A fixed price may not always be fixed in China

by Hew Kian Heong

I bought a painting a couple of months ago which I really liked. I did not have a place to hang it at the time. The gallery owner was eager to make the sale and so agreed I could pick it up later when I had found a place to hang it. So I agreed a price with the gallery owner and paid her a 10% deposit. When I turned up to collect the painting recently, the gallery owner sheepishly asked if I could pay a little more for the painting. The reason she gave was that her landlord had increased her rent significantly and she was struggling to keep the gallery going. I had also driven a hard bargain on the price. I was a little annoyed by the request but agreed to pay 10% more as the gallery owner is a really nice lady and I knew it was true her landlord had increased her rent by a ridiculous amount.

Most employers like the certainty of a fixed price contract from their contractors for their construction projects. Usually, they are required to have fixed price contracts by their financiers. In return for keeping to a fixed price, contractors in theory are allowed to charge a premium for assuming greater risks. This does not however happen in practice very much. But contractors continue to sign up to fixed price contracts because competition for contracts in China is very keen and employers are generally in a much stronger bargaining position than contractors, at least at the tender stage.

However, contractors who find themselves in a position where the contract price is fixed but their costs have increased since signing the contract may have a possible way out. The Interpretation II on Several Issues Concerning the Application of the PRC Contract Law promulgated by the PRC Supreme Court on 13 May 2009 introduced a principle of “significant change of circumstances” into the law of contract in China. Under this principle, the court is entitled to vary a contract or declare a contract discharged if a significant change in the objective circumstances occurring after contract formation renders the fulfillment of the purpose of the contract impossible or the continued performance of the contract manifestly unfair to one party.

In the context of construction contracts, the rule of “significant change of circumstances” provides a potential ground for a contractor to apply to the court to increase the contract price on the basis that the circumstances upon which the fixed price was originally agreed have changed significantly since the signing of the contract. The contractor must however prove a number of things to the court.
Firstly, the contractor needs to show the court that the new circumstances do not constitute a “commercial risk”. The Interpretation does not define the term “commercial risk”. The Guidance Opinion of the Interpretation issued by the Supreme Court however requires the court to take into consideration the market conditions and the circumstances of a particular case together with the following important factors to differentiate a “commercial risk” from a “significant change of circumstances”. A new circumstance will not be a “commercial risk” if:

(a) it is generally not foreseeable in the view of the general public;

b) its effect is far beyond the contemplation of a reasonable man;

c) it is not capable of being prevented or controlled; and

d) the nature of the transaction in question is not one of high risk and high return.

Secondly, the contractor will need to prove that the continued performance of the contract will render the fulfillment of the purpose of the contract impossible or manifestly unfair to the contractor. It is not often that the purpose of a contract becomes impossible to fulfill due to a change of circumstances. It is likely that we will see more reliance on the “manifestly unfair” argument. In this regard, the overriding principle of “fairness” in Chinese contract law comes into play and it requires the rights and obligations of contracting parties to be agreed on the basis of “fairness”. What is “manifestly unfair” is not defined in the Interpretation but the courts in China generally have a wide discretion in determining what is fair or unfair.

I personally do not think that the Chinese courts will apply the principle of “significant change of circumstances” liberally to vary or discharge a contract. If the courts apply the guidelines of the Guidance Opinion strictly, I think it will be difficult for a contractor to be able to prove a “significant change of circumstances”. After all, an experienced contractor will find it difficult to prove that a circumstance or its effects, in particular price fluctuation of materials or labour, is not foreseeable or cannot be prevented or mitigated in some way. More often than not, the particular circumstance was foreseeable but the contractor had to under price to win the contract and therefore left no margin of error in his price. This is perhaps best reflected by the fact that for the contracting business in China, a profit margin of 1 to 3% is the norm.

Although the principle of “significant change of circumstances” is a useful argument to employ for a contractor seeking to vary a fixed contract price, it is likely that most contractors will continue to rely more on the overriding Chinese contract law principle of fairness to achieve the same objective. In conclusion, it is perhaps interesting to note that in the context of liquidated damages, the Supreme Court in a recent opinion said (roughly translated) “In the current more difficult market conditions in doing business faced by companies, with respect to the issue of the amount of an agreed penalty being significantly higher than the actual loss caused by a breach, the contract law principles of good faith and fairness should be applied, and the purpose of a penalty being mainly compensatory and secondarily punitive in nature adhered to, so as to prevent parties using party autonomy as a reason to agree excessive penalties”.

Kluwer Construction Blog