Foolproof: How to draft commercial contracts

Formation of sale and purchase contracts

The general position under PRC law, and in particular the SPC Interpretation on Certain Issues Relevant to the Application of the PRC Contract Law (2) (关于适用《中华人民共和国合同法》若干问题的解释（二）), is that a court will generally recognise the formation of a binding contract, if it can determine the names of the parties, the subject matter and its quantity, unless provided in other laws or separately agreed by the parties. The contract can be concluded in either written or oral form, or by other means. For example, where the parties' intention to enter into a contract can be inferred from their acts, the court may decide that a contract has been formed.

    In practice, when the courts apply the above test, they are more inclined to recognise a contract exists unless evidence to the contrary is presented. This approach is in line with the SPC's view that a purpose of the Contract Law was to “encourage contractual transactions and increase social wealth,” according to the person in charge of the No 2 Civil Court of the SPC. The Interpretation reflects this spirit and provides detailed guidance to certain types of documentary evidence, which may be relevant in determining whether the parties have formed a valid contract. The evidence referred to in the Interpretation is as follows:

    Commodity delivery records, commodity receipts, payment records and other receipts. The PRC courts may recognise the formation of a contract based on these documents and taking into account the method by which the transaction was conducted, the customary approach adopted by the parties and other relevant evidence (Article 1).

• Account statements confirmation letters, letters confirming creditor's rights and other letters and receipts. In situations where these documents do not show the name of the creditor but were relied upon by a contractual party to prove the existence of a contract, the courts will generally recognise the formation of the contract, unless there is sufficient evidence to the contrary (Article 1).
• Subscription letters, purchase orders, reservation letters, letters of intent, memorandum of understanding and other reservation contracts “providing that a sale and purchase contract will be entered into in a certain period of time”. A reservation contract is a contract that aims to secure goods, before the completion of a formal contract. Where a party does not enter into a binding sale and purchase contract following a reservation contract, the courts will generally find that party liable for breach of the reservation contract, or that the reservation contract has been terminated and the party is liable for damages (Article 2).

    Article 2 gives rise to two areas of uncertainty. The first relates to the scope of application and the second on how to calculate damages for breach of contract. From the outset, Article 2 appears to limit the scope of reservation contracts to those “providing that a sale and purchase contract will be entered into in a certain period of time”. In other words, Article 2 will only apply to contracts containing this or a similar provision. It is likely the courts will interpret this to mean that for a reservation contract to be legally binding, it must contain clear indication of the parties' intention to enter into a formal contract.

    Letters of intent and memoranda of understanding are frequently used in the early stages of transactions in China to document the parties' intention to enter into a binding agreement and set out certain key terms of the transaction. Unless the parties intend to proceed and perform the contract immediately, most letters of intent or memoranda of understanding clearly state that they are subject to contract, or that only certain terms are legally binding, like confidentiality and arbitration clauses. It is unclear whether the SPC intended for Article 2 to override the parties' intention where a reservation contract clearly states the parties do not intend for it to be legally binding. It is unlikely that the courts will ignore this wording and impose binding obligations on parties who had clearly stated that they did not intend to be bound.

    The second uncertainty arises when a party breaches a reservation contract. In this situation, it is unclear how the courts would quantify liabilities or damages. One possible approach would be to treat the document as a complete binding agreement and liability for breaching the reservation contract would be the equivalent of breaching the formal contract. Another approach may be to restrict the scope of damages to the wasted costs of the non-breaching party for negotiating the reservation contract. For example, especially when the courts find the reservation contract only imposes an obligation on the parties to negotiate in good faith towards an additional contract.

    In summary, PRC courts may be more inclined to recognise a sale and purchase contract except in situations of clear and compelling evidence to the contrary. When preparing any transactional documents in relation to sale and purchase contracts, companies should consider whether it is necessary to sign any pre-contractual documentation. In the period before signing any binding agreement, avoid statements, communications or discussions that may be construed as evidence of an agreement to enter into a sale and purchase contract.

    Where a pre-contractual document is executed, avoid using words such as “a contract will be entered into within a certain period of time” or “the parties intend to enter into a contract within a certain period of time”. Finally, all written documents in respect of the proposed transaction, whether communications or a pre-contractual document, must properly and clearly state the parties' intention that the document or part of the document is not legally binding. For example, suggested wording could be: “This letter is not legally binding except for the specified clauses (confidentiality clause and dispute resolution clause).”

Breach of contract

The Contract Law considers calculating contractual damages by applying the basic principle of expectation interest. Under this principle, damages are meant to bring the claimant into the same position as they would have been in had the contract been performed. When the court is considering damages, it will seek to establish whether the party alleging the loss had taken steps to mitigate it. This principle is set out in Article 113 of the Contract Law, which states that where a breach of contract by one party causes damages to the other party, the party responsible for the breach is liable to compensate the other party for all losses “including the benefit that could be obtained after the performance of the contract, but not exceeding the losses that may be caused by breach of the contract and that has been foreseen or should have been foreseen by the breaching party when entering into the contract”. Article 119 of the Contract Law also sets out the parties' duty to mitigate their losses: if the party suffering the loss fails to mitigate, and aggravates the loss, it is not entitled to claim for any increased loss.

    The SPC has noted that the courts have not consistently applied these provisions, adding that many judges have failed to apply the principle of expectation interest. Article 29 of the Interpretation reinforces that where the non-breaching party claims expectation interest, the following provisions should apply: Articles 113 and 119 of the Contract Law and Article 30 of the Interpretation, providing that where the non-breaching party also contributed to any losses, this should be deducted from the amount of the compensation. In addition, Article 31 of the Interpretation provides that where the party alleging the loss obtained a benefit from the breach, that benefit should be deducted from the amount of any compensation.

    This is a positive development for companies and individuals entering into commercial agreements in the PRC. It will provide certainty and sends a clear message to all local courts that they are expected to apply these principles when dealing with damages in sale and purchase contracts.

Inspection of commodities

Article 158 of the Contract Law addresses the period for inspection of commodities purchased under sale and purchase contracts. The Article provides that, unless the seller is or should be aware of the defects of the commodities, the following rules applies where the parties have agreed on the inspection period, the terms of the agreement should be followed. Also, where the parties have not agreed on an inspection period, the buyer shall notify the seller of any defects within a reasonable period of time. If the buyer does not advise of any concern within such time or two years from the receipt of the commodities, the commodities will be treated as non-defective (unless any warranty period is applicable).

    Various courts have applied differing interpretations of a “reasonable period of time” and the two-year period. As a result, the SPC has added a further section to the Interpretation. In addition to clarifying the “reasonable period of time”, the Interpretation imposes further restrictions on parties' agreements of the inspection period.

    The position after the Interpretation means parties' agreements on the inspection period will generally be upheld, if the agreed inspection period is too short for the buyer to complete a comprehensive inspection, then the agreed inspection period should be treated as applying to patent defects only. The buyer will be entitled to notify the seller of any latent defects within a “reasonable period of time” (Article 18). It will also be upheld if the agreed inspection period is shorter than the compulsory period provided by any laws, administrative regulations or the warranty period, then the compulsory period or warranty period will apply (Article 18).

    Where there is no agreement, the “reasonable period of time” principle will apply. The Interpretation has set out a list of factors for the courts to consider when determining the “reasonable period of time” (which cannot in any event be longer than two years) (Article 17). Separately, if any delivery receipt or confirmation receipt signed by the buyer sets out the quantity, model and specifications of the commodities, it will be presumed that the buyer has inspected the commodities to confirm both the number and any obvious defects (Article 15).

    Some of the provisions discussed in this section represent significant changes from the previous position and may in fact give rise to increased uncertainty. Companies should consider when negotiating an inspection period as a buyer or seller, to bear in mind that the agreed period might not always be recognised by the courts. It would also be sensible to insert a provision that the buyer agrees that the inspection period is a reasonable one, although the courts may not accept this.

    As a seller, a short inspection period may not always be favourable and may not be applied by the courts, which may choose to impose a longer reasonable period for latent defects. Buyers should be careful not to sign any documentation when receiving commodities (especially without undertaking a full inspection), as this may be considered a waiver of any rights to claim for patent defects.

Multiple sales of the same commodities

The Contract Law does not contain any provisions on priority where the same commodities are sold to multiple purchasers and each contract between the seller and purchasers is valid. Articles 9 and 10 of the Interpretation have addressed this issue. Under these new provisions, where commodities (including vessels, aircraft and vehicles and other goods that must be registered whenever ownership is transferred, but not non-transportable goods) are sold to multiple purchasers under valid contracts, the priority of the contracts is assessed through certain criteria. This includes which purchaser had taken actual possession of the commodities, which purchaser had completed the ownership transfer registration procedure, or which purchaser had made payment under the contract if registration is not required and the timing of the contracts.

    If the first criteria exists, there is no need to consider the second and if that does not exist, then the second criteria has to be examined until finally the court is required to determine the third criteria on its own.

    These provisions are useful as they provide judicial guidance on a situation that frequently arises in China. For companies doing business in China, they should be aware of the risks that can arise even where they have a valid contract with a seller. This contract may not be enforced if the commodities were sold to a second purchaser (either before or following their contract). When purchasing vehicles, vessels or aircraft, registration of ownership is not determinative. Rather, taking actual possession is the safest way to ensure ownership.

    Although the Interpretation has taken many years of work, any guidance from the SPC on the application of any PRC law, and in particular this one, is always welcome. In overall terms, it provides increased certainty for companies on how the PRC courts should approach some of the more complex areas of sale and purchase contracts in China.

Jessica Fei and Weina Ye, Herbert Smith, Beijing