Compliance breach and loss of contract: Be on guard 

Compliance breach and loss of contract- Be on guard, 企业违反反腐败合规义务导致合同解除

The claimant is a Chinese trade company selling medical devices. The respondent is a medical device provider registered in the Shanghai Pilot Free Trade Zone, and a subsidiary of a group company with headquarters in the US. The parties entered into a distribution agreement in 2018, which provides that the claimant, as a distributor, shall sell the products of the respondent in that specific region, with a two-year licence period.

The distribution agreement provides the compliance obligation of the claimant, mainly including:

(1) to comply with local and other laws, and other anti-corruption laws that may be applicable;

(2) to comply with all applicable laws and regulations governing transparent expenditure; and

(3) to comply with the code of conduct drafted by the respondent, which contains all the applicable anti-corruption laws that shall be complied with, such as the Foreign Corrupt Practices Act of the US, and appropriate interactions with government officials.

According to the distribution agreement, the respondent may terminate the agreement if the claimant breaches the compliance obligations, and the termination of the agreement shall not of itself make the respondent liable to pay any compensation to the claimant.

In August 2019, the respondent sent a compliance officer to the claimant’s place to conduct an on-site compliance investigation, after which the compliance officer concluded that the claimant had committed illegal and non-compliant acts, such as bribery of the employees of hospitals, and financial fraud. Accordingly, the respondent determined this to be a material breach, and sent a notice to the claimant to terminate the distribution agreement on October 2019.

But the claimant contended that the termination had no grounds, and constituted the respondent’s breach of the distribution agreement, resulting in the claimant’s loss of prospective profits that would have been acquired through selling inventory under the distribution agreement. Therefore, the claimant applied for arbitration to the Shanghai International Arbitration Centre (SHIAC), demanding the damages in respect of the respondent’s breach of the distribution agreement.

The issues

The tribunal concluded two main issues of this case as follows:

(1) whether the respondent has the right to terminate the distribution agreement; and

(2) whether the respondent shall compensate the damages claimed by the claimant for the termination of the distribution agreement.

For the first issue, the tribunal found that it was not disputed between the parties that the distribution agreement contained concrete and clear provisions on the compliance obligations for the claimant, and the respondent was entitled to terminate the agreement on the conditions that these obligations were not obeyed by the claimant. The code of conduct containing the explanations of these obligations, drafted by the respondent, had also been communicated with the claimant. Therefore, the tribunal considered that all these regulations and rules had been incorporated into the parties’ agreement, and thus, were binding for the two parties.

As to whether the conditions for termination were satisfied, or whether the claimant failed to fulfill its compliance obligation, the tribunal decided that although the testimony and relevant evidence delivered by the compliance officer alone could not be used independently as the basis for affirming the existence of bribery – pursuant to article 90 of Some Provisions of the Supreme People’s Court on Evidence in Civil Procedures – the forged taxi service invoices used by the claimant for accounting, and other evidence submitted by the respondent, were persuasive enough to demonstrate that the claimant falsely issued a large number of invoices.

Based on its understanding of the pharmaceutical industry, the tribunal determined that it was highly probable, in terms of standards of civil proof, that the claimant’s behaviour was not in compliance with its obligations of transparent expenditure.

In addition, the tribunal believed that the non-compliance acts had severely affected the accomplishment of the respondent’s purpose of the distribution agreement, and also may bring huge business risks to the respondent. Therefore, the termination satisfied the legal requirements. Based on the above considerations, the tribunal determined that the respondent had the right to terminate the distribution agreement.

In the case of the second issue, the tribunal noticed that the distribution agreement also included provisions on the outcome of the respondent’s right of termination, saying it was not liable to pay any compensation to the claimant thereunder. Since the stock and profit losses claimed by the claimant had resulted from the respondent’s right of termination under the distribution agreement, the tribunal decided that the claimant has no right to claim for the damages.

Based on the above-mentioned analysis, the tribunal determined that the respondent had the right to terminate the distribution agreement, and the damages claim of the claimant was rejected, and the arbitration fees were borne by the claimant only.

This case illustrates how to exercise the right to terminate a distribution contract under the agreed conditions. According to the principles of Chinese contract laws, when the agreed conditions are satisfied, the party can terminate the contract in accordance with law, and the former consensus. It is quite clear in the distribution agreement that the breach of compliance obligations is one agreed condition for the parties to terminate the contract. Even though the claimant tried arguing the compliance clause alongside the conditions of termination to be standard terms that are drafted in advance for repeated use by the respondent, without consulting with the claimant when concluding the agreement, it did not persuade the tribunal that these provisions remit or mitigate the respondent’s liabilities, or may materially affect its interest.

Notably, the tribunal in this case considered financial fraud behaviour, such as issuing forged invoices, or using false taxi service invoices, in accounting, compatible to constituting breach of the compliance clause, and affecting the accomplishment of the purpose of the contract, which enabled the respondent to terminate the contract with the consented condition satisfied.

What is also particularly considered by the tribunal regarding the purpose of the contract in this case is the rules and regulations in the pharmaceutical industry. The regulatory documents issued by the National Health Commission, the gradual establishment of the Commercial Bribery Records in the Purchase and Sale Of Medicines, and precedents regarding administrative penalty, all illustrated that the non-compliance acts of the claimant could bring huge business risks to the respondent.

Besides, the respondent is a foreign-invested company with headquarters in the US, and is required to act in compliance with the FCPA. If the distributors of the respondent committed bribery, it is possible for the respondent itself, and its affiliated companies, to receive FCPA penalties in the US. Taking all the above elements into consideration, the tribunal determined that the compliance risks of the respondent were comparatively larger than in other industries. Therefore, a stricter standard shall be applied to understand and interpret the conditions for termination in this case; and the non-compliance party was subject to a heavier or aggravated liability.

Business entities are advised to learn thoroughly about relevant laws and regulations in their own industries. When the situation allows, incorporating special compliance needs into a contract is a good way to lower business risks in advance. For providers, training programmes for distributors are recommended to further explain any conduct code drafted by providers for compliance and administrative requirements in specific industries.

It is also suggested to conduct continuing compliance investigation, either by compliance officers or third-party institutions, during the period of performance of the contract. Additionally, an understanding of laws and regulations of both the home state and the host state are necessary when involving external investment. For example, the respondent in this case transferred the content of the code of conduct drafted by itself and the FPCA into the binding distribution agreement. This is the contractual basis for the respondent to terminate the contract without much difficulty and eventually bear no liability for the termination.

Distributors are also required to understand relevant laws and regulations depending on the industries they are in, and to conduct some background investigations on their potential providers, knowing the compliance obligations that will be required by contract and law. One should not ignore compliance obligations, either during negotiation or performance, even though it is an accompanying obligation under distribution agreements, because under certain conditions it would cause termination.

This case offers an example of where compliance breach directly leads to termination of the contract. The financial losses and goodwill impairments to the company are not refundable. Furthermore, there are potential risks of administrative or criminal penalties. This is worthy of the close attention of any enterprise.

Song Ruyi is the head and Zhang Xinzi is a senior case manager of the No.1 Case Management Department at SHIAC. Wei Lin, an intern at SHIAC, also contributed to this article