Court Interpretation of Sale and Purchase Contract Issues in China

The PRC Contract Law, promulgated in 1999, has general provisions relating to the formation and performance of all contracts and more specific provisions relating to the special features of 15 different categories of contracts, including sale and purchase contracts. To assist courts with their handling of cases related to sale and purchase contracts, the Supreme People's Court issued an Interpretation of Issues Relevant to the Application of the Law in Trials of Disputes over Sale and Purchase Contracts in May 2012 (2012 Interpretation), with effect from July 1, 2012.

The 2012 Interpretation has provisions on contract formation, ownership transfer, inspection periods, certain special kinds of sale and purchase contracts, and liabilities and damages for breach. Several provisions which may be of particular interest are highlighted below:

1.      Contract Formation

Under the PRC Contract Law, a contract may be concluded in written, oral or other forms, and a court in practice may rely on other supporting documents to recognize a formation of a contract even if the contract itself is not in written form. 

The 2012 Interpretation stipulates that when a party claims that a sale and purchase contract has been formed without a written contract, the court should consider the transaction method and trading practices and other evidence (e.g., delivery notes, receiving notes, settlement notes, invoices, etc.) to determine whether a sale and purchase contract has been formed. 

2.      Pre-contractual Agreement

For some large deals, it is common to enter into a pre-contractual agreement before a formal sale and purchase contract is executed. For instance, a memorandum of understanding or a letter of intent may be executed to document the major terms and provisions of the final contract. The PRC Contract Law provides that an "honesty and credibility principle" must be followed during the negotiation and execution of pre-contractual agreements, and that a party can be held liable for damages to the other party if the "honesty and credibility principle" is violated. However, the PRC Contract Law does not give any guidance about what would constitute a violation.

The 2012 Interpretation provides that, if a pre-contractual agreement states that a final sale and purchase contract will be entered into in a certain period of time, and if a party subsequently refuses to enter into such a final contract, it may be held liable and made responsible for damages. We understand that the "damages" mentioned here refer to direct losses suffered by the non-breaching party, and that claims for "expectation losses" which might be possible for formal contract claims under the PRC Contract Law may not be granted.     

In light of this provision, the parties to a pre-contractual agreement should carefully consider whether it is really in their best interests to promise that they will enter into a formal contract within a certain period of time.

3.      Multiple Sales

Under the PRC Property Law, the ownership of movables is transferred on delivery. This principle applies to both ordinary movables (e.g., commodities and goods) and special movables (vehicles, vessels and aircrafts). Sales of the same commodity to various buyers sometimes occur, but the PRC Contract Law is silent in this regard. To address this issue, the 2012 Interpretation provides priority criteria for determining ownership transfer where there are multiple sales.

For ordinary movables, when multiple sales and purchase contracts for the same commodity or goods are entered into with more than one buyer and they are all valid, ownership will belong to the buyer to whom delivery is made. In the event that the commodity or goods are still kept by the seller, they should be delivered to the buyer who first makes payment. If no buyer has obtained delivery or made payment, then the ownership will depend on the contract's validity time.

For special movables, which are normally subject to an ownership registration system, the ownership will still depend on who has legally possessed them as mentioned above. However, if the special movables are not delivered, the buyer who first finishes the ownership transfer registration procedures is entitled to claim the transfer. In case there is no delivery and no transfer registration is carried out, then the court will rely on the timing of contract validity to determine the owner.

To avoid risk of multiple sales of movables, it is advisable to take actual possession as soon as possible to ensure ownership. Other actions (including registrations for special movables) may not guarantee the ownership. In such situations, damages may be claimed from the seller, but the movables will ultimately belong to the third-party buyer to whom they are delivered unless it is certified that the sale and purchase contract between the seller and third-party buyer is invalid or revocable.

4.      Inspection Period

The PRC Contract Law stipulates that the buyer should notify the seller about the non-conformity of goods within the inspection period agreed by both parties or a reasonable period for the detection of the non-conformity by the buyer. The 2012 Interpretation specifies the criteria to be used by a court to determine the length of the "reasonable period." They include the transaction nature, transaction objective, transaction method and practice, type and difficulty and quantity of goods, the nature of defects, the buyer's reasonable duty of care, the method of inspection, etc.

The 2012 Interpretation also stipulates that, if there is no agreed inspection period or the inspection period as agreed is too short for the buyer to be able detect defects, the court may specify a "reasonable period" based on the above criteria for "latent defects" detection, and the agreed inspection between both parties will be held by the court as the period for buyer to raise issues on "apparent defects" only even if the buyer has signed the delivery note, confirmation letter, etc.

Also, if the length of an inspection period or quality guarantee is specified by laws or administrative regulations, this will prevail over a shorter inspection period agreed by the parties to a contract.

It is expected that the 2012 Interpretation will have a strong influence on how courts will handle sale and purchase contract dispute cases in the future. To some extent, the 2012 Interpretation can be viewed as a supplement as well as an interpretation, since it is clearly adding a few requirements or rules to the PRC Contract Law. Consequently, it should be taken into account when entering into sale and purchase contracts in China.