Breach of M&A contracts: How best to define losses

By Zhang Tianwu and Liu Yi, East & Concord Partners
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There are various terms to describe compensation for breach of contract in M&A agreements. For example, if one party breaches the contract, it must compensate for the other party’s losses, actual losses, direct losses or indirect losses. Sometimes, these types of losses are used in a mixed way – when parties agree to compensate for the loss of obtainable profits, but also agree to exclude compensation for indirect losses.

Analysing the Civil Code, related laws and regulations, judicial interpretations and relevant meeting minutes of the Supreme People’s Court (SPC) can help identify the most appropriate expression.

LOSSES AND OBTAINABLE BENEFITS

Zhang Tianwu , East & Concord Partners
Zhang Tianwu
Partner
East & Concord Partners

Article 584 of the Civil Code provides: “Where any party fails to perform its obligations under the contract or its performance fails to conform to the agreement, causing losses to the other party, the amount of compensation for losses shall be equal to the losses caused by the breach of contract, including the interests receivable after the performance of the contract, provided that it shall not exceed the probable losses caused by the breach of contract which are foreseen or should have been foreseen by the breaching party when the contract concluded.”

The article specifies that the “losses” caused by breach of contract also include “interests receivable after the performance of the contract”, which means obtainable benefits. In the section, “distinguishing the types of obtainable benefit losses and properly identifying the obtainable benefit losses”, in the Guiding Opinions of the Supreme People’s Court on Several Issues Concerning the Trial of Disputes over Civil and Commercial Contracts under the Current Situation, the SPC states that, “according to the nature of the transaction, the purpose of the contract and other factors, the obtainable benefit losses are mainly divided into loss of production profits, loss of business operation profits and loss of resale profits, etc.

“In calculating and determining obtainable benefit losses, the rules of foreseeability, impairment, gain-and-loss offset and contributory negligence should be applied to deduct the unforeseeable losses of the defaulting party, the losses improperly enlarged by the non-defaulting party, the benefits obtained by the non-defaulting party due to the default, the losses caused by the non-defaulting party and the necessary transaction costs from the total amount of compensation for obtainable benefits claimed by the non-defaulting party.”

DIRECT AND INDIRECT LOSSES

Liu Yi, East & Concord Partners
Liu Yi
Associate
East & Concord Partners

Article 933 of the Civil Code provides: “Either the principal or the agent may terminate the commission contract at any time. If the other party suffers any loss due to such termination, except for causes not attributable to such party, the party that terminates a gratuitous commission contract shall indemnify the other party for direct loss due to the premature termination, while the party that terminates a non-gratuitous commission contract shall compensate for the direct loss and the obtainable benefits after the performance of the contract.” Losses caused by termination in breach of commission contract can be divided into direct losses and losses of obtainable benefits.

With regard to indirect losses, article 193 of the Maritime Law, as a special law, provides: “General average refers to the special sacrifice or expenditure intentionally and reasonably made or incurred for the common safety in the relief of a vessel, cargo and other property from common danger caused on the one voyage. Losses incurred due to the delay by a vessel or cargo during or after a voyage, including sailing losses and quotation losses, as well as other indirect losses shall not be listed into the general average.” Theoretically, direct loss refers to the direct reduction of property, and indirect loss, also known as lost benefits, refers to the loss of obtainable benefits.

ACTUAL LOSSES

Article 10 of the Notice of Supreme People’s Court on Promulgation of the Minutes of National Court Work Conference on Implementation of the Civil Code provides: “Where one party violates the obligations of notification, assistance, confidentiality, recycling of used articles, etc., as prescribed in article 558 of the Civil Code, causing losses to the other party, and the other party claims compensation for actual losses, the people’s court shall support such claims.”

Article 29 of the Interpretation by the Supreme People’s Court on Several Issues Concerning the Application of the Contract Law of the People’s Republic of China (II) provides: “Where one party asserts that the agreed liquidated damages are too high and petitions for reasonable adjustment, the people’s court shall rule on the basis of the actual losses, taking into consideration comprehensive factors such as the performance of the contract, the extent of culpability of the relevant party, and the expected benefits, and adjust in accordance with the principles of fairness and good faith.” Based on the above-mentioned clauses, the authors believe that “actual loss” should be the loss excluding obtainable benefits or indirect loss, which should be equivalent to direct loss.

SOME SUGGESTIONS

The Civil Code merely contains three expressions: “loss”, “obtainable benefits after the performance of the contract” and “direct loss”. Although “indirect loss” and “actual loss” are also mentioned in the relevant judicial documents of the SPC and special laws, we believe it is more appropriate to keep the stipulation on compensation for breach of contract in M&A agreements consistent with the Civil Code.

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Such a clause may be expressed as follows: (1) if one party breaches the contract, it shall compensate the non-defaulting party for the losses, including the benefits that the non-defaulting party may obtain after the performance of the contract, and the enlargement of expenses, the decrease of income and compensation claimed against the non-defaulting party, etc., arising from the non-defaulting party’s performing the contract with a third party due to the breach of contract; or (2) if one party breaches the contract, it shall compensate the other party for the losses, excluding the benefits that the non-defaulting party may obtain after the performance of the contract, the enlargement of expenses, the decrease of income, or compensation claimed against the non-defaulting party, etc., arising from the non-defaulting party’s performing the contract with a third party due to the breach of contract.

Zhang Tianwu is a partner and Liu Yi is an associate at East & Concord Partners

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