What makes a contract valid?

There is some mythology about when a contract is a contract in China. Much of this probably comes from the fact that many Chinese businessmen are energetic negotiators of contracts, and one negotiating strategy is to pretend that what was agreed yesterday does not apply today. The Contract Law of the PRC was drafted to solve the problem of the occasional failure to honour contracts by providing legal recourse. The Contract Law also sets out a number of instances where a document which appears to be a contract can be either void (of no legal validity at any time), rescinded freely at the option of a party, or valid but unenforceable in China.

The Contract Law specifies various technical requirements for contracts, but in general contracts with technical deficiencies (non-compliance with one or more of the usual clauses that a contract of that type should contain) may still be enforced in whole or in part.

An issue sometimes missed by foreign investors in China is that certain basic defects such as lack of fairness, violation or social norms and a few other basic requirements, can cause a contract to be unenforceable in China. These issues are worth some attention.

The Requirement of Fairness:

Article 5 of the Contract Law requires adherence to the principle of fairness. A Chinese judge or arbitrator would decide what is or is not fair according to his standards, which need not be the same as the standards usually used by the parties to the contract. Chinese standards of fairness are not necessarily the same as a foreign party's concept of fairness. Because the requirement of fairness, in the expression of the obligations and rights of the parties to the contract, is a basic requirement, a contract lacking in fairness could be either void, rescindable at the option of the innocent party, or unenforceable against the innocent party (based on the best judgment of a judge or arbitrator).

Standard contracts in particular are required to be fair to the party which is not permitted to negotiate the terms of the contract. Some guidance can be gleaned from the law on standard contracts as to what Chinese legislators consider "fairness" to require. It is considered unfair to exempt one's self from liability or to increase the liability of the other party in circumstances where the other party does not have an opportunity to negotiate such terms.

Standard Clauses

A standard clause is void (non-binding at any time) if it purports to do any of the following:

• exempt the party providing the clause from liability;
• increase the liability of the other party;
• deprive the other party of a major right;
• if the clause purports to exempt liability for bodily harm caused to the other party; or
• if the clause purports to exempt liability for property losses due to willfulness or gross negligence.

In addition, a standard clause will be void if it is contained in a contract which is void by reason of Article 52 of the Contract Law. Article 52 stipulates that the following contracts are void (non-binding at any time):

• if fraud or coercion was used to conclude the contract and the interests of the State (as understood by the State) are harmed;
• if the contract involves a malicious conspiracy to harm the State, or collective or third party interests;
• if an illegal objective is concealed in a legal form;
• if the subject matter of the contract harms public interest; or
• if the contract violates mandatory provisions of law (here again, if only a part of the contract is out of compliance, and that part is severable, then it is possible that only the non-compliant part is void, but at some point if enough of the clauses are non-compliant, the whole contract could be considered void).

The requirement of social acceptability

Article 7 requires that the parties to a contract respect public morals and avoid disturbing the social or economic order or harm public interest. The article also requires contract parties to comply with laws and administrative regulations. It becomes difficult to determine when a contract is unenforceable because of violation of applicable law. Certainly if the main purpose of a contract involves the violation of law, the entire contract is invalid. However sometimes the violation of law is a minor infraction, or the non-complying portion of the contract can be severed. In such cases the contract, or the valid parts of the contract should remain in force.

Damages under an invalid contract

If a contract or parts of a contract are invalid, the non-complying party may owe damages to the other party or sometimes to third parties arising from acts undertaken in performance of the contract. This avoids permitting a contract party to benefit from non-compliance with the law. Under WTO

Contract clauses requiring foreign exchange balancing cannot be enforced under the terms of China's accession to WTO.

For further information, please contact Luke Filei at [email protected] or on + 86 10 6590 0389.