Navigating Contract Management in China: Key Insights from the Judicial Interpretation on Contract in the Civil Code

On December 5, 2023, the Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of the General Principles of Contract Part of the Civil Code of the People’s Republic of China (hereinafter referred to as the “Judicial Interpretation of the Contract Part”) came into effect.

Originally adopted by the Judicial Committee of the Supreme People’s Court on May 23, 2023, the Judicial Interpretation of the Contract Part addresses prevalent and emerging judicial challenges within the realm of contract law. Additionally, it incorporates relevant provisions from previously annulled judicial interpretations that continue to offer practical guidance.

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Tailored to assist judges in handling contract cases, the style of the Judicial Interpretation of the Contract Part is more technical compared to general laws and regulations, making it less accessible for non-legal professionals. However, for businesses aiming to enhance their contract management and secure greater legal certainty, this Interpretation holds more significance as a reference document than any other.

In this article, we endeavor to simplify the contents of the Judicial Interpretation of the Contract Part, emphasizing key points that enterprises should particularly focus on in their contract management practices.

Is a Letter of Intent (LOI) or Memorandum of Understanding (MOU) a contract? How will they bind the contracting parties?

In the realm of daily commercial activities, it’s common for negotiating parties not only to formalize initial negotiation outcomes, making them legally binding, but also to retain flexibility for unresolved matters in subsequent negotiations. Consequently, LOIs or MOUs are often executed during this stage.

However, here the question arises: Are LOIs or MOUs contracts, and do they impose binding obligations on the parties involved?

According to the Judicial Interpretation of the Contract Part, the determination of whether an LOI, MOU, or a similar agreement carrying transaction intent constitutes a contract depends on its content.

Such documents are deemed a contract, specifically a “preliminary contract,” if they:

• Specify the parties, subject matter, etc., of the future contract to be concluded.
• Indicate that the parties are bound by the terms of the document.

In cases where a party to the preliminary contract fails to continue negotiations or doesn’t finalize the ultimate contract in the future, the breaching party is obligated to compensate the other party for resulting losses.

In practice, it’s also common for both parties to explicitly agree in the LOI or MOU that “they are not bound by the expression of intent” or “this document is not legally binding.” In such instances, the LOI or MOU does not constitute a preliminary contract. Consequently, any party choosing to terminate negotiations or decline to enter the final transaction contract will not be considered a breaching party under the contract and will not be obliged to compensate the other party.

Is a purchase order (PO) considered a contract?

In practical sourcing scenarios, purchase orders are widely utilized for procuring products from suppliers. Some individuals may not categorize a PO as a contract, as its content is typically concise, encompassing fundamental commercial terms like product name, quantity, prices, and delivery terms, often lacking detailed legal clauses.

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However, from a legal perspective, a document is generally recognized as a contract if it reflects the mutual consent of both parties and, as stipulated in the Judicial Interpretation of the Contract Part, clearly outlines the names of the parties, subject matter, and quantity.

One reason some people may not view a PO as a contract is the potential absence of explicit “mutual consent.” For instance, neither party may sign or affix an official stamp to the physical PO. Communication might occur through email, where the buyer sends a request, and the seller responds with a brief acknowledgment like “Well received” or “Okay.” Alternatively, in established relationships, the seller may initiate goods preparation upon receipt of the PO without formal confirmation.

“Mutual consent” can be expressed flexibly, including through “trade practice,” as outlined in the Civil Code. The Judicial Interpretation of the Contract Part further defines trade practice as:

• Customary practices between transaction parties.
• Practices generally adopted in the transaction location, relevant field, or industry, known to the counterparty.

Is a contract valid and binding to a company if it is merely signed by the legal representative or a staff member (e.g., sale/procurement manager) without the company stamp?

According to the Judicial Interpretation of the Contract Part, a contract is generally effective for the company if it is signed by the legal representative or staff member within their authorized scope, even in the absence of a company stamp, unless the contract itself explicitly requires one for validity.

In determining whether an act is “beyond the scope of authority,” the Judicial Interpretation provides two scenarios:

• If common sense dictates that matters involved in the contract require higher-level authority approval, and the legal representative or staff member fails to provide necessary resolutions, decisions, or authorization documents, the contract may be deemed “beyond the scope of authority.”
• If the matters in the contract clearly exceed what the staff member can represent, e.g., a junior receptionist signing a purchase contract for crucial scientific research machinery, the contract may be considered “beyond the scope of authority.”

In practice, there are few scenarios where the legal representative behaves beyond their statutory scope of authority. Unlike “staff member”, the legal representative has a broad scope of authority over the company. The second paragraph of Article 61 of the Civil Code stipulates this broad authority- “the legal representative engages in civil activities in the name of a legal person, and its legal consequences shall be borne by the legal person“. Therefore, the legal representative can basically sign most general commercial contracts on behalf of the company.

Moreover, even if the company limits the scope of authority of the legal representative through the articles of association (AoA) or internal regulations, the contract concluded by the legal representative beyond these internal provisions of scope of authority may be still valid and binding on the company, as the third paragraph 3 of Article 61 of the Civil Code provides that “limitation on the representation of the legal representative by the legal person’s AoA or the legal person’s authority shall not be used as a confrontation against the bona fide counterparty“.

The Judicial Interpretation of the Contract Part further reiterates this point. Accordingly, even if the legal representative signs a contract beyond the internal provisions of the scope of authority, the counterparty who does not know such internal restriction (i.e., the bona fide counterparty) is still entitled to require the company represented by the legal representative to assume the obligations and responsibilities in the contract.

As for the scope of authority of a staff member, it is generally linked to the functions of the department where the staff member works. For example, the purchasing director of a company has the authority to purchase, and the sales representative of a company has the authority to sell products or services. The counterparty to the contract should judge according to common sense whether the staff member signing a contract is within his/her scope of authority. The example above regarding the junior receptionist signing an important contract for the company is obviously unreasonable, accordingly the contract he/she signed without the company’s stamp should not be effective for the company.

In summary, a contract with the signature of the legal representative but without the company stamp is much more likely to be recognized by law and the court for its validity over the company than a contract with the signature of a staff member but without the company stamp.

What are the potential risks in drafting and providing the contract (to the other party) for the initiating party?

Assume that you have pre-drafted some terms for the purpose of reuse in the future and fail to negotiate them with the counterparty when concluding a contract (such terms are defined as “Standard Terms” in the PRC Civil Code), there will be a risk that these terms might be deemed invalid in certain scenarios.

To be specific, if the provider of the Standard Terms fails to remind the counterparty or explain to the counterparty the Standard Terms in which the counterparty has material interests (e.g., those Standard Terms exempting or mitigating the liability of the provider of the Standard Terms), resulting in the counterparty’s omission or misunderstanding of these terms, then the counterparty will be entitled to claim that these Standard Terms are invalid.

On the other hand, these Standard Terms in which the counterparty has significant interests could be valid if the provider reasonably reminds the counterparty and explains them per the counterparty’s request, unless the content of such Standard Terms is obviously unreasonable and unfair. This is a rule that has already been stipulated in the Civil Code.

The Judicial Interpretation of the Contract Part further elaborates on what should the Standard Terms provider do to fulfill the obligation of “reminding” and “explaining”.

Among others, the Standard Terms provider shall use keywords, symbols, fonts, and other obvious signs, which are obvious enough to attract the attention of the counterparty to the exceptional terms that the counterparty’s significant interests are involved, such as those exempting or reducing the liability of the Standard Terms provider or excluding or limiting the rights of the counterparty.

In addition, if requested by the counterparty, the Standard Terms provider shall also explain to the counterparty, in written or oral, the concept, content, and legal consequences of the Standard Terms in an easy-to-understand language.

What are the risks of a dual contract?

A dual contract refers to two contracts that are made by the same contracting parties for the same transaction, to achieve certain purposes such as reducing tax payment or circumventing some prohibitive provisions. In practice, there are mainly two scenarios where a dual contract might be applied.

One is that the true agreement between the parties violates the mandatory provisions of the law. To avoid this violation, the parties use a false contract to cover up the true agreement. For example, surrogacy is banned in China. An employer and a surrogate woman may sign a nanny agreement, but in fact, the labor fee the employer pays to the “nanny” is the surrogacy compensation.

The other scenario is that the parties hope to use the false contract to avoid or reduce the legal obligations or liabilities arising from the true agreement. For example, to reduce taxes, the buyer and seller of real estate may sign two contracts—one with a low transaction amount to be used for registration at the property exchange center and tax bureau, and the other with a higher transaction amount, which is the real amount that should be paid by the buyer to the seller.

How to deal with dual contracts if the parties have a dispute, such as when the two parties have disagreements over the true and false amounts? The Judicial Interpretation of the Contract Part gives relatively clear guidelines.

What other situations that are easily overlooked can make a contract invalid?

The PRC Civil Code stipulates that “Any civil juristic act that violates public order and good morals is null and void”. The Judicial Interpretation further elaborates on what are regarded as “public order and good morals”, which include:

• National security, such as political security, economic security, military security, etc.
• Public order, such as social stability, the order of fair competition, public interests, etc.
• Customs of goodness, such as social morality, family ethics, and personal dignity.

A contract, if it impacts, deviates from, or harms any of the above items, will be likely to be ruled invalid by the court after considering comprehensive factors, even if the contract itself does not violate the mandatory provisions of laws and regulations.

For example, under the state’s policy of restricting the purchase of commercial housing, if a buyer enters into a property purchase contract (somehow successfully) beyond the restriction policy for the purpose of real estate speculation, then the purchase contract is likely to be deemed invalid, because it deviates from the social public order (stable housing prices).

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