In a typical court judgment or arbitration award, the validity of contract is the first item to be examined in a civil or commercial case if the applicable law is PRC Law. An invalid contract shall be void ab initio (see article 56 of the Contract Law).
The general rules for handling invalid contracts are: return of property, compensation through conversion of the property into money, and compensation for losses by the faulty party (article 58 of the Contract Law). Parties may expect that the invalidity of a contract will result in non-performance of all contents of the contract (except for dispute resolution clauses), as many judgments and awards have ruled.
It is such an expectation that makes certain parties believe that their claim of invalidity would benefit them by avoiding adverse performance or consequences. It is also the reason why the claim of invalidity is commonly seen as a defence of the party that fails to perform its contractual obligations. The claim of invalidity is particularly frequent in financial and construction cases.
Two arbitration cases that the author encountered recently are given as examples. The first case is the disputes over an equity transfer and entrusted shareholding contract. In this case, the claimant purchased shares from the respondent. The target company was to be listed at the moment of transaction and has been listed subsequently.
The respondent was entrusted by the claimant as a registered shareholder of the target company and was asked to make registration change and transfer the dividends after the public offering. The respondent claims that the contract violates certain laws and regulations that prohibit such entrusted shareholding. The contract therefore violates the public policy and shall be deem invalid. As a result, the applicant has no ground for claiming registration change and transfer of the dividends.
The second case involves disputes over a construction contract. In this case, the claimant, as the subcontractor, requested the respondent, as the general contractor, for workload compensation and liquidated damages for arrears. The respondent, however, alleged the invalidity of its own general contract since the company itself failed to conform with the contractors’ qualification requirements. Therefore, the subcontract is also invalid, and the liquidated damages clauses in the subcontract shall not apply.
Similar scenarios are not rare, either in arbitration or litigation. A similarity is witnessed with the two cases, as the claiming parties were aware, or should have been aware, of the risk of invalidity when entering the contract. But they kept their silence before the dispute arose. When other parties file a case against the claiming parties, the invalidity defence may become an excuse to turn down the contract and avoid performance.
Although an adjudicator should examine the validity of the contract, regardless of parties’ claims, such a claim of invalidity may still be defined as a malicious claim that ought to breach the contract, and even be harmful to market rules and commercial norms.
In view of this, the author argues that the adjudicator shall adopt comprehensive thinking and rules, in case a contract concerned is indeed invalid, when making a judgment or award. A fair balance of parties’ rights and interests should be achieved. The general principle is to sustain the good faith and to safeguard a more cost-effective game rule; in other words, to enhance the predictability of commercial activities.
Three approaches are suggested by the author. They are: (1) the proximity to the cause of invalidity should be considered in the determination of the faulty party. If a party enters an invalid contract with awareness, or should have known the risk of invalidity better than the other party, the party should be liable to the consequence of invalidity, or at least bear the main liabilities; (2) the invalid contract with de facto effectiveness. If the invalidity of a contract and non-performance benefits the faulty party inappropriately, to acknowledge the de facto effectiveness of the invalid contract could be a solution. This practice has already existed in situations where a contract violates laws that provides administrative rules. Article 2 of the Supreme People’s Court Interpretation on Issues Concerning the Application of Law in the Trial of Construction Contract Disputes illustrates such practice; and (3) the provisions regarding the breach of contract should continue to be effective. If parties agree the liability and consequence of the breach of contract, such agreement should still bind the faulty parties, even if the contract itself is invalid.
This approach may be deemed inconsistent to laws and theories. However, in the author’s view, this approach could be effective in preventing the wrongdoer arbitrarily claiming the invalidity of a contract. It also helps allocate liability, as it has already been agreed to by the parties.
In fact, article 98 of the Contract Law provides that, “The termination of the contractual rights and obligations shall not affect the validity of the settlement and winding-up clauses in the contract”. The understanding of the settlement and winding-up clause may help gain reasonable ground for the third approach, although the invalidity of a contract does not accurately fit in the notion of the termination of a contract. It is, however, a reasonable path dealing with the above-mentioned scenario.
Zhang Jiechao is an arbitrator of Beijing Arbitration Commission/Beijing International Arbitration Center (BAC/BIAC). BAC/BIAC’s senior manager Terence Xu also contributed to the article
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