Culpa in Contrahendo: PRC Judgment in Dispute over Financial Derivatives Services

By Guan Feng and Wu Sijie, King & Wood’s Litigation & Arbitration Group

In 2008, a financial derivatives dispute arose between a foreign-funded bank (the "Bank") and a local Chinese company (the "Company"). Although both parties executed certain documents to conclude the transaction, due to adverse changes in the international financial environment, the Company denied that the parties had entered into any contract regarding the derivative transaction and refused to perform. As a result, the Bank initiated a lawsuit against the Company to seek damages.
 

In the first instance judgment, the court found that no contract existed regarding the derivative transaction between the parties and dismissed all claims made by the Bank. The Bank appealed that decision to the Shanghai Intermediate People’s Court. The Court of Appeal rendered its final judgment at the end of 2009. In that judgment, the Court of Appeal found that the parties had not entered into a contract, but held that the Company was liable for the non-conclusion of such a contract and was required to bear fifty percent of the Bank’s losses pursuant to the principle of culpa in contrahendo under Article 42 of the PRC Contract Law. The implications of the case for future similar disputes are as follows:

In financial derivative transactions, what type of contract should be signed between a financial institution and a company?

One of the most significant points of argument in this case was whether the parties had entered into any contract regarding the financial derivative transaction.

The Court of Appeal found that no such contract was formed. In its judgment, the Court of Appeal expressed the following opinions on this point:

(1) Both parties to the transaction should execute a single standardized agreement; and

(2) On March 11, 2009 the People’s Bank of China ("PBOC") released its Announcement No.4 of 2009 (the "PBOC Announcement No.4") announcing the introduction of the Master Agreement of Financial Derivative Transaction in the PRC Inter-bank Market (the "NAFMII Master Agreement") after which market participants in China must execute the NAFMII Master Agreement for derivative transactions entered into after the issuance of PBOC Announcement No. 4. If a financial derivative contract was executed prior to March 11, 2009, as was the case here, the parties can continue to perform their obligations in accordance with the documents filed with the relevant authorities by the bank.

Is it compulsory for a financial institution to execute the NAFMII Master Agreement in a financial derivative transaction, no matter whether it is a RMB or non-RMB transaction, when the counter party is a non financial company?

PBOC Announcement No.4 provides that when trading financial derivatives, market participants must execute the NAFMII Master Agreement designated and published by China’s National Association of Financial Market Institutional Investors ("NAFMII").

According to NAFMII, it is unclear whether "market participants" include financial institutions and non-financial institutions as PBOC’s Announcement No. 4 does not define this term. The market participant in a specific transaction is decided on a case by case basis according to PBOC’s regulations in respect of the different types of financial derivative products (each product is, in effect, subject to a separate regulation).

For RMB derivative transactions, the current and generally accepted practice of NAFMII is to include both financial and non-financial institutions as market participants. Therefore, the NAFMII Master Agreement should always be adopted in RMB derivative transactions, whether the transaction is between financial institutions or between a financial institution and a non-financial institution.

For foreign exchange ("FX") derivative transactions, only financial institutions are allowed to access the China Foreign Exchange Trading System ("CFETS"). According to NAFMII, this implies that financial institutions are the only market participants in FX derivative transactions. In other words, companies and other non-financial institutions are excluded from the market participants in FX derivative transactions. Therefore, NAFMII believes that a financial institution and a non-financial institution do not have to execute the NAFMII Master Agreement when carrying out a FX derivative transaction since a non-financial institution is not regarded as the "market participant" in such a transaction.

However, Neither PBOC nor NAFMII has issued any official document addressing whether the NAFMII Master Agreement must be adopted in financial derivatives transactions between a financial institution and a non-financial institution (including RMB derivatives transactions and FX derivatives transactions). Therefore, this issue remains a question and requires further clarification by the relevant authorities.

Will there be any legal risk if financial institutions fail to adopt the form of contract submitted to or filed with the authority?

In China, financial institutions are required to file the form of the master agreement of their financial derivative services with the competent financial regulatory authority. But a financial institution’s noncompliance with the administrative rules will not lead to the invalidation of a contract under the PRC Contract Law. The general understanding is that whether the contract is subsequently filed with the regulatory authority as required or whether the filed form of contract is adopted should have no impact on the effectiveness of the contract. However, according to the Court of Appeal’s judgment, financial institutions may be subject to legal risks where they fail to adopt the form of the master agreement submitted to or filed with the authority. The court did not establish that master agreements would be invalid if financial institutions executed them in a form different from that filed with the authority. Yet, financial institutions would bear a heavier burden of proof to prove that there is an effective and binding contract between the parties with respect to the specific transaction.

This decision indicates that Chinese courts are making efforts to understand the characteristics of derivative transactions and to establish their rules regarding what issues they should focus on when hearing disputes arising from such transactions. It shows the importance for financial institutions to pay attention to 1) communication with the authorities such as PBOC and China Banking Regulatory Committee, 2) all of the applicable regulatory requirements, including those concerning the form of documents, authorization, risk disclosure and other compliance requirements, and 3) ongoing communication with the client, evidenced in writing, regarding the details of a specific transaction.