Thoughts on deciding an invalid contract
In a typical court judgment or arbitration award, a contract’s validity is the first item to be 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 contents of the contract (except for dispute resolution clauses), as many judgments and awards have ruled.
Such an expectation makes certain parties believe that their claim of invalidity would benefit them by avoiding adverse performance or consequences. It is also why the claim of invalidity 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 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 the 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 a registration change and transfer the dividends after the public offering. The respondent claims that the contract violates specific laws and regulations that prohibit such entrusted shareholding. The agreement, therefore, violates the public policy and shall be deemed 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. However, the respondent alleged the invalidity of its 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 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 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.
Given this, the author argues that the adjudicator shall adopt comprehensive thinking and rules if 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.
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 effectiveness of the invalid 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 agreement should still bind the injured parties, even if the contract itself 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 arbitrarily claiming the invalidity of a contract. It also helps allocate liability, as it has already been agreed to by the parties.
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. However, the invalidity of a contract does not accurately fit in the notion of a contract’s termination. It is, however, a reasonable path dealing with the scenario as mentioned above.