact
determined on the basis of Hotel Operators' foreseeable actual
losses. In addition, the parties should define the components
of the Hotel Operators' foreseeable actual losses, which would
include, for example, the Hotel Operators' loss of future management
fees, development expenses already expended by the Hotel Operators
and loss of other business opportunities.
- The Hotel Operators should insist that the Hotel Owners waive
any right to contest the amount of liquidated damages. In other
words, the Hotel Owners should agree in the Management Contracts
that they will not request that a court or arbitration tribunal
modify the amount of liquidated damages at the enforcement stage.
While this paper discusses the use of liquidated damages provisions
in the situation where the Hotel Owners or Hotel Operators wish
to exercise a termination option before the end of the term of the
Management Contracts, it is worth noting that the liquidated damages
are also available in the event either party delays its performance
under the Management Contracts. In that situation, the Management
Contracts should provide that specific performance may be sought
in court simultaneously with the demand for payment of liquidated
damages.
Published by DWT's China
Practice Group
This China Practice Article is a publication of the China Practice/Shanghai
Office of Davis Wright Tremaine LLP. Our purpose in publishing this
Article is to inform our clients and friends of recent legal developments
in China. It is not intended, nor should it be used, as a substitute
for specific legal advice as legal counsel may only be given in
response to inquiries regarding particular situations.
Copyright © 2004, Davis Wright Tremaine
LLP.
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