Covid-19: Impact on commercial contracts – Mainland China
How is the applicable law determined by the courts in case of commercial contracts?
The parties to a commercial contract can choose the governing law, provided such contracts involve foreign elements, e.g.
- either party is a foreign person or legal entity (whereas foreign ownership is not sufficient to create a foreign element);
- the subject matter of the contract is located outside mainland china;
- the legal facts that give rise to, amend or terminate the contractual relationship occurred outside mainland China.
For a contract that has no foreign element, regardless of the parties’ choice of law, PRC law will be the governing law of the contract. In addition, the application of PRC law is mandatory for certain contracts, such as agreements for equity joint ventures, contractual joint ventures and joint ventures of exploitation and development between a mainland Chinese and a foreign party and performed within mainland China. In the absence of a choice of law, the governing law will be determined by the laws that have the closest connections with the contract.
Are there any statutory provisions relating to force majeure?
Clause 180 of the PRC General Provisions of the Civil Law and Clauses 94(1),117 and 118 of the Contract Law contain statutory provisions relating to force majeure, which is defined as any objective circumstances that are unforeseeable, unavoidable and insurmountable. Where the force majeure event prevents the performance of contractual obligations, the affected party may be partially or wholly exempted from its obligations and/or liabilities. If the purpose of the contract becomes futile because of the force majeure event, the affected party is entitled to terminate the contract.
Although mainland China is not a case law jurisdiction, in practice, the PRC Supreme Courts and the courts of provincial levels publish guidelines or opinions to facilitate adjudication of disputes. The interpretation of the Supreme Court is legally binding. While the judicial opinions published by the courts on provincial level are indicative only, they are nevertheless influential and persuasive. In 2003, the Supreme Court published guidelines to deal with contract disputes arising from or in connection with the occurrence of the Severe Acute Respiratory Syndrome (“SARS”). Following the outbreak of Covid-19, several courts on the provincial levels also published guidelines relating to, among other things, the interpretation and application of the doctrine of force majeure and the doctrine of “Change of Circumstance” in resolving contract disputes.
The prevailing view of the PRC government is that the outbreak of Covid-19 constitutes a force majeure event, and mainland Chinese authorities such as the China Council for the Promotion of International Trade (CCPIT) issue “force majeure certificates” to affected mainland Chinese companies. However, the key issues to be determined are whether a force majeure event prevents the performance of the specific obligations concerned and whether no alternative means are available to mitigate its impact on the (non-)performance to achieve the purpose of the contract.
As a result, the affected party seeking to be exempted from its contractual liabilities needs to prove that (i) the outbreak of the novel coronavirus was unforeseeable, unavoidable and insurmountable and thus constitutes a force majeure event; and (ii) such force majeure event prevents the performance of individual obligations. The affected party seeking to terminate the contract needs to further prove that the purpose of the contract can no longer be achieved even after taking reasonable measures to prevent or mitigate the impact of such non-performance. In any event, a party cannot be exempt from liability if the force majeure event happened after its delay of performance.
In practice, where the impact of Covid-19 on the performance or the purpose of the contract is substantial but less severe so that it does not amount to “prevention of the performance of contractual obligations by force majeure”, many mainland Chinese courts will encourage the parties to amend the contract terms through amicable negotiations under the principle of equity. If no agreement between the parties can be reached, it is possible that mainland Chinese courts may adjudicate on the amendment of the contractual terms to fairly allocate the losses/risks between the parties in accordance with equity considerations, rather than exempting one party from its obligations or liability completely.
How are force majeure clauses in commercial contracts applied and interpreted in practice?
In the absence of statutory provisions and / or contractual arrangements on force majeure, which instruments are available to avoid the performance of contractual obligations?
The doctrine of “Change of Circumstance” under PRC law is similar to the concepts of “frustration” or “hardship” in other jurisdictions. The party invoking this doctrine needs to prove that (i) a material change in circumstances (such as fundamental currency devaluation or other material change of economic factors) has occurred after the formation of the contract; (ii) these material changes were unforeseeable when concluding the contract and exceed the usual scope of commercial risks; and (iii) one party’s obligation to perform would be dramatically unfair or the contractual purpose frustrated due to such change.
If a “Change of Circumstance” can be proven, the affected party can request mainland Chinese courts to either amend or, if the contractual purpose can no longer be achieved, to terminate the contract at the courts’ discretion. The affected party has no right to unilaterally terminate the contract.
However, the limited case law applying the “Change of Circumstance” doctrine indicate mainland Chinese courts’ conservative approach when amending or terminating contracts on this basis. Procedurally, a ruling applying this doctrine would need to be approved by the courts of provincial level and sometimes also by the PRC Supreme Court.
What else needs to be considered by clients that are party to a contract which is affected by Covid-19?
Once a force majeure event occurs, the affected party must, to the extent reasonably possible, explore alternative means to achieve the purpose of the contract and take all reasonable steps to mitigate the loss resulting from non-performance (e.g., by changing the loading port to another place that is not or less affected by the force majeure event). It is exempt from performing its obligations only if it can establish that – and to which extent – the non-performance was caused by the force majeure event. Any loss incurred due to the affected party’s failure to take timely mitigation measures cannot be asserted against the counterparty. The affected party is advised to keep detailed records/evidence.
The force majeure doctrine requires that the affected party notifies the counterparty in a specific and timely manner, i.e. as soon as – and specifying how – the outbreak of Covid-19 and/or the epidemic control measures risk to impact contract performance.
As an affected party is often part of a supply chain where it is both debtor wanting to rely on the force majeure defence and creditor against whom the defence is raised, it is advisable to collect force majeure related evidence from suppliers or subcontractors and pass them (if desirable and on a selective basis) to the upstream creditors in a timely manner. In addressing any questions or requests raised by the upstream parties, it is prudent to reserve the position pending clarification or details provided by the downstream parties.
It is also advisable to carefully analyse the contract terms and assess the legal position before invoking the force majeure doctrine and taking any relevant legal actions. For example, in international sales of goods, the different price terms (CIF or FOB) should be evaluated to determine whether the force majeure event happened before or after transfer of risks.
If the contract performance is affected but not completely prevented by the effects of the novel coronavirus, both parties are advised to firstly explore commercially sensible solutions (e.g. extension of time for performance, change of the performance method) to enable a “win-win” situation rather than instantly invoking the doctrines of force majeure or “Change of Circumstance”. As previously mentioned, mainland Chinese courts have discretion – and a strong preference for equity considerations – to adjudicate on the amendment of the contractual terms in certain circumstances even if the doctrines of force majeure/“Change of Circumstance” cannot be invoked.