Invalidity of contracts for violating ‘public order and good morals’

By Chen Zhuo and Yin Yutong, Tian Yuan Law Firm
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While law dictates that commercial contracts in violation of “public order and good morals” are invalid, the determination of violations leading to contract invalidity is a frequent point of contention

In the context of encouraging civil and commercial trials to support regulators in performing their duties, the Minutes of the National Courts of Civil and Commercial Trial Work expressly list regulations related to “public order and good morals such as financial security, market order and national macro policies” as the basis for judging the validity of contracts. The Civil Code also clearly stipulates that “civil legal acts violating public order and good morals are invalid”.

In current judicial practice, it has become a common disputed point, whether a commercial contract violating regulations or the normative documents constitutes a violation of public order and good morals, which leads to the invalidity of the contract. In this regard, it is necessary for commercial litigation lawyers to consider relevant coping strategies in advance.

JUDICIAL APPLICATION

Invalidity of contracts for violating ‘public order and good morals’ Chen Zhuo
Chen Zhuo
Partner
Tian Yuan Law Firm

As to “whether the violation of regulatory provisions in a commercial contract constitutes a violation of public order and good morals”, a set of preliminary judgment criteria has been formed, mainly reflected in article 31 of the above-mentioned minutes, in the Supreme People’s Court’s second-instance civil judgment of Fujian Weijie Investment v Fuzhou Tiance Industrial (2017) concerning a dispute over a business trust, and Shanghai Financial Court’s first-instance civil judgment in Sugiura Tatsumi v Gong Yin (2018) concerning a dispute over equity transfer. The key points of these regulations and legal documents are:

Principle of prudent application. Since the conceptual interpretation of public order and good morals is inherently flexible, in order to avoid its abuse and excessive derogation from the autonomy of a civil subject’s will, the court should be prudent in its specific application, comprehensively consider factors such as targets of regulation, regulatory intensity, transaction security protection and social influence, and fully reason in the judgment. This means that the party accusing the other of violating public order and good morals will have a heavier burden of proof and explanation obligation.

Public order should be given priority when examined in laws and administrative regulations. The concept of public order and good morals consists of two parts, in which public order refers to the basic order and fundamental concept in the fields of politics, economy and culture being the basic principle, value and order pertinent to the overall interests of the state and society.

The disputes over the validity of commercial contracts mainly involve the judgment of whether they violate public order. Because of the basic and fundamental nature of public order, it should be given priority when examined in laws and administrative regulations.

In the absence of explicit provisions of laws and administrative regulations, to determine whether regulations or normative documents constitute public order, both substantive justice and due process should be considered. Substantive justice means the regulations should reflect the overall interests of the state and society as stipulated by laws and administrative regulations in the field. Specifically, the formulation of the regulations has clear authorisation from upper-tier laws, the purpose of the regulations is consistent with the legislative purpose of those laws, the content contradicts neither upper-tier law nor norms of the same level, and allowing the conduct of specific behaviours may endanger the order of the entire industry, social stability or the interests of the unspecified public.

The specific connotation of due process includes that the formulation subject has the legal authority for formulating such regulations, the formulation and promulgation procedures meet legal requirements, and such regulations, deemed as the basic norms in the industry, are generally known and recognised by the public.

COPING STRATEGIES

Invalidity of contracts for violating ‘public order and good morals’ Yin Yutong
Yin Yutong
Associate
Tian Yuan Law Firm

With regard to these points on the application of public order and good morals for judging the validity of contracts, the party claiming the validity of the contract may consider the following defences:

(1) The rule in question is not clearly stipulated by laws and administrative regulations, nor is it a basic norm in the industry. It is also highly mutable and does not fall into the category of public order and good morals.

The minutes (draft for comment) originally stipulated that “if the violation of regulations and regulatory policies, and the violation of public order occur at the same time … the contract shall be deemed invalid”. However, the effective version removed the wording “regulatory policies”, retaining only “regulations”.

One reason is that regulatory policies are ever-changing, and determining validity of contracts based on the original provision may undermine market order, as well as the seriousness and guiding capacity of court decisions. Therefore, if it can be proven that regulatory policies are about to change or may change, that also can be used as grounds for defence.

(2) The purpose of the rule or the legislative purpose of the corresponding upper-tier law does not focus on, or at least not primarily, the protection of unspecified public interests, but rather protects of the rights of individuals or groups. So, even if the rule is violated, it cannot be presumed to endanger public order or harm public interests.

(3) In particular cases, violation would not result in harmful consequences, or the possible harmful consequences are negligible.

(4) The formulation of the rule lacks any basis from upper-tier law, or the formulator lacks legal authority, or the procedures of formulating and promulgating the rule are grossly illegal.

According to article 64 of the Administrative Procedure Law, if the court holds after examination that the normative documents under the regulations are unlawful, they cannot be used as a basis for determining the legality of any administrative act. Similarly, in civil litigation, one may claim that unlawful normative documents should not be used as the basis for determining contract validity.

(5) The content of the rule contradicts the upper-tier law, or conflicts with the norms of the same level, and its validity needs to be determined first according to the statutory procedures.

(6) The public knows little about the rule and the perpetrator has sufficient evidence to prove lack of awareness.

(7) The rule suffers from a low level of public recognition since it has not been enforced or strictly enforced.

It is worth noting that although the court suggested the legality of the administrative norms may become an influential factor in judging the contract validity, it remains to be further observed in practice whether courts will directly negate the legality of administrative norms and affirm contract validity in civil litigation, since the law clearly stipulates that regulatory rules shall be reviewed by specific procedure, and regulatory documents shall be examined along with the administrative action.


Chen Zhuo is a partner at Tian Yuan Law Firm. He can be contacted at +86 138 1041 7260 or by e-mail at chenzhuo@tylaw.com.cn

Yin Yutong is an associate at Tian Yuan Law Firm. She can be contacted at +86 138 1139 4158 or by e-mail at yinyutong@tylaw.com.cn