PRC Court Admits Subsequent Conduct in Construction of Contract
By Patrick Zheng | Charles Qin
In interpreting a contract, Chinese courts will take into account surrounding circumstances including both prior negotiations[1] and subsequent conducts of the parties.
The Chinese approach is thus more in line with the United Nations Convention on Contracts for the International Sale of Goods[2], the UNIDROIT Principles of International Commercial Contracts[3] and the Principles of European Contract Law[4].
This starkly contrasts with the well-established English common law approach which generally excludes reference to the prior negotiations and subsequent conducts when interpreting contracts except in certain specified circumstances. This common law approach is derived from the underlying common law philosophy that contracts should be interpreted in accordance with the objective meaning of the words used in the contract and not in accordance with the subjective intentions of the parties.
As we have previously discussed,[5] the recent trend in English common law towards more contextual or purposive approach has, however, been focused almost entirely on widening the occasions when “antecedent” circumstances (i.e. things that take place before the contract is made) can be referred to when interpreting a contract. English common law has not taken the same approach to “subsequent” circumstances (i.e. things that happen after the contract is made). English common law still almost entirely prevents reference being made to “subsequent” conduct and circumstances when interpreting contracts even though it has somewhat relaxed the rules on the admissibility of “antecedent” circumstances. This again derives from the underlying common law philosophy. Lord Reid noted that, one might have the result that a contract meant one thing the day it was signed, but by reason of subsequent events meant something different a month or a year later.[6]
There are therefore only a very few and very limited cases where English common law will allow “subsequent” circumstances to be considered. One of these exceptions is when the courts need to decide what type of transaction the parties have created rather than interpreting the contract itself. For example, English insolvency law applies different treatment to “fixed charges” and “floating charges”. The courts may be able to have regard to “subsequent” conducts when deciding whether the transaction created by the parties falls into the category of “fixed” or “floating” charge.
The case set out below illustrates how the Chinese courts deal with a situation in which the parties were arguing about the proper characterization of the legal transaction they had entered into, and the resulting obligations. The Supreme Court considered that “subsequent” conduct was highly relevant and material. It also approached the determination more as contractual interpretation than contractual characterization.
Background
On 28 July 2015, Shanghai Beidou New Energy Co., Ltd. (“Beidou Company”) signed a “Letter of Intent on Investment”[7] with Lijiang City Bus Co., Ltd. (“City Bus Company”), agreeing to acquire the latter’s 100% shares (“Acquisition”).
In an attempt to secure performance of the Letter of Intent on Investment, the parties further entered into a series of agreements in terms of sale of buses as follows:
Ultimately, the Acquisition did not work out. Disputes arose as to the performance of the Series Sales Contracts. Beidou Company filed a lawsuit before the competent court and claimed payment due for the buses actually delivered according to the Series Sales Contracts.
Beidou Company contended that a sale of goods relation was established between the parties, signified by the Series of Sales Contract. Therefore, City Bus Company was obliged to effect the corresponding payment for the buses. City Bus Company, however, argued that the true intention of the parties was not the sale of the buses and it had no obligation to make payment. Beidou Company should take back the buses at its disposal.
Decision
The trial court ruled in favor of City Bus Company, holding that no sale of goods relation had ever been established.
On appeal, the Supreme Court started with the guiding principles of contractual interpretation set out in Article 125 of the PRC Contract Law.[8] The Supreme Court particularly emphasized that when determining the object and purpose of the contract, the court takes into account all of the surrounding circumstances including subsequent conducts in order to ascertain the parties’ true intention.
The Supreme Court held that:
“The Series Sales Contracts are merely a step moving forward the performance of the Letter of Intent on Investment. After the conclusion of the Series Sales Contracts, the parties entered into the Bus Deposit Agreement and the Supplementary Agreement, which provided that should the Acquisition fail, the parties would make further arrangement on the disposition of the buses. So no standalone sales of buses relationship had ever been contemplated by the parties outside the context of the Acquisition. Also, evidence for acts after the conclusion of the Series Sales Contracts shows that, in dealing with the buses, Beidou Company treated them as investment to City Bus Company and never confirmed the existence of any sales of goods relation. By virtue of the foregoing, there is no sale of goods relation because the parties had no intention in binding each other as buyer and seller.”
In light of this, the Supreme Court held that the Series Sales Contract did not give rise to a sale of goods relation between the parties, and thereby dismissed the appeal.
Comment
The Supreme Court classified this case as a dispute over the interpretation of contract and purported to ascertain the “true intention” of the parties by reference to Article 125 of the PRC Contract Law, which comes into play when the parties dispute the meaning of contract terms.
The Supreme Court considered that the proper categorization or characterization of the contract turned upon the proper interpretation of the contract provisions. The Supreme Court did not draw a distinction between the exercise of interpreting the contract terms and the proper categorization of the transaction.[9] Under Chinese law, it seems no such distinction has been made.
This is significant as the proper characterization of a transaction can have significant legal implications under Chinese law--affecting which Chinese laws apply and what contractual obligations ensue. In this case, characterizing the transaction as a “failed investment” meant that City Bus Company could avoid the buyer’s payment obligations.
In the process of characterization, the Supreme Court took into account prior negotiations, subsequent conducts and the purpose of the transactions.
This case is a useful illustration that Chinese courts are willing to have recourse to the widest possible evidence to characterize or categorize the underlying transactions. The parties’ chosen nomenclature or label is not conclusive.
It is therefore advisable that, in order to avoid disputes over the characterization of the transaction, due regard should be given to not only prior negotiations, but also how the contract or transaction is in fact carried out.
【Endnote】
[1] Find more information on contractual interpretation in Llinks Dispute Resolution Bulletin No. 12 March 2019, available at:
http://www.llinkslaw.com/uploadfile/publication/10_1551683860.pdf
[2] Article 8(3), United Nations Convention on Contracts for the International Sale of Goods (Vienna, 1980), “In determining the intent of a party or the understanding a reasonable person would have had, due consideration is to be given to all relevant circumstances of the case including the negotiations, any practices which the parties have established between themselves, usages and any subsequent conduct of the parties.”
[3] Article 4.3(c), UNIDROIT Principles of International Commercial Contracts (1994), “In applying Articles 4.1 and 4.2, regard shall be had to all the circumstances, including: (c) the conduct of the parties subsequent to the conclusion of the contract.” Note that this provision stays unchanged in subsequent 2004, 2010 and 2016 versions.
[4] Article 5:102, Principles of European Contract Law (Part I 1998 revision), “In interpreting the contract, regard shall be had, in particular, to: (b) the conduct of the parties, even subsequent to the conclusion of the contract.”
[5] Supra Note 1.
[6] James Miller & Partners Ltd. v Whitworth Street Estates (Manchester) Ltd. 1916 1 A.C. 281.
[7] Find more information on the legal effect of a letter of intent in Llinks Dispute Resolution Bulletin No. 11 February 2019, available at: www.llinkslaw.com/c3pr90ntc0td/uploadfile/publication/15_1550827407.pdf
[8] Article 125, Contract Law of the People’s Republic of China (1999), “In the event of disputes between the parties concerned over the understanding of a clause of their contract, the true meaning of the clause shall be determined on the basis of the wording used in the contract, related clauses of the contract, purposes of the contract, trade practices and the principle of good faith.”
[9] Gerard McMeel, McMeel on The Construction of Contracts Interpretation, Implication, and Rectification (3rd edn, Oxford 2017), 242.
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