Application of deposit penalty rule

Practice and advice show courts are respecting the choices of contract parties when it comes to deposits – as long as there is a clear agreement on what the deposit is for.

A deposit refers to the monetary payment made by one party to another as a form of security for contract performance. It has a long history as a legal tool in contracts and can be categorised into different types, based on function:

• Expressing sincerity to contract (deposit of invitation to offer);
• Proving contract has come into force (deposit of conclusion of the contract);
• Urging the parties to perform (deposit for breach of the contract); and
• Granting one party the right to terminate the contract (deposit for termination of the contract).

In practice, there are frequent instances where the terms of deposit are unclear and require interpretation.

For example, in one contract it was agreed that “party A shall make a downpayment of RMB100,000 (USD13,700) to party B, and if party A fails to pay the remaining balance by the due date, party B is not obliged to refund the said payment. In the event that party B fails to deliver the goods by the due date, party B shall compensate party A with an amount of RMB50,000.” Party A proceeded to pay RMB100,000 to party B, who acknowledged the payment in the receipt as a “deposit” of RMB100,000.

During the performance of the contract, party B breached the contract by failing to deliver goods, prompting party A to demand double the deposit amount as per the penalty rule provided by the Civil Code. However, party B insisted on only refunding the RMB100,000 deposit and paying a penalty of RMB50,000.

In this case, although the parties had initially agreed on a downpayment of RMB100,000, the provision stating that, “if party A fails to pay the remaining balance by the due date, party B is not obliged to refund the said payment” closely resembles the deposit penalty rule.

Meanwhile, the parties agreed that the consequence of party B’s breach was RMB50,000 as compensation for losses. It remains uncertain whether party B’s designation of the term “deposit” on the receipt accurately describes the nature of the payment acknowledged by party B.

To solve these problems, it is necessary to clarify the legal nature of a deposit and inquire into its jurisprudence within the framework of China’s legal system.

It is generally believed that deposits have the nature of guaranteeing the realisation of creditor’s rights. For example, article 586 of the Civil Code allows parties to agree to one party making a deposit as a guarantee for the creditors’ rights.

It should be noted that a deposit is mainly a “general guarantee” on the basis of responsible property, or a credit protection realised by the party who pays deposit and performs the contract first, and given to the party who performs the contract later.

In addition, the structure of a deposit guarantee differs from that of mortgage, pledge and other forms of property guarantees – both parties may be subject to the potential disadvantages of the deposit penalty rule, meaning that there is no designated secured party explicitly defined within the deposit terms.

The purpose of using deposits as a guarantee for the realisation of creditors’ rights primarily stems from the punitive aspect of deposits. In other words, the application of deposit penalty rule is not necessarily based on the actual damages suffered by the parties.

Specifically, when looking at article 587 and paragraph 2 of article 585 of the Civil Code, the current laws stipulate that the amount of liquidated damages may be adjusted according to losses, but there is no mentioning of any rule to regulate deposits.

Although this does not mean that the law doesn’t regulate the amount of penalty under the deposit penalty rule at all, it at least indicates the cautious attitude of current laws to the regulation of the amount of deposit. Unless it constitutes a violation of public order and good morals, honesty and credibility, and other basic principles, there is no room for the law to regulate the deposit.

Under the private law principle of freedom of contract, the law does not regulate the amount of deposits. However, it does regulate the content and form of deposit terms to find a balance.

The law’s binding force on the content of deposit terms is mainly reflected in limitations on the degree of punishment. According to paragraph 2 of article 586 of the Civil Code, the amount of deposits “shall not exceed 20% of the amount of the main contract, and the portion in excess of which does not have the effect of the deposit”.

The law’s binding force on the form of deposit terms is mainly reflected in requirements on the delivery prerequisite nature and formality of deposit terms. For requirements on the delivery prerequisite nature, paragraph 1 of article 586 of the Civil Code provides that “the deposit contract is formed upon the actual payment of the deposit”, and “where the amount of the deposit actually paid is more or less than the agreed amount, it shall be deemed as alteration of the agreed amount of the deposit”. As for requirements on the formality of deposit terms, there are special requirements in current laws on how these terms should structure.

There has been controversy in China’s judicial practice over the criteria for determining the formality of deposit terms – that is, whether the application of deposit penalty rule requires both the word “deposit” in the relevant agreement to reflect the nature of deposit, and the clear agreement on deposit penalty rule to reflect the type of deposit.

In a judgment issued by Supreme People’s Court, Min Shen Zi No. 469 (2015), the court held that if the parties expressly agreed on liabilities for breach of contract in a contract, but lacked an agreement on the application of deposit penalty rule, the payment designated as a “deposit” should not be seen as deposit guarantee.

However, in article 71 of the draft Judicial Interpretation of General Principles of the Contract Chapter of the Civil Code, the court further clarified that, as long as there is an agreement on the nature of a deposit, the relevant payment shall be deemed as a deposit and, in the absence of agreements or evidence to the contrary, the deposit penalty rule shall apply.

This provision indicates that, in terms of judicial policy, the Supreme People’s Court will no longer insist on the specific agreement of deposit penalty rule. Instead, as long as the nature of the deposit is agreed on, the court shall deem the payment as a deposit.

This could imply that the court considers the deposit penalty rule has been generally recognised by transaction practice, and the specific stipulation on deposit penalty rule was being no longer necessary in contracts. If parties agree on both liquidated damages and deposit in a contract, article 588 of the Civil Code shall apply.

Meanwhile, the exclusions stipulated in the proviso of article 71 of the judicial interpretation are also worthy of attention. If the parties change the nature of a deposit or exclude the application of the deposit penalty rule through the actual performance, such activities shall also be admitted by the court. For instance, if parties treat a relevant payment as an advance payment in the course of performance, the parties may not claim deposit penalty rule thereafter.

In short, when handling a deposit dispute, it is necessary for judicators to consider the nature of the deposit, the terms of deposit penalty rule and default clause, as well as the performance of the contract.

When there is an agreement on the nature with the word “deposit” in the contract, as well as a special agreement on deposit penalty rule or default clause, the special agreement of the parties shall be respected by judicators.

This is because an agreement or remarks regarding the use of the wording “deposit” represent a broad and vague expression, while an agreement on the consequences of breach of contract is specific and clear, which is an arrangement based on careful consideration or negotiation, as demonstrated in the example case.

Where parties have a clear agreement on the type of deposit, their choice of nature and type of the deposit shall be respected. For example, if the party who pays the deposit terminates the contract, they have no right to ask for the return of the deposit; and the party who accepts the deposit terminates the contract shall refund double the amount of the deposit, and such agreement shall be regarded as the deposit for termination of the contract.