Contract interpretation

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1 January 2021 was a significant date in the development of China’s legal system, as it was on this date that the Civil Code of the People’s Republic of China came into effect, repealing various laws including the Contract Law (for a discussion about the Civil Code and the recognition of custom, see China Business Law Journal volume 8, issue 6: Custom and Law). However, in line with the principle that law should not have retroactive effect, the Contract Law still governs legal acts that occurred prior to 1 January 2021. This is provided by articles 1 and 20 of the Certain Provisions of the Supreme People’s Court concerning the Time Validity of the Application of the Civil Code of the People’s Republic of China (passed at the 1,821st meeting of the judicial committee of the Supreme People’s Court on 14 December 2020).

This column discusses two issues: The continuing application of the Contract Law in respect of contracts and contracts disputes; and the above-mentioned provisions of the Civil Code in respect of contract interpretation.

Continuing application of Contract Law

Under the provisions, matters concerning formation in respect of contracts, entered into prior to 1 January 2021, will be governed by the Contract Law. This is subject to the exception in article 8 of the provisions that, in circumstances where the application of the Contract Law would result in the invalidity of the contract but the application of the Civil Code would result in the validity of the contract, the Civil Code will apply.

Article 20 of the provisions provides that in circumstances where performance of a contract entered into before 1 January 2021 continues after 1 January 2021, disputes in respect of the performance of the contract before 1 January 2021 will be governed by the Contract Law, and the judicial interpretations in respect of the Contract Law, and disputes in respect of the performance of the contract after 1 January 2021 will be governed by the relevant provisions of the Civil Code.

Contract interpretation under Civil Code

Articles 142 and 466 of the Civil Code govern contract interpretation and are applicable to the interpretation of all contracts governed by PRC law, whether entered into prior to or after 1 January 2021. These provisions clarify the previous position concerning contract interpretation under article 125 of the Contract Law. In order to understand how the new provisions governing contract interpretation clarify the previous position, it is necessary to compare the previous position under article 125 of the Contract Law with the new position under articles 466 and 142 of the Civil Code.

Article 125 of the Contract Law provided as follows:

Article 125

Where the parties have a dispute about the understanding of a contract clause, the true meaning of the clause shall be determined according to the words and sentences used in the contract, the relevant provisions in the contract, the purpose of the contract, transaction custom and the principle of good faith.

Articles 466 and 142 of the Civil Code have amended the position under article 125 of the Contract Law as follows:

Article 466

Where the parties have a dispute about the understanding of a contract clause, the meaning of the disputed clause shall be determined according to the provisions in the first paragraph of article 142 of this code.

Article 142

Where an expression of intent is made to another person, The true intention of the clause the meaning of the intention expressed shall be determined according to the words and sentences used in the contract, with reference to the relevant provisionsin the contract, the nature and purpose of the contractcivil juristic act, transaction custom and the principle of good faith.

Some PRC legal scholars are of the view that article 125 of the Contract Law and the position under articles 466 and 142 of the Civil Code are basically the same. Others, however, argue persuasively that the new position under the Civil Code incorporates substantive clarifications. The following three substantive clarifications are relevant:

(1) First, the “meaning of the disputed clause” in article 466 and the “meaning of the intention expressed” in article 142 have replaced the “true meaning of the clause” in article 125 of the Contract Law as the purpose of contract interpretation. Whereas article 125 of the Contract Law was primarily subjective in nature, and emphasised that the purpose of contractual interpretation was to seek the true intention of the contracting parties at the time the contract was signed, the new provisions in the Civil Code are primarily objective in nature, and clarify that the purpose of contract interpretation is to seek the meaning of the disputed clause in terms of the “intention expressed”.

(2) Second, article 125 did not expressly establish any order of priority in terms of the five methods of interpretation referred to in the provision – namely, the literal method (the words and sentences used in the contract); the contextual method (“the relevant provisions in the contract”); the purposive method (“the purpose of the contract”); the custom-based method (“transaction custom”); and the good faith method (“the principle of good faith”). Scholars have noted, however, that article 125 established the literal method as the starting point, and have suggested that the order of priority was: First, the literal interpretation of the disputed clause; second, the contextual method in respect of the other relevant clauses in the contract; and third, the purpose of the contract, the transaction custom and the principle of good faith.

Article 142 of the Civil Code, on the other hand, suggests that priority is to be given to the literal method of interpretation, and that the other methods are to be used when the meaning cannot be determined by the literal interpretation.

(3) Third, article 142 of the Civil Code includes reference to the “nature” of the contract, alongside the purpose of the contract. As a result, it provides that the disputed clause must be interpreted with reference to both the purpose and the nature (or type) of the contract, with the aim of aligning the disputed clause with the basic nature of the contract.

Scholars have further suggested that the purpose of the clarifications in the Civil Code is “to protect and promote market transactions, to limit judicial discretion, and to standardise the rules for judicial determination” [This and the following quotes are taken from Tian Ye “The Amendment and Judicial Application of Contract Interpretation Rule in the Civil Code” (2020)]. The need to limit judicial discretion is particularly relevant in the case of the good faith method of contract interpretation. An outline of each of the five methods of contract interpretation is set out below.

Literal method of interpretation

This method has been defined as “interpreting the words contained in the contract based on the general understanding of the ordinary person, and in accordance with the usual elements such as grammar, syntax and the meaning of words”.

Contextual method of interpretation

This method has been defined as “interpreting the disputed clause by locating it within the contract as a whole, connecting it with the context and with reference to the other related clauses”.

The reference to “the context” – also referred to as the “surrounding circumstances” – is generally understood to allow courts to consider extrinsic evidence such as pre-contractual correspondence and negotiations. Chinese law does not recognise the “parol evidence” rule as is applicable in common law jurisdictions. Instead, Chinese law proceeds in accordance with the principle of “seeking truth from facts”, the effect of which is that it is all relevant evidence, in respect of the intention of the parties appears to be admissible.

A recent Chinese case accepted the proposition that prior negotiations are part of the surrounding circumstances.

Purposive method of interpretation

This method has been defined as “interpreting the disputed clause in a manner that seeks to realise the purpose of the contract”.

Custom-based method of interpretation

This method has been defined as “interpreting the disputed clause in accordance with factors such as the business practices and transaction custom adopted at the time locally, and by both parties themselves”.

Good faith method of interpretation

This method has been defined as “requiring the parties to be honest and trustworthy in their transactions, emphasising that the rights and obligations between the parties [should be] broadly equivalent, fair and reasonable, and requiring that the parties not harm the state, public welfare or the interests of others”. It appears to require a contract to be interpreted in a way that is consistent with how a person acting in good faith would interpret the contract. The principle of good faith was established in article 6 of the Contract Law:

Article 6

The parties should observe the principle of good faith in exercising their rights and performing their obligations.

It is now reflected in article 7 of the Civil Code:

Article 7

When conducting a civil activity, a civil entity should follow the principle of good faith, uphold honesty, and abide by commitments.

It has been acknowledged that the principle or duty of good faith operates very broadly. In view of its broad scope, it has been argued that the principle of good faith should be used as the last resort for the interpretation of a contract.

It will be interesting to follow Chinese cases as they apply the provisions of the Civil Code in respect of contract interpretation.

葛安德 Andrew Godwin

A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew is currently on secondment to the ALRC as special counsel to assist with its inquiry into corporations and financial services regulation. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at www.vantageasia.com