Determining validity of contracts against regulatory provisions

By Yao Xiaomin, Lian Tianjiao, Lantai Partners
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In the current backdrop of strong supervision on the financial sector, financial regulators are attaching increasing importance to punishing financial institutions for violations of laws or rules. These include violations of contracts, which are considered a basis for commercial transactions. One of the most discussed issues is about how to determine validity of contracts that only violate provisions of financial regulators. In particular, the issue attracts widespread interest from the legal community after the closing of the case involving business trust dispute between Fujian Weijie Investment, Fuzhou Tiance Industrial (the appellee), and June Life Insurance. a third party in the first instance (see [2017] Zui Gao Fa Min Zhong No 529, hereinafter, the case).

YAO XIAOMIN Partner Lantai Partners
YAO XIAOMIN
Partner
Lantai Partners

In consideration of the principles of encouraging transactions and protecting the related stability, courts are generally cautious about holding contracts invalid, determining validity strictly in accordance with Article 52 of the Contract Law. As far as the application of laws is concerned, the principle of allowing the “Party Autonomy in Private Law” with contracts is increasingly respected. Besides, Contract Law Interpretation I and Contract Law Interpretation II further clarify the basis on which contracts may be found invalid, stating that the findings shall be based on laws formulated by the National People’s Congress (NPC) or the NPC Standing Committee or regulations formulated by or on behalf of the State Council, but not any local rules or regulations. Clarifying that the mandatory provisions in Article 52 of the Contract Law are generally understood as being related to validity, the Interpretations are cautious about the impact of administrative mandatory provisions on contract validity.

The case involves a Shareholding Agreement via Trust, which violates the provisions of the Measures for the Administration of Equity of Insurance Companies (the measures) that prohibit nominee shareholding. Instead of the measures, which, as rules of government authorities, are generally called “departmental rules”, Article 52 (4) of the Contract Law, which prohibits contracts “detrimental to social or public interest” is cited by the Supreme People’s Court (SPC) to hold the contract invalid. At first glance, it seems that this case marks a breakthrough in existing legislation, comprising particularly Article 52 (5) of the Contract Law and relevant judicial interpretations, regarding restrictions on the levels in the legal hierarchy that may be cited to hold contracts invalid, as the contract involved is found invalid merely because of violation of departmental rules. However, it is still too early to conclude that all contracts that violate rules or guidelines of regulators are invalid.

LOGIC OF RULING

Given the logic behind the rulings for this case, the contract is considered invalid for three reasons.

LIAN TIANJIAO Associate Lantai Partners
LIAN TIANJIAO
Associate
Lantai Partners

First, the rules that the contract violates are consistent with its superior legislation in terms of both basis and purpose of formulation. Specifically, the contract violates provisions of the measures that prohibit nominee shareholding arrangements for equity of insurance companies, whereas the measures, wihch the regulator formulated with explicit authorization under the Insurance Law, are consistent with the Insurance Law in terms of legislative purpose. Both are intended to strengthen regulation and administration of the insurance industry, maintain social and economic orders, and protect social and public interest. Second, as content is concerned, the prohibitions on nominee shareholding under the measures do not contravene relevant laws or regulations that take precedence over them. Also, they are not in conflict with any other regulatory documents at the same level of the legal hierarchy. Moreover, the measures are substantively rightful and legitimate because they are formulated and published in compliance with legal procedures.

Third, as consequences are concerned, violations of the like are detrimental to social and public interest because, involving vital interest of many non-specific persons, they impede the healthy and orderly development of the industry. Based on the aforementioned, the contract involved in the case that violates regulatory rules is held invalid because of being “detrimental to social or public interest”.

This logic is also reflected in relevant judicial precedents. For example, in the rulings for case (2008) Min Ti Zi No 61, the SPC argues that, in the absence of applicable laws or regulations, departmental rules concerning protection of social or public interest formulated by administrative authorities may be applied with reference to Article 4 of the Contract Law Interpretation I. Any contract that violates prohibitory stipulations regarding validity may be confirmed as invalid on the ground of violation of Article 52 (4) of the Contract Law, which prohibits contracts “detrimental to social or public interest”. In its rulings for case (2017) Su Min Zhong No 66, the Jiangsu Higher People’s Court also finds the agreement involved invalid on the ground of damage to social or public interest. Based on the above, among other things, courts consistently consider if any social or public interest has been damaged when determining whether or not violations of regulatory provisions lead to invalidity of contracts.

As for how “social or public interest” is defined, the SPC gives a definition in the rulings for case (2015) Min Er Zhong Zi No 129, in which it states that public interest generally refers to the well-being of all members or a non-specific majority of all members of the society, which mainly comprises social public orders and boni mores.

Therefore, when determining if a contract that violates mandatory provisions not concerning validity is invalid, the author believes it is appropriate to assess, first of all, whether the contract has any contents that may be detrimental to “the interest of all members or a non-specific majority of all members of the society” or “destructive to the order of social administration”. If the answer is affirmative, it is highly likely that the court will hold the contract to be invalid because of being “detrimental to social or public interest”. If not, the court would normally nullify the contract.

In judicial practice, courts understand the nature of mandatory provisions in varied ways and have the discretion to decide qualifying conditions to be applied when hearing cases requiring them to determine the validity of contracts, which are considered to be stemming from intervention of regulators with the doctrine of autonomy of contract. Although there are unstated “rules”, a well-defined model of law application has not been established. That is why there are still uncertainties surrounding trial results of similar cases.

Yao Xiaomin is a partner, and Lian Tianjiao is an associate at Lantai Partners

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