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  • Compensation for Damages for Breach of Contract

  • DATE:2011-7-18
  • Written by: Li Xiaohan, Zhang Kehua & Joshua Katz

    Compensation for damage caused by a breach of contract refers to the liability a party faces for failing to perform the contract, either in full or in part, based on the terms of the contract itself or according to PRC law. Currently, the PRC Contract Law, the relevant judicial interpretation and the United Nations Convention on Contracts of International Sales of Goods that China was party to (hereinafter referred to as “Convention”) provide the following for damages for breach of contract:  

    I. Scope of Compensation for Damage

    According to Article 113 of the PRC Contract Law, when a party fails to perform its contractual obligations or its performance fails to conform to the agreement and causes losses to the other party, the amount of compensation for losses shall be equal to those losses and include the interests receivable after performance. Article 74 of the Convention also conforms to this definition.

    Losses to Existing Property

    Losses to existing property, or “active losses,” are the damages suffered by the injured party due to the defaulting party’s breach of contract. These include direct and indirect losses such as expenses made towards performance of the contract and reasonable expenses made to limit the extent of damages. The injured party seeks compensation restoring it to the position it was in before the contract.

    Losses to Interests Receivable

    Interests receivable are different from existing interests in that they are not in the possession of the contracting parties prior to performance. This form of interest is a property right that the contracting party expects to obtain after the contract is fully performed. Interests receivable are pure profits, and thus fees paid for obtaining these interests are excluded.

    Interests Receivable Bear the Following Three Features:

    the interest is not in the contracting parties’ real possession


    the interest is expected by the contracting parties upon the execution of the contract, and is expected to be obtained through performance of the contract

    the profit has conditions of realization and will be acquired by the contracting party after performance. The injured party can claim for compensation for losses to the interest receivable, which would put the injured party in the position that it would have achieved if the contract were performed.

    II. Rules Limiting  Compensation for Damages

    Rule of Foreseeability

    According to Article 113 of the PRC Contract Law, the amount of compensation for losses shall not exceed the probable losses caused by the breach of contract that were foreseeable or should have been foreseeable when the contract was originally formed. According to this rule, the injured party is entitled to compensation only when the damage caused by breach of contract is foreseeable by the defaulting party at the time of contract formation. If the damage is not foreseeable, then the defaulting party does not have to compensate. This reasonable foresight test ensures that the contracting parties can adequately measure future risk, and calculate possible expenses and interest. If the future risk is too great, then the contracting parties can choose to forego business dealings. But parties are not burdened by fears of endless liability. The principle of reasonable foresight limits the scope of compensation for damages, thus promoting autonomous and equitable transactions.

    Three points should be noted in applying the rule of reasonable foresight:

    It limits damages to actual losses and losses of interests receivable.
    It does not apply to the stipulated compensation for damages.
    Whether the loss was or should have been foreseeable is judged according to the facts and conditions when the was contract formed.

    Rule of Mitigating Losses

    The rule of mitigating losses means that after one party breaches the contract, the other party should take reasonable measures to prevent further losses. Otherwise, the injured party may not claim losses that occurred after the breach. This rule is reflected in Article 119 of the PRC Contract Law and Article 77 of the Convention.

    This rule is based on the principle of good faith. Failure to perform this obligation constitutes a breach of good faith. All of this reflected in the principle of fault liability. Here, the party that fails to take reasonable measures to prevent further losses after breach of contract is at fault, and the wrongdoer should thus be liable for the consequences caused by his fault.

    In summary, the rule of mitigating losses has three features: First, it recognizes that the breach of contract by one party causes losses. This means the injured party is not at fault for the loss, so the breach of contract by two parties is not constituted. Second, the injured party is sometimes in a position to prevent further losses stemming from the breach of contract. The injured party’s actions in preventing further losses should be considered under the principle of good faith. The measures taken by the injured party must be economically reasonable and timely. And third, the rule of mitigating losses takes into account whether further losses actually occurred.

    III. Calculation of Amount of Compensation for Damage

    Calculation of Losses to
    Actual Property

    Calculation of losses to actual property is a relatively simple concept. Generally, the amount of compensation is calculated based on the losses and fees that the injured party suffers. For example, in a sale of goods contract, after one party is found to be in breach, the other party adopts an alternative transaction (the buyer buys alternative goods or the seller resells the goods). The injured party can then claim for compensation based on the difference between the contract price and the trading price of the alternative goods The injured party can also choose to instead, when there is an established market price for the goods, claim for compensation based on the difference between the contract price and market price of the goods when the goods were received or when the contract was determined valid.

    Calculation of Interests Receivable

    Generally, compensation for lost interests receivable is calculated by comparison. The amount should reflect that of a typical transaction under the same circumstances. The accuracy of this calculation will depend on how similar the surrounding circumstances of the transaction are to a typical transaction of its kind. For instance, in a claim for lost wages, you could consider the amount of income earned by the injured party prior to the breach of contract as compared to what he actually earned (nothing).

    IV. Agreement on Liquidated Damages

    When Applied Jointly with Compensation for Damage

    Article 114 of the PRC Contract Law provides that contracting parties can agree to a predetermined damages award, or liquidated damages, to be paid in the event that one of the parties breaches the contract. In practice, contracting parties always reach an agreement on liquidated damages.

    In contract liability, liquidated damages have the dual purpose of compensation and penalty. This contrasts with compensatory damages, which are only intended to compensate the injured party. Thus, compensation for damage is always closely related to actual damage, while the amount of liquidated damages is not necessarily associated with actual damage. Even when the breach of contract does not cause any actual damage, liquidated damages must still be paid. If the compensatory portion of the liquidated damages is insufficient to cover the losses suffered by the injured party, then the party in breach should pay the difference to achieve full compensation. Liquidated damages and compensation for damage can thus be used jointly. However, if both types of damages are used, the amount of liability cannot exceed the actual loss to the injured party. This has been codified in the Notice of the Supreme People’s Court on Correctly Applying the Interpretation II of Several Issues concerning the PRC Contract Law. Thus, a liquidated damage clause is often included to limit damages rather than to increase them.

    Limit on the Amount of Liquidated Damages

    Parties to a contract can freely determine the amount of liquidated damages to be paid when one party violates the contract. Furthermore, Chinese law does not impose limits on the amount of stipulated liquidated damages. However, according to Article 114.2 of the PRC Contract Law, when the amount of stipulated liquidated damages is less than the losses incurred, the injured party can seek an increased damage award by applying to the People’s Court or an arbitration agency. Likewise, if the amount of liquidated damages is unduly greater than actual losses incurred, then the party in breach can apply to the People’s Court or an arbitration agency for a reduction. Judicial Interpretation II specifies that liquidated damages should not be thirty percent greater than the actual losses incurred by the non-breaching party.

    In adjusting liquidated damage awards, the court bases its decision on actual losses, the parties’ course of performance, fault of the parties, and expected profit. The court always considers these factors in light of the principles of fairness and good faith.

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