China Supply Chain Contracts: The Contract (Liquidated) Damages Provision

One of the hallmarks of a good China supply chain contract is that it provides for very specific penalties if the Chinese side fails to abide by its crucial terms. These penalties will typically be in the form of a liquidated damages provision (also sometimes called “contract damages”). Liquidated damages are damages whose amount the parties specify in advance and during the formation of a contract that the injured party can automatically collect as compensation for a breach of the contract by the other side.

Chinese courts tend to view contractual liquidated damages provisions very favorably and so long as they are “harmonious” and not unreasonable, they will be enforced. If the number is too low from actual damages the injured party/plaintiff can ask for more. If the number is too high from actual damages, the defendant can ask for a reduction. In either case the validity of the contract is not affected. In our OEM agreements we have found these clauses to be a very effective tool in particular to “encourage” the Chinese supplier to comply with shipping dates and quality specifications.

Most importantly, if the Chinese counterparty breaches the contract, a liquidated damages provision provides a specific damage amount to discuss when you contact the breaching party. Chinese courts can seize Chinese company assets based on a liquidated damages provision and they can seize these assets before trial (prejudgment attachment of assets). Chinese companies know and fear this, so this can be a great leverage tool. Stated differently, a well crafted and reasonable liquidated damages provision is one of the best leverage tools out there for preventing your Chinese counterparty and supplier from breaching the agreement, and that is the primary reason for having a written contract in the first place.

The Liquidated Damage Clause: How Much Do I Ask For?

Here, an analogy we sometimes use is the American children's story “Goldilocks and the Three Bears” – not too much, not too little, but just right.

A well-crafted liquidated (contract) damages provision in China is the “just-right” amount of damages should there be a breach. We are sometimes asked what the “just-right” amount? This generally depends on two things: (1) the specific facts of your situation, deal and industry; and (2) what the Chinese side will/will not agree to.

To help you better understand, here is an email excerpt regarding a contract damages provision in an NNN Agreement we once drafted for a client. We had recommended one figure for the contract damages, but against our advice, the client had insisted on a much higher figure. The Chinese supplier rejected the higher figure and out of a desire to get going quickly, the client suggested that we just dispense entirely with the provision. The below email is our response to that idea:

With regard to our proposed language about minimum damages, we can understand why this supplier is balking at your $350,000 figure. As we discussed when drafting the initial NNN Agreement, that is a relatively high amount, and considerably more than the $100,000 to $150,000 figure we discussed be used. This amount is more art than science. It is not supposed to be a penalty, but rather a realistic assessment of the damages that you would incur if the Chinese side were to breach this NNN Agreement, say by selling a container full of your products directly to a third party. We strongly advise against deleting this language entirely, though, as specified contract damages are what helps to give this agreement real teeth, not least because they allow the Chinese court to impose a pre-judgment seizure of assets. That is a big advantage and leverage for you, and not one that you should give up willingly.

In summary, it's a balancing act. It the amount is set too high, a Chinese court may throw it out. If it's too low, your Chinese manufacturer may not fear the clause enough and then violate the agreement. Pick an amount that is reasonable, balanced and fair to both sides.

SC
MR