Contracts v regulations: a philosophical shift

A gradual alignment is occurring between adjudication philosophy and regulatory requirements, with courts less tolerant of contracts that violate regulations and morals

Social and economic development is customarily accompanied by law reforms and regulations. This rings especially true in the financial sector, where the Supreme People’s Court (SPC) has issued important guidance.

A JUDICIAL SHIFT

In the case of contracts that violate financial regulations, plenty of precedent cases have concluded with a contract being found to be valid because it did not fall under the circumstances of “violating mandatory provisions of laws and administrative regulations”, as stipulated under article 52(5) of the Contract Law.

However, in recent years, we have witnessed realignments between judicial standards and financial regulatory requirements. Especially since 2022, the SPC has issued a series of trial guidelines and exemplary cases to illustrate and recalibrate the established viewpoint.

Practitioners and related personnel in the financial sector should pay attention to the evolving trial of financial cases, as well as the state’s determination to correct market “disarray” and maintain order in the financial market.

NEW CONSENSUS

On 8 November 2019, the court issued the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts. Article 31 provides that “Violation of regulations generally does not affect the validity of contracts, but if the content of the regulation involves financial security, market order, national macro policy and other aspects of the public order and good morals, the contract violating such regulations shall be found void”.

The court expressly pointed out that, if a contract is to be found void for violating financial regulations, the underlying reason should be that it violates public order and good morals. This acted as a response to certain prior court reasoning that a contract violating regulations should not be found void as the regulations were relatively low-tiered in the legal hierarchy.

In January 2023, court vice president Liu Guixiang delivered a speech entitled The Concept, Mechanism and Application of Law in Financial Civil and Commercial Trials at the National Conference on Financial Trials of Courts. He reaffirmed that mandatory provisions of financial regulations are essentially “made under the authority of laws or designed to implement the mandatory provisions of laws and administrative regulations”.

Given the ever-changing nature of the financial sector, financial laws and administrative regulations inevitably lag to some extent. In this regard, financial regulations are a supplement that can timely and effectively fill a regulatory gap and maintain a fair and stable financial market.

Publicly available financial regulations form the basic rules of the financial market, which should be understood and complied with by all parties. Only when judicial rulings are made in accordance with financial regulations can they align with the general knowledge of, and public expectations for, these rules, thereby maintaining the predictability of justice.

The rules of judgment of the Sixth Circuit of the SPC, also published in January 2023, provided further guidance on the criteria for courts determining the validity of regulation-breaching contracts:

“Article 30 of the minutes makes it clear that the nature of mandatory provisions should be determined upon consideration of the type of legal interests protected by them, the legal consequences of the violation and the protection of transaction security, and the reasons should be fully explained in the adjudication documents … If any violation of regulations also constitutes violation of public order and good morals, such as damage to financial security, market order, or national macro policy, the contract should be found void.”

As we can see, it has been the consensus of financial trials, as repeatedly reaffirmed by the SPC, that contracts violating financial regulations involving public order and good morals are void according to law.

A SIGNIFICANT CASE

In January 2023, the court’s website listed the top 10 commercial cases of national courts in 2022. One was the matter of Nanjing Hi-Tech Xinjun Growth Phase I Equity Investment Partnership v Fang, Liang et al, which concluded with a decision that a repurchase clause linked to the stock market value, signed by investors, shareholders and actual controllers, was void. The decision again recognised the principle that contracts are void if they violate securities regulations.

The case’s agreement included a repurchase clause directly linked to the market value of stocks in the secondary market. First and foremost, this clause violated the Shanghai Stock Exchange’s securities industry regulations and, by extension, China’s Securities Law. Given its disruption of orderly securities trading and financial security and stability, as well as damage to the public interest, the court found the clause void on the grounds of violation of public order and good morals.

The case was significant in that the contract merely violated the rules of securities trading before being found void because it contravened public order and good morals. This means that the validity of a contract that violates higher-tier financial regulations, and results in even greater damage to the financial order and graver infringement to the rights of financial consumers and small and medium-sized investors, stands little to no chance.

Judging from this shift in the philosophy of financial trials concerning the validity of contracts that violate financial regulations, we can safely conclude that China is increasingly paying attention to the synergistic governance of justice and regulation as financial system reform continues, and the connection between judicial practice and financial regulations will only become more pronounced.

Guo Jun is a senior partner and the director at the Shanghai office of W&H Law Firm. He can be contacted by phone at +86 21 2225 7698 and by email at guojun@weihenglaw.com

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