Llinks Review | SPC Further Clarifies on Liquidated Damages
By Patrick Zheng | Charles Qin
Damages can be defined as “the sum of money that a person wronged is entitled to receive from the wrongdoer as compensation for the wrong”. Five categories of damages may be found in international practice: (1) compensation/reparation; (2) punitive damages; (3) liquidated damages; (4) restitution and (5) unjust enrichment.
Liquidated damages mean “an amount contractually stipulated as a reasonable estimation of actual loss to be covered by one party if the other party breaches”. Under Chinese law, the parties may agree ex ante on the liquidated damages amount for breach of contract, but may ask the court for proper adjustment if the amount is lower or excessively higher than the loss caused by the breach.
The “loss” in this context has been unclear under Chinese law, whether it includes both the two categories of damages, “damnum emegens” and “lucrum cessans” or not.
Damnum emegens represents the concept of “an actually realized loss” (such as the expense incurred in performing the contract, amount spent in reliance, incidental cost after a breach etc.) as opposed to an expected future loss (such as loss of profit).
Lucrum cessans (also known as “net gain/loss”) denotes “damages awarded to include a loss of anticipated profit”, which encompasses expectation loss or consequential loss while loss of profit is the most common one.
The notion of actual loss is unclear under Chinese law, which is in some context regarded as direct loss and refers to any injury or decrease in property value that has actually occurred.[1] It should be noted that it might be different from English law that direct loss is the loss arising naturally as the result of breach of contract. Consequential loss (indirect loss), on the other hand, covers anticipated profit, namely expectation loss under Chinese law. Again, there is no clear definition of consequential loss as that of English law.
In its recent decision,[2] the PRC Supreme Court affirmed that the exact meaning of “loss caused by the breach” under Article 113 of the PRC Contract Law includes both actual loss (damnum emegens) and expectation loss (lucrum cessans). Simply put, if the liquidated damages are lower or excessively higher against the actually realized loss and anticipated profit combined, the aggrieved or breaching party may ask the court to adjust the sum of liquidated damages. The Supreme Court considered the liquidated damages amount set out under the agreement in this case was appropriate and saw no need for adjustment, thus it uplifted the amount earlier reduced by the Gansu High Court.
Background
China Cinda Asset Management Co., Ltd. Gansu Branch (“Cinda”), Zhilin Real Estate Development Co., Ltd. (“Zhilin Real Estate”), Zhilin Industrial Co., Ltd. (“Zhilin Industrial”) and others entered into an Assignment Agreement, in which Zhilin Industrial agreed to assign to Cinda the credit owed to Zhilin Real Estate, and in return, Cinda agreed to provide payment correspondingly. The agreement contains a liquidated damages clause, which provides that the liquidated damages are set at 0.05% of the overdue payment per day starting from the day that either party breaches the agreement. Later, the debtor, Zhilin Real Estate failed to repay its debts and Cinda filed a suit and claimed its credit along with liquidated damages.
Zhilin Real Estate applied for a reduction of liquidated damages, and the Gansu High Court adjusted from 0.05% per day (which is equivalent to 18% annually) to an annual rate of 6%, because it considered the liquidated damages were too high and not compatible with the actual loss suffered. Cinda appealed to the Supreme Court and the main issue, inter alia, revolved around whether the Gansu High Court correctly adjusted the liquidated damages amount.
Adjustment of Liquidated Damages
Article 114 of the PRC Contract Law concerns the adjustment of liquidated damages, which provides that the breaching party may request the competent court to appropriately reduce the liquidated damages amount, if the amount agreed ex ante for breach of contract is excessively higher than the loss caused by the breach. However, it is ambiguous as to the exact scope of “loss caused by the breach”. The Gansu High Court considered 0.05% of the overdue payment per day as liquidated damages was too high compared with the actual loss suffered and thus needed to be reduced.
On appeal, the Supreme Court overruled the holding and affirmed that “loss caused by the breach” within the meaning of Article 114 of the PRC Contract Law refers to both actual loss and expectation loss. In its reasoning, the Supreme Court referred to Article 113 of the PRC Contract Law, according to which the loss caused by breach of contract shall include the expectation loss that may be obtained upon the completion of performance of the contract, and it shall not exceed the amount that has been or ought to be foreseen by the party in breach in concluding the contract. Reading “loss caused by the breach” in the context of Articles 113 and 114 in the entirety, it is supposed to include expectation loss.
Therefore, the Gansu High Court wrongly reduced the liquidated damages amount, because the amount was appropriate after taking expectation loss into account.
Takeaway
Under Chinese law, the court has the power to make adjustment of lower or excessively higher liquidated damages against loss suffered by the aggrieved party, if the aggrieved or breaching party so requests, by considering such factors as the performance of contract, fault of the parties concerned and expectation loss, and assess in accordance with the principles of equity and good faith in the light of actual loss.[3]
The PRC Supreme Court reaffirmed that expected profit shall be taken into account when making adjustment of liquidated damages amount. However, it leaves questions open as to how to calculate such expectation loss, and whether expectation loss is left for the injured party to prove or is a matter of iura novit curia by the court. Because the amount of expectation loss lacks definiteness and is often speculative, it is rarely articulated in the Chinese judicial practice that what formula or operative standard should be applied. It would thus be advisable for parties not familiar with Chinese law to prudently assess all the possibilities and outcome of a project/case, before reaching any agreement on the liquidated damages amount.
【Endnote】
[1] Kangsheng Hu (ed.), Legislative Affairs Commission of the Standing Committee of the National People’s Congress, Commentary on the PRC Contract Law (3rd edn Law Press 2013) 205.
[2] China Cinda Asset Management Co., Ltd. Gansu Branch v Zhilin Real
Estate Development Co., Ltd. and others, PRC Supreme People’s Court,
(2018)最高法民终355号.
[3] Article 29, Interpretation II of the Supreme
People's Court of Several Issues concerning the Application of the
Contract Law of the People's Republic of China, Fa Shi [2009] No. 5.
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