Perspective | Practical Research on the Rules for Adjusting Penalty for Breach of Contract

According to the basis for the generation of liquidated damages, liquidated damages can be divided into statutory liquidated damages and agreed liquidated damages. Statutory liquidated damages are a type of breach of contract liability where laws and regulations directly stipulate the breach of contract behavior and the amount of liquidated damages. For example, the relevant regulations of the People's Bank of China on overdue penalty interest belong to statutory liquidated damages. Agreed liquidated damages are the amount or calculation method voluntarily agreed upon by both parties to the contract based on the principle of autonomy of will, which usually applies to contractual debts. Article 585, paragraph 1, of the Civil Code of the People's Republic of China clearly affirms that the parties can pre-agree on the amount, calculation method, and scope of the payment for breach of contract through contract clauses.

In addition, according to the type of liquidated damages, liquidated damages can also be divided into compensatory liquidated damages and punitive liquidated damages. Compensatory liquidated damages primarily aim to compensate for the actual losses of the party in compliance. Actual losses include both direct losses and the loss of potential gains. Punitive liquidated damages emphasize the punishment of the breaching party and the deterrence of potential breaches in addition to compensation. Parties usually stipulate high liquidated damages in the contract to urge the other party to perform its contractual obligations actively, timely, and comprehensively.

From the functions of liquidated damages, it can be seen that liquidated damages have the functions of compensating the party in compliance, facilitating transaction guarantee, and promoting transaction efficiency. From the perspective of compensating the party in compliance, when the other party breaches the contract, the party in compliance incurs certain real losses and losses of expected interests. The establishment of the liquidated damages system is to allow the party in compliance to obtain compensation relatively easily, avoiding cumbersome evidentiary procedures regarding the scope and amount of losses in litigation. From the perspective of guaranteeing transactions, stipulating higher liquidated damages in the contract can effectively enhance the protection of the party in compliance and also force the party that may breach the contract to consider carefully when considering whether to breach the contract. This deterrent attribute is also the reason why judicial practice retains appropriate space for the liquidated damages system. From the perspective of promoting transaction efficiency, because liquidated damages are often regarded as "predetermined damages", when the parties have disputes, there is no need to conduct complex evidentiary procedures on the amount of losses, which helps to reduce transaction costs and improve the efficiency of dispute resolution.

It is worth noting that although the law reserves a certain space for the autonomy of the parties' will, excessively high or low liquidated damages may lead to unfairness or even violate the principle of good faith. In this case, if the standard of liquidated damages is not adjusted, it will violate the basic principles of civil law. Therefore, under what circumstances liquidated damages need to be adjusted, and according to what standards they need to be adjusted, has become a question worth discussing.

Respecting the autonomy of the parties' will is one of the most important basic principles in civil law. In civil and commercial transactions, the party in compliance and the breaching party can pre-agree on the amount of liquidated damages, both to reduce the difficulty of proving damages and to reflect the parties' free agreement after weighing their own commercial risks and interests. In principle, the court should respect the parties' autonomous agreements to the maximum extent, rather than arbitrarily interfering.

However, liquidated damages clauses may appear in practice to have a significant gap from objective losses. If the court does not allow the modification of the agreed clauses in any case, it may condone one party's abuse of its dominant commercial position or "exploiting others' difficulties in performance to seek exorbitant profits", which is contrary to the principles of fairness and good faith. Therefore, Article 585 of the Civil Code of the People's Republic of China and relevant judicial interpretations explicitly grant the court a certain degree of discretionary power to prevent the occurrence of obviously unfair results.

Specifically, Article 585 of the Civil Code of the People's Republic of China stipulates that the parties may agree that one party shall pay a certain amount of liquidated damages to the other party according to the circumstances of the breach of contract, or they may agree on the method of calculating the amount of loss compensation caused by the breach of contract. If the agreed liquidated damages are lower than the losses caused, the people's court or arbitration institution may increase them at the request of the parties; if the agreed liquidated damages are excessively higher than the losses caused, the people's court or arbitration institution may appropriately reduce them at the request of the parties. If the parties have agreed on liquidated damages for delayed performance, after the breaching party has paid the liquidated damages, it shall still perform its obligations.

Through the analysis of this article, it can be seen that the first paragraph of this article confirms the legality of agreed liquidated damages and allows the parties to agree on the method of calculating the amount of loss compensation. The second paragraph stipulates the increase and reduction of liquidated damages: if the liquidated damages are lower than the actual losses caused, the court may increase them at the request of the parties; if the liquidated damages are excessively higher than the actual losses caused, the court may reduce them at the request of the parties.

As for the standard for adjusting liquidated damages, see Article 65 of the Interpretation of the General Provisions of the Contract Code of the Civil Code, which clearly states that "if the agreed liquidated damages exceed 30% of the losses caused, it can generally be considered as excessively higher than the losses caused". In addition, the Supreme Court also emphasized in the "Nine Civil Records" that the court should adjust liquidated damages based on actual losses, while also considering factors such as the degree of fault of the breaching party and potential benefits.

In addition, courts in different regions also have their own judicial opinions or rulings, for example, Shanghai courts emphasize that a one-size-fits-all approach to liquidated damages in commercial contracts is not advisable, and encourage judges to comprehensively judge based on the principles of fairness and good faith in individual cases.

In contract disputes, the initiation procedures for adjusting liquidated damages are divided into two categories: active requests by the parties and adjustments by the court ex officio. Active requests by the parties are the most common and are the principle. In accordance with Article 585, paragraph 2, of the Civil Code of the People's Republic of China and relevant judicial interpretations, the premise for the court to adjust liquidated damages is generally that the parties make a request. In other words, if the breaching party does not claim that the liquidated damages are too high or too low, the court should not intervene proactively in principle.

However, rules have exceptions. In some cases, courts, considering public order and good morals, good faith and credit, and the balance of significant interests, may adjust liquidated damages ex officio if there is a clear lack of fairness or serious harm to public interest. However, it should be noted that this ex officio intervention is more inclined towards remedying "major unfairness" in individual cases, and courts are generally extremely cautious in practice. The author will illustrate this exceptional situation with a case example below.

Regarding the timing and level of court at which parties can request adjustment of liquidated damages, according to judicial practice, if the breaching party did not clearly raise the defense of excessive liquidated damages in the first instance, nor appeared in court, but raised the claim of "excessiveness" in the second instance, the second-instance court should still conduct a hearing and not simply refuse on the grounds of "abandoning the defense." The court believes that this is conducive to the substantial resolution of disputes and also conforms to the dual requirements of maintaining procedural and substantive justice.

Also, since the outcome of adjusting liquidated damages may affect the core economic interests of the parties, some courts, during the trial, will adopt an explanatory approach, asking the breaching party whether it is willing to request an adjustment of liquidated damages. If the breaching party clearly waives the request for reduction, or the non-breaching party clearly requests an increase, the court should not directly intervene in the adjustment.

Regarding the issue of excessive liquidated damages, Article 65, paragraph 2 of the "Interpretation of the General Provisions of the Contract Code of the Civil Code" clearly states that if liquidated damages exceed 30% of the actual loss, it can generally be considered excessive. This 30% indicator is not a mandatory limit, nor is it a rigid, one-size-fits-all standard; it is more like an empirical threshold in judicial practice, based on which the court will determine whether further reduction is necessary. However, exceeding 30% does not necessarily mean a reduction. When determining the specific amount of liquidated damages, the court will comprehensively consider the progress of contract performance, the degree of fault of the parties, the expected benefits, and the particularity of punitive liquidated damages clauses. If the breach of contract is serious and the parties had a full expectation of high liquidated damages when entering into the contract, the court may also set the final amount above 30% of the loss.

Regarding the issue of excessively low liquidated damages, in judicial practice, if the agreed liquidated damages are significantly lower than the actual loss of the non-breaching party, the non-breaching party may request the court to increase the liquidated damages. However, two points are worth noting: First, the total amount after the increase must not exceed the actual loss. If the court believes that the amount of liquidated damages to be increased is sufficient to compensate for the loss of the non-breaching party, it will usually no longer support a separate claim for damages to avoid double compensation or excessive profit for the non-breaching party. Second, the party requesting an increase in liquidated damages has the burden of proving that the actual loss is indeed higher than the agreed liquidated damages. If the specific amount of additional losses cannot be proved, the court may reject the application for discretionary increase.

According to Article 584 of the "Civil Code of the People's Republic of China," the scope of loss includes actual loss and lost profits. Determining lost profits requires examining whether the breaching party, at the time of contract conclusion, had foreseen or should have foreseen the benefits the non-breaching party might have obtained. If the lost profits significantly exceed normal business expectations, the court will usually not include them in the scope of loss. In addition, actual loss is often difficult to quantify precisely, especially in highly professional fields such as online live streaming, intellectual property licensing, investment and financing cooperation, and mergers and acquisitions. The non-breaching party needs to provide more sufficient evidence regarding the scope of loss; if the breaching party claims that the amount is "excessive," it must also provide corresponding refuting materials.

If the contract has been partially performed and the breach has not caused significant loss to the non-breaching party, or has only partially contributed to the expansion of the loss, the agreed liquidated damages may be deemed "excessively higher than the loss" and subject to reduction. If, at the time of breach, the contract performance is still in the early stages, or the breaching party has engaged in malicious fraud or unilateral breach, this will also affect the specific adjustment of the liquidated damages.

The degree of malice, subjective intent, and fault of the breaching party will significantly affect the extent of adjustment of liquidated damages. Breaches committed with malice will be dealt with strictly by the court. Also, if the non-breaching party has already acknowledged the amount of loss in the litigation, the court will generally respect the parties' self-acknowledgment, unless the damage caused by the serious breach is particularly huge or has a serious impact on the transaction order, in which case the court may consider maintaining the high liquidated damages.

For contracts between commercial entities, if the parties are relatively balanced in strength and there is a complete negotiation process, the court will generally be more restrained in adjustments, respecting the free agreement in commercial transactions. Intervention will only occur in cases of extreme unfairness or manifest injustice. However, if consumer rights protection or the legitimate rights and interests of workers are involved, the court will pay more attention to whether the contract clauses are unilaterally formulated by taking advantage of a dominant position, and may therefore more proactively adjust excessive liquidated damages.

To more intuitively analyze the specific application of liquidated damages adjustment rules in adjudication, this article selects some typical cases and guiding cases for analysis.

Case Number: (2018) Gan Min Zai 228

Case Analysis: In this case, the applicant for retrial argued that the first and second instance court judgments lacked legal basis for reducing the agreed liquidated damages for FX Company ex officio when FX Company did not request a reduction, violating both the contract agreement and fairness. The contract stipulated liquidated damages of 200,000 yuan, reflecting the autonomy of the parties, yet the first and second instance courts unilaterally reduced this amount, harming the interests of the applicant for retrial. However, the retrial court found that although the amount of liquidated damages stipulated in the contract was clear, the wording "Party A failed to fully perform the terms of this agreement" did not distinguish between degrees of breach. Without distinguishing the severity of Party A's breach, a 200,000 yuan penalty for any breach would cause a serious mismatch between the liability and the nature and severity of the breach. The breach situation was not clearly defined, therefore, the court could not directly determine the 200,000 yuan liability based on this clause alone. Therefore, the retrial court did not fully support the applicant's retrial request. This shows that once it is determined that the standard for attributing liability for breach of contract is unclear, and the actual breach is not serious, maintaining the high amount of liquidated damages would be clearly unfair. Therefore, even if the breaching party does not explicitly raise a defense, the court can adjust the overly harsh liquidated damages clauses ex officio. This reflects the court's proactive reduction of liquidated damages in extreme cases to uphold the principles of fairness and good faith, while emphasizing that this ex officio intervention is an exception rather than the norm.

Case No.: (2016) Jing 03 Min Zhong 13939

Case Analysis: In this case, the breaching party was absent and did not present a defense in the first instance, but argued in the second instance that the liquidated damages were excessive. The second-instance court conducted a substantive hearing of this request. According to the court's judgment, the breaching party cannot be deemed to have automatically waived its right to raise such defenses simply because it remained silent or was absent in the first instance. If evidence shows that the liquidated damages significantly exceed the actual losses, then an adjustment can be made. However, the breaching party's bad-faith litigation behavior can also be reasonably regulated according to the specific circumstances (such as increasing litigation costs, interest on delayed performance, etc.).

Case No.: (2021) Supreme People's Court Min Shen 2084

Case Analysis Article 7 of the "Notice of the General Office of the State Council on Standardizing the Management of Income and Expenditure from the Transfer of State-Owned Land Use Rights" stipulates that "if the land user fails to pay the land transfer income in full and on time as agreed in the land transfer contract or land requisition agreement, a daily penalty of 1‰ of the liquidated damages shall be levied. The liquidated damages shall be paid into the local treasury together with the land transfer income". This liquidated damages standard reflects the state's determination to maintain the normal order of the state-owned land transaction market and is not a clause that can be arbitrarily negotiated by both parties to the land transfer contract; it cannot be simply judged by the interest rate of bank loans or the interest rate stipulated in private lending. This liquidated damages standard is binding on both parties to the land transfer contract and has the function of urging compliance and punishing breaches of contract. Therefore, in such cases, the mandatory liquidated damages standard of laws or administrative regulations should be followed, and the court will generally not intervene in making adjustments.

Case No.: (2024) E 01 Min Zhong 10090

Case Analysis: For internet anchors breaching contracts and jumping ship, when the live streaming platform requires the internet anchor and brokerage firm, etc., as the breaching party, to bear liquidated damages in accordance with the contract, and the breaching party argues that the amount is excessive and requests an adjustment based on the actual losses, the people's court should consider the characteristics of the online live streaming industry and follow the following principles in adjusting the liquidated damages for the breach of contract by anchors: Firstly, it should comprehensively consider the characteristics of the online live streaming industry, the platform's investment, the participation of the brokerage firm, the individual income of the anchor, and the fault of four dimensions, taking into account the difficulty in quantifying the income and costs of the live streaming industry that are projected onto the individual anchor, and should not simply limit the adjustment to the "obvious" actual losses that can be proven; secondly, it should be based on the healthy development of the industry, adhere to de-bubble and rationality, and adjust excessive and unreasonable liquidated damages.

Therefore, when the losses of liquidated damages are difficult to calculate precisely, the court will reasonably determine them based on multiple dimensions such as industry characteristics, platform investment, audience scale, and the personal influence of the anchor. It does not simply use the difficulty of proof as an absolute standard, but attempts to balance the relationship between platform interests and anchor mobility.

Case No.: (2024) Ji 7502 Min Chu 22

Case Analysis: Credit card overdraft transactions are essentially financial institutions lending money to cardholders. Where a cardholder claims that the interest and fees and liquidated damages charged by a financial institution are excessive and requests a reduction, the people's court should comprehensively consider relevant national financial regulatory regulations, the amount and term of the outstanding loan, the degree of fault of the parties, the actual losses of the card issuer, etc., and make adjustments to the total amount of interest, fees, and liquidated damages claimed by the card issuer based on the principles of fairness and good faith, with the upper limit being calculated based on the principal of the outstanding loan and with an annual interest rate of 24% as the upper limit.

This shows that adjustments to liquidated damages in financial loan contract disputes need to take into account both financial stability and civil fairness. Although banks and other financial institutions have certain autonomous pricing power, if the actual fees charged are excessively high, the court will also appropriately regulate them with reference to the interest rates of private lending and relevant judicial interpretations and regulatory provisions.