By Susan Ning, Tao Huang, and Yang Yang

As was the case throughout the world, the global economic downturn beginning in 2008 caused many in the Chinese market to face difficulties in fully performing executory contacts which had been formed prior to the crisis. As such, many parties to such contracts requested modification or even rescission of their contracts under the changed circumstances. As a response to these trends, the Judicial Interpretation on Contract Law II was issued by the Supreme People’s Court of the People’s Republic of China (hereinafter the “SPC”) to further clarify certain legal rules under current Chinese Contract Law . In particular, Article 26, Chapter 4 of the Judicial Interpretation on Contract Law II (hereinafter “Article 26” or the “Fundamental Change in Circumstances” Provision") provides guidance on a party’s right to modify or rescind a valid contract when a Fundamental Change of Circumstances occurs after contract formation. A Fundamental Change of Circumstances in this regard is differentiated from a force majeure event and does not cover changes that may arise from normal commercial risks, and under which the purpose of the contract would be frustrated or performance will result in extreme unfairness.

Article 26 or the “Fundamental Change of Circumstances” Provision

The “Fundamental Change of Circumstances” doctrine was not originally included in the Contract Law, but was issued as a judicial interpretation during the global economic downturn. The provision gives a contracting party the right to request for modification or rescission of a contract under “fundamental change of circumstances,” but also sets up very strict condition precedents. The Article 26 states:

“After a contract is legally formed, in view of objective circumstances not anticipated by the parties when the contract was formed, not caused by force majeure nor commercial risks, and significant changes occur so that continuing the performance of the contact is unfair and inequitable to one party or the objective of the contract cannot be fulfilled, then a party or both parties may request the people’s court to modify or rescind this contact. The people’s court shall abide by the principle of fairness and consider the actual situations involved in this case before making a decision on modifying or revoking the contract at issue.”

Accordingly, there are four elements that must be present in order to establish a prima facie case so that a request may be made to a court to modify or rescind a valid contract:

A. objective circumstances exist that were not anticipated by the parties when the contract was formed;
B. the change of circumstances is not caused by force majeure;
C. the change of circumstances is not a result of a normal commercial risks; and
D. the continuing performance of the contact would be unfair and inequitable to one party or the objective of the contract cannot be fulfilled.

In deciding whether to grant a request for modifying or revoking a contract, the people’s courts will primarily consider (1) the principle of fairness and (2) the surrounding facts involved in each individual case.

In addition, the SPC announced two other policies after Article 26 which further clarify the application of Article 26: (1) Guidance for Trials on Contract Litigation in the Current Environment ; and (2) Announcement on Serving the State and Communist Party by Correctly Applying Judicial Interpretation of the Application of Contract Law of the People’s Republic of China II . In particular, the Guidance for Trials on Contract Litigation in the Current Environment provides four policy objectives which we will be further discussed. These policies are very important in ensuring fair and unified application of Article 26.

A. Objective Circumstances Unanticipated by the Parties when the Contract was formed.

First, the Guidance for Trials on Contract Litigation in the Current Environment provides standards for the interpretation of “unanticipated” Based on a reasonable person in common society standard, whether the level of risks is beyond a reasonable person’ expectations, whether the risks can be avoided or controlled, and whether transactions are of a high risk or high return nature determine what is “unanticipated”. In addition, the people’s courts shall consider the situations involved in specific cases and make decisions on a case-by-case basis.

Second, some recent cases may provide insight on the meaning of “unanticipated objective circumstances.” In April, the Beijing Municipal Government issued an announcement that prohibited banks from issuing mortgage loans to home purchasers who already owned two residential units. At the time of the issuance of this announcement, many real estate purchasers that already owned two or more units had entered into purchase agreements. Therefore, many residential unit purchasers filed lawsuits with the people’s courts claiming that due to this announcement, they could not obtain mortgage loans and subsequently could not afford to perform their end of the purchase agreements. In July, the Beijing Haidian District Court announced that they would recognize this development as an “unanticipated objective circumstance.”

B. What is Force Majeure

“Force majeure” under Chinese Contract Law means an extraordinary circumstance that is unforeseeable, unavoidable and out of the control of any Party. In practice, events of force majeure mainly include natural disasters, war, strikes, riot, civil commotion, fire, explosion, sabotage, terrorism or embargo. In 2003, the Chinese Supreme Court issued an announcement which recognized “SARS” as an event of Force Majeure.

Article 26 requires that the objective circumstance unanticipated by the parties is not caused by events of force majeure. However, Article 26 does not provide the difference between force majeure and fundamental change of circumstances. From the Beijing Haidian District Court’s decision referred to above, it seems that changes in laws may be recognized as a fundamental change in circumstances. Article 26 was issued last year, and more time is needed to fully understand the courts’ attitude in differentiating between the two.

C. Difference between “Fundamental Change of Circumstances” and “Commercial Risks”

Both Article 26 and the Guidance for Trials on Contract Litigation in the Current Environment stressed that a fundamental change of circumstances shall not include changes arising from normal commercial risks. Generally, common commercial risks can be reasonably anticipated and assumed by the parties.

During the global economic downturn, most disputes seeking application of Article 26 refer to changes in commercial markets, such as price fluctuations in raw materials or commodities. When distinguishing “fundamental change of circumstances” and “commercial risks”, the courts generally take a cautious approach and will consider whether the event could have been reasonably anticipated by the parties.

The Guidance for Trials on Contract Litigation in the Current Environment provides that when it comes to a significant increase or decrease in prices of raw materials, changes in supply and demand, insufficient cash flow and other similar reasons, the people’s courts shall strictly abide by the principle of fairness and carefully scrutinize the objective circumstances alleged by one party. Generally, prices of raw materials, supply and demand, and cash flow issues usually contain lower or more manageable risks than other market factors such as currency fluctuations or interest risks. Market participants may conduct routine transactions involving the same raw materials in the same territories. Such risks are more likely to be routine commercial risks.For some higher-risk areas, the Supreme Court has called for a strict approach. The Guidance for Trials on Contract Litigation in the Current Environment requires much stricter inspection on commodities that are extremely active on the market such as petroleum, coal, nonferrous metals, or commodity price indexes and financial product contracts such as stocks and futures. In a recent arbitral award related to swap contracts, the China International Economic and Trade Arbitration Commission did not recognize the global economic crisis as a “fundamental change of circumstances.” This decision is based on two reasons:

(1) the global economic crisis was in many respects a gradual process instead of an abrupt event which caught market participants off guard. The rationale behind this reason is that as the downturn unfolded, market participants are able to anticipate and seek solutions to control risks; and
(2) the underlying index of the swap contract involved in this arbitration was the Libor interest rate which was recognized as high risk derivative trading. All parties were aware of such high risks at the time of contract. The rationale behind this reason is that if parties are aware of higher risks through the reasonableness standard, they shall bear such anticipated risks. In addition, parties that enter into high risk transactions are hoping to achieve high returns and correspondingly they shall bear any losses that may arise in these transactions.

This arbitral decision implies that with the increased scrutiny the people’s courts will impose on the financial derivative contracts, the global economic crisis will generally not be recognized as an unanticipated circumstance because these transactions are considered by a reasonable person as containing high commercial risks.

D. Continuing Performance of Contact is Unfair and Inequitable to One Party or Objective of Contract Cannot be Fulfilled

This element is the same as that of mandatory rescission whereby one party is entitled to rescind a contract if the other party breaches ancillary debt obligations after the expiry of the performance period and such breach frustrates the objective of the contract. Generally, the contract purpose may be described in the contracts or inferred from the negotiations and execution between the parties.

On August 25, 2009, the Beijing Chaoyang District People’s Court issued a decision on an exclusive licence agreement suit brought by Song Ying, etc. against Beijing Chang Xiang Bang Pet Information Consultancy Service Center. In this case, the courts held that failure to obtain a required license which partially contributed to a default would be considered as a situation where “the objective of the contract cannot be fulfilled.”

This case provides guidance for what may frustrate the purpose of a contract such as failure to obtain a required licence by one of the parties. In addition, this case provides a basis whereby if a party’s fault partially contributed to any event which will frustrate the purpose of the contract, it would be unfair to have the other party perform the contract and incur losses.

E. Cautious Attitudes of People’s Courts on Applying Article 26

The Guidance for Trials on Contract Litigation in the Current Environment provides a policy objective where the people’s courts shall protect the interests of parties who have performed their contractual obligations in accordance with a valid contract. What’s more, the policy is for people’s courts to not permit debtors escape from performing their debt repayment obligations.

The SPC requires all people’s courts to conduct very strict reviews on the unanticipated circumstances alleged by parties seeking modification or rescission.

If based on the specific situations of individual cases, the court considers applying this provision, the trial court must first report this case to the high court at the provincial level for examination and approval. When necessary, the case may be reported to the SPC for examination and approval. Having the high court at the provincial level as the primary authority for applying Article 26 ensures unified application at least by province.