Systematic entanglement in judging validity of financial contracts

Financial risks are escalating with the growing complexity of financial innovation, calling for stronger regulation characterised by look-through review to maintain financial stability. Against this backdrop, financial justice and regulation systems are demonstrating growing signs of alignment.

In financial judicial practice, contract disagreement is the primary cause of financial disputes. Determining contract validity is therefore the very first judgment to make, laying a foundation for the entire trial of financial disputes.

In recent years, under the collaborative governance of financial justice and regulation, administrative rules have emerged as a “shadow criterion” for contract validity. Meanwhile, the mentality behind the judgment is shifting from “strict observation of criteria for contract invalidity” to an expansion of scope.

In the recent online version of the Minutes of the National Courts’ Financial Trial Work Conference (Draft for Comments), the word “无效 (invalid)” appears nearly 80 times across 22 clauses, partially addressing the issue of inadequate grounds for judicial decisions.

Regarding the validity of financial contracts, the alignment with regulation is significant for financial justice, both in terms of further development and exploring ways of risk governance.

Changes in contract validity amid the ebb and flow of financial justice and regulation. With supporting policies and technological progress, financial products are constantly being upgraded and reinvented. But more risks are also added to the pile. Since 2017, there have been efforts to tighten up financial regulation, aiming to rectify disorderly expansion.

In 2022, the report of the 20th National Congress emphasised that modern financial regulation should be strengthened and enhanced, calling for the incorporation of all types of financial activities into the regulatory regime by look-through standards.

The strength of regulation has a profound impact on the judicial measurement of financial contract validity. In 1999, the Contract Law regarded laws and administrative rules as the basis for judging contract validity.

In 2009, the second part of the interpretation of the Contract Law narrowed the source of law down to mandatory provisions on validity. In 2019, under article 31 of the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, the regulatory regime was incorporated into the evaluation sequence for contract validity by harnessing the principle of public order and good morals.

Since then, the judiciary has been converging with financial regulation. Article 153 of the Civil Code, promulgated in 2020, strictly followed the Interpretation to the Contract Law regarding hierarchies of provisions based on contract validity decisions made, and excluded administrative rules from the rank of legal sources.

In April 2023, Liu Guixiang, a full-time vice-ministerial member of the Judicial Committee of the Supreme People’s Court, told the national courts’ financial trial work conference that financial regulation generally cannot be used as a direct basis for invalidity, but may be used as an important basis or reason when judging whether a contract violated public order and good morals.

According to article 1 of the above-mentioned draft for comment, the normative document known as National Financial Regulatory Policy is an expanded interpretation of “regulations” in the Minutes of the National Courts’ Civil and Commercial Trial Work Conference.

Academic debate: Move toward or away from regulation? The alignment of financial justice and regulation has sparked heated discussion in the academic world. On one side, advocates of “moving closer to regulation” argue that, due to the complexity and volatility of the financial market, relying solely on laws and administrative rules may be insufficient to ensure effective legal supply. They also contend that evaluating contract validity based solely on legal hierarchy may lead to overcorrection.

On the other hand, advocates of “moving away from regulation” argue that incorporating administrative rules and national regulatory policies into the evaluation of contract validity – resorting to judgment of public order and good morals – would result in encroachment of public power into the private law. They believe that this would undermine the principle of autonomy of will, and weaken the stability of legal hierarchy.

Furthermore, regulation changes at a rapid pace, which cannot always be followed by the justice system, lest it compromise its stability and negatively affect the entire financial market. The resulting uncertainty and unpredictability can also affect the business environment.

Judicial confusion caused by inconsistent basis for contract validity evaluation. In the regulatory regime, the principle of public order and good morals, or violation of the principle, serves to trigger evaluation of validity of financial contracts. The purpose of this mechanism was to act as filter during nascence of the legislation. But due to uncertainties caused by its reliance on judge discretion, and inconsistent evaluation standards, there is much disorder in the area of validity determination.

For example, the Interim Measures for the Supervision and Administration of Private Equity Investment Funds, and the Interim Regulations on the Operation and Administration of the Private Equity Asset Management Business of Securities and Futures Institutions (respectively issued by the China Securities Regulatory Commission in 2014 and 2016), were considered by the Beijing Higher People’s Court to be within the scope of public order and good morals, as stipulated in the above-mentioned minutes.

However, the Shanghai First Intermediate People’s Court held that they were not laws or administrative rules, and therefore could not serve as a basis for determining contract validity.

In some other cases, lacking evidence to support that the financial act had damaged the financial market, the courts simply equated violation of financial regulation with that of public order and good morals, which seriously contradicts the intention of the legislation.

Resolving the dilemma between financial justice and regulation in terms of validity. Financial justice and regulation should not be isolated from each other, but instead work in tandem towards a common goal. Resolving judicial confusion in the evaluation of contract validity goes a long way to finding common ground of collaborative governance between the two systems.

Armed with a look-through approach and mentality, the limitations of a rigid hierarchy in legal validity evaluation can be overcome.

By delving into the original intent of financial policies and regulations – employing the principle of proportionality and establishing harmful outcomes as a benchmark for assessment – a prudent balance may be struck between financial justice and regulation, eventually leading to healthy and orderly progress of the financial market.

Jiang Qi is the chairman of the national board of directors and Wang Qiuyue is a paralegal at Hylands Law Firm