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How to Set Penalty Clauses in Contracts When Doing Business with Chinese Companies



Many foreign companies engage in transactions with Chinese companies under contracts governed by the laws of the foreign company's jurisdiction. While these contracts often include provisions for liability of breach of contract, which tend to be overly general. To better protect your interests, foreign companies are advised to apply Chinese law when signing contracts with Chinese companies. Not only should they include breach clauses, but also specify the compensation for breach losses in more detail.

 

Chinese law does not explicitly distinguish between compensatory and punitive liquidated damages but recognizes their dual nature, primarily compensatory with a secondary punitive function. The main purpose of liquidated damages is to compensate for losses rather than to harshly punish the breaching party. When damages are below the loss, they serve a compensatory function; when they exceed the loss, they have a punitive aspect, teaching the breaching party a lesson to some extent. However, in judicial practice, Chinese courts generally do not recognize or support punitive damages in most cases.

 

  • To set up practical breach clauses, it is essential to understand how to calculate compensation for breach losses.

 

According to Article 584 of the Chinese Civil Code, if one party fails to fulfill contractual obligations or their performance does not meet the agreed terms, causing losses to the other party, the amount of compensation should be equivalent to the losses caused by the breach, including the benefits that could have been obtained from contract performance. However, the compensation should not exceed the losses foreseeable by the breaching party at the time of contract formation.

 

Thus, we can conclude that "compensation amount = loss." Recognizing "loss" is important because it sets the standard for statutory breach compensation and serves as the basis for court judgments when parties claim the stipulated liquidated damages are too high or too low. Additionally, the clause indicates that losses include benefits obtainable after contract performance. Therefore, losses can be summarized as "compensation amount = loss = obtainable benefits/expectation interest + other actual losses."

 

  • What are Obtainable Benefits/Expectation Interests?

According to relevant judicial interpretations, when determining the benefits that could have been obtained after contract performance, courts can deduct reasonable costs incurred by the non-breaching party for contract formation and performance, then calculate based on production profits, operational profits, or resale profits obtainable by the non-breaching party.

 

If the non-breaching party lawfully terminates the contract and conducts a substitute transaction, claiming the difference between the substitute transaction price and the contract price as the benefits obtainable after contract performance, the courts should support this claim. If the substitute transaction price significantly deviates from the market price at the time of the transaction, the courts should support the breaching party's claim based on the market price difference.

 

If the non-breaching party lawfully terminates the contract but does not conduct a substitute transaction, claiming the market price difference at the contract performance location within a reasonable period after the breach as the benefits obtainable after contract performance, the courts should support this claim.

 

In summary, losses can be simplified as:

Breach compensation amount = obtainable benefits/expectation interests + other actual losses - unforeseeable losses by the breaching party - increased losses due to the non-breaching party - losses caused by the non-breaching party's own fault - benefits or reduced necessary expenses gained by the non-breaching party due to the breach.

 

  • How to Set Breach Clauses

 

We provide the following suggestions for setting liquidated damages:

 

  1. Analyze Specific Contracts for Liquidated Damages: Determine the specific stages and scenarios where breaches may occur based on the transaction and risk assessment. Consider your core concerns, the likelihood of the other party breaching, and its impact on you to set targeted liquidated damages clauses. For unspecified breach scenarios, a catch-all clause can be included, such as "Party B shall pay liquidated damages amounting to X% of the total contract amount for any other breaches."

  2. Clearly Define Trigger Conditions for Liquidated Damages: For example, when stipulating "serious circumstances," "general breach," or "serious breach," provide clear definitions or detailed listings to avoid disputes when applying the liquidated damages clauses, preventing potential adverse consequences.

  3. Specify the Amount or Calculation Method of Liquidated Damages: Liquidated damages can be stipulated as a specific amount or a calculation method. Consider the contract amount when setting this. For smaller contracts, a specific amount can be set, while for larger contracts, prioritize the calculation method, using the total contract amount or unfulfilled amount as the base, with the liquidated damages ratio set as a total or daily percentage. If favorable to you, set your calculation base and liquidated damages ratio lower than the other party's.

  4. Sequence of Contract Termination and Liquidated Damages Payment: Do not set contract termination as a precondition for liquidated damages payment. It is suggested to state, "If Party B commits such breach, Party A has the right to demand Party B to pay liquidated damages amounting to 20% of the total contract amount and has the right to unilaterally terminate the contract."

  5. Agree on Direct Deduction Rights: To enhance the operability of liquidated damages payment and reduce litigation, stipulate in the contract, "If Party B breaches, Party A has the right to directly deduct the liquidated damages from any payment or performance bond due."

  6. Use in Conjunction with Deposits and Bonds: Liquidated damages clauses are vital for risk control and dispute protection but are not the only measures. Consider using deposits, performance bonds, and quality bonds in the contract to enhance risk control and maximize benefits.

 

Doing business with Chinese companies, if you have paid all or most of the payment before receiving the corresponding goods, the Chinese company is more likely to breach the contract. Therefore, it is crucial to set effective and enforceable liquidated damages clauses in the transaction contract, isn't it?



Disclaimer


This article has been prepared for general reference purposes only and should not be relied on as legal advice or regarded as a substitute for detailed advice in individual cases.

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