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Thoughts on deciding an invalid contract

Thoughts on deciding an invalid contract


In a typical court judgment or arbitration award, a contract’s validity is first examined in a civil or commercial case if the applicable law is PRC Law. An invalid agreement shall be void ab initio (see Article 56 of the Contract Law).
The general rules for handling invalid contracts are the property’s return, compensation through the conversion of the property into money, and compensation for losses by the faulty party (article 58 of the Contract Law). Parties may expect that a contract’s invalidity will result in non-performance of all contract contents (except for dispute resolution clauses), as many judgments and awards have ruled.
Such an expectation makes certain parties believe their invalidity claim would benefit them by avoiding adverse performance or consequences. It is also why the invalidity claim is commonly seen as a defense of the party that fails to perform its contractual obligations. The claim of invalidity is persistent in financial and construction cases.
Two arbitration cases that the author encountered recently are given as examples. The first case involves 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 the transaction and has been listed subsequently.
The claimant entrusted the respondent as a registered shareholder of the target company and was asked to make a registration change and transfer the dividends after the public offering. The respondent claims the contract violates specific laws and regulations prohibiting such entrusted shareholding. The agreement, therefore, violates public policy and shall be deemed invalid. As a result, the applicant has no grounds 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. However, the respondent alleged its public contract’s invalidity since the company failed to meet 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 in the two cases, as the claiming parties were aware, or should have been informed, 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 defense may become an excuse to turn down the contract and avoid performance.
Although an adjudicator should examine the contract’s validity, regardless of the parties’ claims, such a claim of invalidity may still be defined as a malicious claim that ought to breach the agreement and even be harmful to market rules and commercial norms.
The author argues that the adjudicator shall adopt comprehensive thinking and rules if a contract is invalid when making a judgment or award. A fair balance of parties’ rights and interests should be achieved. The general principle is to sustain good faith and to safeguard a more cost-effective game rule; in other words, to enhance the predictability of commercial activities.
The author suggests three approaches. They are: (1) the proximity to the cause of invalidity should be considered in determining the injured party. If a party enters an invalid contract with awareness or should have known the risk of disability better than the other party, the party should be liable to the consequence of falsity or at least bear the central liabilities; (2) the invalid contract with de facto effectiveness. If the disability of a deal and non-performance benefits the injured party inappropriately, acknowledging the de facto point of the null agreement could be a solution. This practice has already existed in situations where a contract violates laws that provide 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 on the liability and consequence of the contract breach, such an agreement should still bind the injured parties, even if the contract is invalid.
This approach may be deemed inconsistent with laws and theories. However, in the author’s view, this approach could help prevent the wrongdoer arb from arbitrarily claiming a contract’s invalidity and also helps allocate liability, as the parties have already agreed to it.
Article 98 of the Contract Law states, “The termination of the contractual rights and obligations shall not affect the validity of the settlement and winding-up clauses in the contract.” Understanding the settlement and winding-up clause may help gain reasonable ground for the third approach. However, the invalidity of a contract does not accurately fit in the notion of a contract’s termination. However, dealing with the scenario mentioned above is a reasonable path.

Elizabeth Coleman

I am a lawyer by profession and a blogger by passion. I started blogging to express my views on various issues.The blog has now become one of my passions. After seeing so many of my friends and colleagues using blogs for their business purposes, I decided to share my views through my blog.I love reading other people's blogs. I am trying to write one every day, and sometimes when I have time I write two or three posts per day.


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