Supreme Court: Is it Valid to Agree in a Contract That Punitive Damages Cannot Be Adjusted?

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In practice, when the non-breaching party sues the breaching party for payment of liquidated damages, the breaching party often requests the court to reduce the liquidated damages based on the provisions of the Civil Code regarding the adjustment of liquidated damages. However, in some contracts, not only are high liquidated damages stipulated, but it is also agreed that both parties waive the right to request the court to adjust the liquidated damages. Is such an agreement valid?

Main Judgement Point

If both parties to the contract agree to waive the right to request an adjustment of punitive liquidated damages, such an agreement does not violate mandatory provisions of laws or administrative regulations, nor does it violate the principle of fairness, and the agreement is valid.

Case Summary

1. On May 6, 2015, Leping Huaren Company (Party A) and Hongkelong Company (Party B) signed a "Lease Agreement", agreeing that Leping Huaren Company would build a property on the land in question according to Hongkelong Company's requirements and lease it to Hongkelong Company for the opening of a supermarket. Article 3 of the contract stipulated the liquidated damages clause. In both Clause 2 and Clause 3, it was agreed that "the nature of the liquidated damages is punitive liquidated damages." Clause 4 stipulated, "The liquidated damages of the contract are 5 million yuan, and both parties agree to waive the right to request the People's Court to adjust the liquidated damages or compensation as stipulated in this agreement according to the provisions of the Contract Law and other laws, regulations, and judicial interpretations."

2. Later, Leping Huaren Company built the property on the land in question according to Hongkelong Company’s requirements, and by February 18, 2016, the rental property in question had basically reached the condition for delivery for use.

3. Between March 25, 2016, and July 4, 2016, Leping Huaren Company sent multiple letters to Hongkelong Company, requesting that Hongkelong Company inspect the leased property, but Hongkelong Company never responded. On August 8 of the same year, Leping Huaren Company sent a letter to Hongkelong Company, formally proposing to terminate the lease contract.

4. In 2017, Leping Huaren Company filed a lawsuit in court, requesting the court to order Hongkelong Company to pay liquidated damages and requesting the court to increase the amount of liquidated damages. The Jiangxi Provincial Higher People’s Court in the second instance and the Supreme People’s Court in the retrial both recognized the validity of the waiver of the right to request an adjustment of liquidated damages and did not support Leping Huaren Company's request to increase the liquidated damages.

Key Judgement Points

The agreement between the disputing parties to waive the right to adjust the punitive liquidated damages does not violate legal provisions, nor does it violate the principle of fairness:

1. Article 585 of the Civil Code grants parties the right to request the court to adjust the amount of liquidated damages, but this article is not a mandatory provision. The parties' agreement to exclude the application of this article does not automatically render the agreement invalid.

2. The right to request the adjustment of liquidated damages is a civil right that parties may freely dispose of, and the principle of legal paternalism does not apply. Therefore, the People's Court should respect the parties' prior agreement in this case to waive the right to request an adjustment of liquidated damages.

3. The agreement to waive the right to adjust liquidated damages was a true expression of intent by both Hongkelong Company and Leping Huaren Company, and there is no situation of manifest unfairness, as Hongkelong Company did not take advantage of any superior position or the other party’s rashness or inexperience in concluding the lease contract.

4. According to the principle of assuming one's own risk, Hongkelong Company and Leping Huaren Company are equal in status and both are rational individuals engaged in commercial activities. The agreement to waive the right to request an adjustment of punitive liquidated damages was a commercial decision made by both parties in their own commercial interests, and both parties should bear the corresponding commercial risks.

Practical Experience Summary

1. There is no clear legal provision on whether the agreement to waive the right to adjust liquidated damages in advance is valid, and there is debate in both theoretical and judicial practice:

Valid View: The clause in the contract that waives the right to adjust liquidated damages is valid. The main reasons are:

(1) From the nature of the legal provisions, most of the provisions in the contract section are optional laws, and optional provisions can be excluded by agreement; (2) From the nature of liquidated damages, under normal circumstances, liquidated damages are compensatory, but punitive liquidated damages can also be agreed upon. Punitive liquidated damages serve as a mutual constraint and prevent breaches of contract, and punitive liquidated damages are not subject to the foreseeability rule; (3) The significance of stipulating liquidated damages lies in quickly determining the scope of compensation, avoiding the burden of proof, and thereby improving transaction efficiency. Since the agreement is clear and unambiguous, there is no room for adjustment; (4) According to the principle of autonomy of will, under the concept of "freedom where there is no explicit legal prohibition", parties have the right to dispose of their substantive rights; (5) Waiving the right to adjust liquidated damages in advance does not violate the principle of fairness. The law does not conduct a simple, abstract evaluation of the fairness of the transaction result when determining manifest unfairness, but applies it to situations where the unfairness in the process of concluding the contract leads to a severe imbalance in the parties' rights and obligations. In other words, the system of manifest unfairness protects the fairness of the contracting process, not the fairness of the result.

Compromise View: Valid in principle, invalid in exceptional cases. This view respects freedom of contract but allows for judicial intervention to adjust when it can be proven that not adjusting the liquidated damages would lead to obvious injustice. At the same time, this view advocates that when determining invalidity, the court should comprehensively consider the performance of the contract, the degree of fault of the parties, the expected benefits, and the identity of the parties.

Invalid View: The clause in the contract that waives the right to adjust liquidated damages is invalid. The main reasons are:

(1) The right to request an adjustment of liquidated damages is a right to seek judicial protection with a public law nature, and an agreement between the parties to waive this right does not bind the court; (2) Judicial intervention in adjusting liquidated damages contains a public policy that combines "freedom of contract" and "justice of contract", and the agreement to waive the right in advance violates basic principles such as fairness, good faith, and public order and good morals; (3) If parties are allowed to freely agree on breach liability and restrict the court's adjustment power, it may lead to situations where one party intentionally breaches the contract and maliciously damages the other party's interests; (4) If such clauses of waiving the right in advance are deemed valid, they may become a "standard configuration" in liquidated damages clauses in the future, and judicial control over unreasonable high liquidated damages will lose its grip.

Relevant Laws and Regulations

Article 585 of the Civil Code: Parties may agree that one party should pay a certain amount of liquidated damages to the other party in the event of a breach, or they may agree on the method of calculating the amount of compensation for losses caused by the breach.

If the agreed liquidated damages are lower than the losses caused, the People's Court or arbitration institution may, at the request of the parties, increase the liquidated damages; if the agreed liquidated damages are excessively higher than the losses caused, the People's Court or arbitration institution may, at the request of the parties, reduce them to a reasonable amount.

Where the parties agree on liquidated damages for delayed performance, after the breaching party pays the liquidated damages, the breaching party should still perform the obligations.

The court's ruling in the judgment during the trial phase:

The second-instance court held: The agreement between the disputing parties to waive the adjustment of liquidated damages does not violate legal provisions nor the principle of fairness. The reasons are as follows:

First, according to the legal principle of autonomy of will, parties have the right to dispose of their civil rights, and the people's court should respect the agreement in this case where both parties waived the right to request an adjustment of liquidated damages in advance.

Second, the agreement to waive the right to adjust liquidated damages does not violate the principle of fairness. Objectively, both parties voluntarily signed the lease contract, and in Article 3, Clauses 2 and 3 of the agreement, they agreed that "the nature of the liquidated damages is punitive." In Clause 4 of Article 3, it is stated that "both parties agree to waive the right to apply to the people's court to adjust the liquidated damages and compensation stipulated in this agreement according to the provisions of the Contract Law and other laws, regulations, and judicial interpretations." This agreement does not violate mandatory legal provisions in terms of its content, and from the perspective of reciprocal rights and obligations, it does not violate the principle of fairness either.

Subjectively, Hongkelong Company did not take advantage of any superiority or the other party’s rashness or inexperience when entering into the lease contract. The other party decided to sign the lease agreement based on its own commercial interests, making an independent commercial decision, for which it should bear the corresponding commercial risk.

The Supreme People's Court held: The original judgment's determination that the parties waived the adjustment of liquidated damages does not violate legal provisions, and the analysis is as follows:

First, the agreement between the two parties to waive the adjustment of liquidated damages does not violate legal provisions. Subjectively, both parties were conducting this transaction for their own commercial interests, and they signed the lease contract under conditions of voluntary and equal participation. Objectively, the content of the contract signed by both parties does not violate mandatory legal provisions.

Second, the agreement between the parties to waive the adjustment of liquidated damages falls within the scope of autonomy of will. The agreements in Article 3, Clause 3, and Clause 4 of the "Pre-Lease Agreement for the House" and Article 10, Clause 5 of the "Lease Contract" have clearly stipulated the waiver of liquidated damages adjustments. Regardless of the extent of the loss, the liquidated damages are fixed at RMB 5 million. According to the first paragraph of Article 8 of the "Contract Law of the People's Republic of China," "a legally established contract is binding on the parties. The parties shall perform their obligations as agreed and shall not arbitrarily alter or terminate the contract." The people's court should respect the agreement between the parties in this case to waive the adjustment of liquidated damages in advance.

Finally, the original judgment’s decision not to determine the liquidated damages based on the rental price difference did not violate the second paragraph of Article 114 of the "Contract Law of the People's Republic of China." The parties’ true intention when signing the contract was that the amount of RMB 5 million in liquidated damages was determined as the maximum compensatory amount, which serves a punitive function, while safeguarding the interests of both parties. This decision was made from a commercial interest perspective, and the parties should bear the corresponding risks. Additionally, whether the determination of liquidated damages is conditioned on "actual damage caused by the breach" can be agreed upon by the parties. In this case, since the parties have clearly agreed on the liquidated damages, there is no impropriety in the court’s decision not to adjust the amount.

Case Source:

Supreme People's Court, Reexamination and Supervision Civil Ruling of the Lease Contract Dispute between Leping Huaren Real Estate Co., Ltd. and Hongkelong Department Store Investment (Jingdezhen) Co., Ltd., [Case No. (2019) Supreme Court Civil Application 3344].

Further Reading

Judicial Viewpoint One

The right to adjust liquidated damages as stipulated in the Contract Law is a statutory right of the parties to the contract, and it cannot be excluded by agreement. If the party in breach requests the court to adjust the liquidated damages according to the law, the court may adjust them in accordance with the principle of fairness. (This adopts the invalidation theory, contrary to the viewpoint in the main text)

Case 1: Intermediate People's Court of Yichang City, Hubei Province, Hubei Shenghe Investment Guarantee Co., Ltd. v. Liu Certain and Others, Recourse Right Dispute Case 【(2014) E Yi Chang Zhong Min Er Chu Zi No. 00010】

The right to adjust liquidated damages as stipulated in the Contract Law is a statutory right of the parties to the contract, and it cannot be excluded by agreement. Thus, although the "Entrusted Guarantee Contract" involved in this case explicitly stipulates that Liu Certain voluntarily waives the right to adjust liquidated damages, if the performance bond clause combined with the liquidated damages clause is excessively higher than the actual loss of Shenghe Guarantee Company, Liu Certain still has the right to request an adjustment. Referring to the legal cost of private financing (not exceeding four times the benchmark interest rate of the People's Bank of China for the same period), combined with the amount and duration of compensation by Shenghe Guarantee Company, this court believes that deducting 625,000 yuan from the performance bond is sufficient to compensate for Shenghe Guarantee Company’s loss. Liu Certain's claim that the performance bond of 625,000 yuan should offset the principal and that the contract's stipulation of 10% of the principal amount as liquidated damages is excessive, thus requesting a reduction, is partially valid. Therefore, while supporting Shenghe Guarantee Company’s decision not to return the performance bond of 625,000 yuan, this court does not support Shenghe Guarantee Company’s request for Liu Certain and Yichang Canned Food Factory to jointly bear 503,047.40 yuan of liquidated damages and the overdue payment interest at the People's Bank of China's benchmark interest rate.

Judicial Viewpoint Two

Even if the parties have an agreement that liquidated damages cannot be adjusted, such an agreement should be limited to not violating the principle of fairness. At the same time, the amount of liquidated damages must not violate the foreseeability rule. For liquidated damages or clauses that are excessively high compared to the damages caused by the breach or are highly punitive, the court may adjust them considering the balance of interests between the parties. (This adopts the compromise theory)

Case 2: Supreme People's Court, Daxiang City Tianli Real Estate Development Co., Ltd. v. Shanxi Tongzhiren Commercial Management Co., Ltd. and Wu Jianguo, Housing Lease Contract Dispute Appeal Case 【(2015) Min Yi Zhong Zi No. 340】

The first-instance court believes: Regarding the issue of liquidated damages payment, the "Housing Lease Contract" stipulates that regardless of which party breaches the contract, they must pay the other party 100 million yuan in liquidated damages. However, from the legislative spirit, the nature of liquidated damages as stipulated in Article 114 of the Contract Law is dual in nature, primarily compensatory and secondarily punitive. To uphold the principles of fairness and good faith in civil law, the People's Court can adjust unreasonable liquidated damage amounts. According to Article 29, Paragraph 2 of the "Interpretation (II) of the Supreme People's Court on Several Issues Concerning the Application of the Contract Law of the People's Republic of China," if the agreed liquidated damages exceed 30% of the loss caused, it can be deemed as "excessively high compared to the loss caused" as stipulated in Article 114, Paragraph 2 of the Contract Law. Therefore, the most important standard for determining whether liquidated damages are excessively high is the loss caused by the breach. In this case, the damages caused to Tianli Company due to Tongzhiren Company’s failure to pay rent and property management fees on time should be the sum of unpaid rent, property fees, utilities, heating fees, business and interest subsidies, and the interest generated. The agreed liquidated damages are clearly more than 30% of the above losses, so they should be adjusted according to the law.

The second-instance Supreme People's Court believes: In this case, although the parties have an agreement not to adjust liquidated damages, such an agreement should be limited to not violating the principle of fairness. Considering that Tianli Company's contract performance also has certain flaws, from the perspective of balancing the interests of both parties, the original judgment to adjust the amount is not inappropriate.

Case 3: Intermediate People's Court of Nantong City, Jiangsu Province, Nantong Xinqian Asset Investment Management Co., Ltd. v. Zhang Jinming and Others, Equity Transfer Dispute Civil Second Instance Judgment 【(2021) Su 06 Min Zhong Zi No. 2323】

Regarding whether liquidated damages should be adjusted. The agreement in the case does indeed stipulate that “in any circumstances, both parties waive the right to request a reduction or exemption of the liquidated damages,” that is, the parties have agreed in advance to waive the right to adjust liquidated damages, and the contract involved is a commercial contract. Generally speaking, commercial transaction parties should have stronger risk recognition ability and more transaction experience. The parties voluntarily agreed to waive the adjustment of liquidated damages in advance, and the People's Court should respect their commercial arrangements as much as possible. Of course, for liquidated damages or clauses agreed upon by the parties in the contract that are excessively high compared to the damages caused by the breach or are highly punitive, the People's Court should also reasonably adjust the amount of liquidated damages according to relevant legal provisions and the spirit of adjusting excessively high liquidated damages to fairly resolve the issue of breach of contract. In this case, the parties agreed to pay 10% of the amount involved in the breach as liquidated damages. This standard of liquidated damages is still within a reasonable range and does not constitute an excessively punitive liquidated damages clause. Therefore, the 10% ratio should not be adjusted.

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