Calculating breach of contract damages in arbitration

In commercial arbitration involving early termination of long-term and/or continuous contracts, which are the norm for energy management, real estate management and professional service contracts, the issues of liability for breach of contract and compensation for damages, particularly lost profit claimed by the non-breaching party, are frequently controversial and difficult to resolve.

In this article, we summarise the analytical process for disputes with respect to liability for breach of contract and damages on lost profits due to early termination of long-term contracts, with reference to a real case handled at the SHIAC, and provide practical guidance to improve the quality and efficiency of long-term contract arbitration.

Case overview

In 2020, the parties entered into an energy management contract (EMC), pursuant to which the project manager shall be responsible for investment in the project and carrying out energy conservation renovation for the owner’s five production lines, and the owner shall pay service fees to the project manager.

Under the EMC, the parties agreed on rules to divide the energy conservation income, made certain guarantees of income attributable to the project manager in the event of termination or rescission of the contract or early repurchase of the project funds, and established a formula for calculating payable compensation.

In the end, however, only two out of five production lines were completed and accepted by the owner. In a written statement to the project manager, the owner stated that because of policy impact, the remaining production lines would not be put into operation.

The project manager held that the owner had for some time been in arrears in payment of energy conservation income. In 2021, it issued a termination notice to the owner and submitted an arbitration to the SHIAC, requesting an award to confirm that the contract in question had been terminated and to order the owner to pay the arrears of energy conservation income, late payment fees, damages arising from contract termination, as well as the cost and interest of the unused production lines.

After hearing the case, the arbitral tribunal identified the core issues as: (1) whether the notice of termination issued by the project manager had a rescinding effect, and that the EMC had been terminated accordingly; (2) for the two production lines that had been activated but not continued, whether the project manager was entitled to compensation for the guaranteed energy conservation income and the resultant late payment fees in accordance with the ECM; and (3) whether the project manager is entitled to compensation from the owner for costs and interests invested in the three production lines that were abandoned.

Dissecting the issue

First, in cases involving foreign elements, the arbitral tribunal must immediately clarify the laws applicable to the adjudication. Second, the tribunal should determine the validity of the contract and whether a party has breached the contract by considering the following questions:

• Is the contract legitimate and valid at the time of conclusion, and what is its status?
• Has the contracting party committed any breach?
• Has the non-breaching party suffered any losses?
• Is there a causality between the loss and the breach?

The tribunal should determine the type of losses suffered by the non-breaching party, with common ones including actual loss, loss of profits and loss of reliance interest. In accordance with interpretations by the Supreme People’s Court on the application of “Book III Contract” of the Civil Code, after the early termination of a long-term contract, lost profits within a reasonable period in which a substitute transaction is carried out or may be carried out shall be upheld. Lost profits may be calculated based on the profits of production, operation and resale obtained by the non-breaching party. Below is a formula for calculation:

Lost profits = (market price – contract price) × reasonable period – reasonable costs. Alternatively, lost profits = production/operating/resale profits – reasonable costs.

Where the reasonable period cannot be determined with reference to the substitute transaction, the tribunal may decide at its own discretion based on the principle of fairness and good faith, taking into consideration interest obtained by the breaching party because of the breach, the degree of fault of the breaching party, and whether there are other circumstances of breach.

Furthermore, with respect to the calculation of lost profits suffered by the non-breaching party due to early termination of long-term contracts, such as in the above-mentioned case, the tribunal should focus on the depth to which the contract had been performed prior to the dispute, and the reasonableness of the calculation method for damages as agreed by the parties.

As to remedies, the tribunal should determine whether the remedies sought by the non-breaching party ‒ such as continuous performance, remedial measures, compensation of damages, or restitution ‒ are reasonable.

If the tribunal deems it necessary to compensate the non-breaching party for the losses, it should consider the following factors relevant to the determination of losses.

Foreseeability of loss. In determining the scope of damages, the tribunal should limit liability to the extent of foreseeable damages. If the damages could not be foreseen by the parties at the time of concluding the contract, the injured party should not be liable for compensation.

The tribunal may, according to the parties’ objectives in concluding the contract, determine ‒ based on losses that commercial entities in the same or comparable situations as the breaching party foresaw, or should have foreseen at the time of concluding the contract, given the subject of the contract ‒ the content, the type of transaction, the transaction habits, the negotiation process and other factors.

Remoteness of loss (direct/indirect loss). When the actual damages are deemed too remote from the consequences of the defendant’s breach of contract, the non-breaching party usually cannot obtain damages for such indirect loss. Admittedly, it is not easy for an arbitral tribunal to determine the boundary of compensability, as it requires extensive experience and case-specific analyses and judgments.

Fault of the parties. In China, where strict liability is the dominant principle of liability for breach of contract, subjective fault is not a prerequisite for liabilities. However, with varying types of contracts, principles of fault and exemptions also persist.

It is worth noting that under PRC law, an accident is not a statutory exemption event. If a third party or other accidental factors are at fault instead of the breaching party, whether the breaching party shall bear the liability for breach, and the scope of such liability, should be analysed on a case-by-case basis by referencing the parties’ agreement and the individual case situation.

Non-breaching party’s duty of mitigation. If the expansion of losses can be partially attributable to inaction of the non-breaching party, the tribunal should consider excluding this part of the losses when determining the scope of liability for damages.

Non-breaching party’s benefitting from the same cause for loss. If the non-breaching party benefitted from the same cause for loss, the tribunal should deduct such benefits when determining the damages. Notably, such benefits should be limited to property interests.

Contributory negligence. Article 63 of the above-mentioned Supreme People’s Court interpretations stipulates that contributory negligence shall be considered if the breaching party claims to deduct the losses caused by the negligent non-breaching party.

Takeaway

Back to the case discussed above: the liquidated damages clause was deemed reasonable, as it did not exceed the scope of compensation available to the non-breaching party within a reasonable time, nor did it lead to any notable unfairness to either party. Therefore, the arbitration tribunal upheld the liquidated damages clause on the calculation of lost profits.