On August 27, the Supreme People's Court officially issued the "Reply on the Validity of Clauses Agreed Between Large Enterprises and Small and Medium-sized Enterprises Making Payment of Amounts by a Third Party a Precondition for Payment" (hereinafter referred to as the "Reply").

This is an important judicial measure by the Supreme People's Court to implement the decisions and arrangements of the CPC Central Committee and the State Council on clearing up arrears owed to enterprises. The "Reply" gives a negative assessment of the validity of agreements between large enterprises and small and medium-sized enterprises that make payment of amounts by a third party a precondition for payment, and provides rules on how to determine the payment period and liability for breach of contract after the relevant clauses are invalidated. It reflects a clear stance of safeguarding, in accordance with the law, the fair participation of small and medium-sized enterprises in market competition and protecting their lawful rights and interests, and is of great significance for preventing and defusing financial risks and promoting the substantive resolution of conflicts and disputes.

The "Reply" consists of two articles. Article 1 provides that where a large enterprise, in the course of construction project works, procurement of goods or services, agrees with a small or medium-sized enterprise that payment shall be premised on its receipt of amounts paid to it by a third party, because the content of such agreement violates Articles 6 and 8 of the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises," the people's court shall, in accordance with the provisions of Paragraph 1 of Article 153 of the Civil Code, determine that such agreed clause is invalid.

Article 2 provides that, after determining that the agreed contractual clause is invalid, the people's court shall, based on the specific circumstances of the case and in light of industry norms, the trading practices of both parties, and other factors, reasonably determine the payment period of the large enterprise and the corresponding liability for breach of contract. Where the parties have agreed on the standard for calculating interest on the outstanding amount, such agreement shall be followed; where the agreement is unlawful or there is no agreement, interest shall be calculated at the one-year loan prime rate published by the National Interbank Funding Center. Where a large enterprise requests a reduction of its liability for breach of contract on the ground that the contract price already includes compensation for overdue payment, and upon review the defense is found to be established, the people's court may uphold it.

"Back-to-back" clauses are commonly found in fields such as construction projects. In essence, they are risk-bearing clauses in construction project contracts, an industry customary term gradually formed in long-term construction project practice, and are payment clauses for project funds agreed between the general contractor and subcontractors. Specifically, they refer to agreements in construction contracts between the general contractor and subcontractors that the general contractor's payment of project funds to the subcontractor is premised on the general contractor's receipt of project funds paid by the employer; the Supreme People's Court's professional formulation is "making a third party's performance the condition for one party's performance of its debt." Because China's legislation had previously not clearly provided for the application of "back-to-back" clauses and the relevant dispute resolution mechanisms, such clauses have given rise to many disputes in practice. This time, the Supreme People's Court's officially issued "Reply" gives a negative assessment of the validity of agreements between large enterprises and small and medium-sized enterprises that make payment of amounts by a third party a precondition for payment, and provides rules on how to determine the payment period and liability for breach of contract after the relevant clauses are invalidated.‍

Scope of application

The types of cases to which the "Reply" applies are contract disputes; as to the subjects of the contract, it mainly refers to contracts concluded between large enterprises and small and medium-sized enterprises. Regarding the criteria for identifying large enterprises and small and medium-sized enterprises, Article 2 of the "Law of the People's Republic of China on Promoting Small and Medium-sized Enterprises" and Article 3 of the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises" set clear identification standards, which may serve as the basis for determination in judicial practice. As to contract types, the "Reply" lists typical contract types such as construction project works, procurement of goods or services, which are also the areas where problems are currently most concentrated. As to the content of contractual agreements, these mainly manifest as clauses agreeing that a large enterprise's payment to a small or medium-sized enterprise is premised on its receipt of amounts paid to it by a third party such as the employer or an upstream purchaser; unreasonable trading conditions agreed in practice, such as paying the small or medium-sized enterprise according to the proportion of progress payments allocated by the third party to the large enterprise, should also be included. From the perspective of case adjudication, similar agreements may take various forms, but in essence they all involve the large enterprise not bearing the default risk or bankruptcy risk of its counterparty, but instead shifting the risk to the small or medium-sized enterprise. In adjudication work, this aspect may be used to grasp the unreasonable trading conditions to which the "Reply" applies, so as to resolve the problem of arrears owed to small and medium-sized enterprises to the greatest extent possible. In addition, we note that in practice, contracts concluded between government organs or public institutions and small and medium-sized enterprises also contain clauses making payment of amounts by a third party a precondition for payment, resulting in arrears owed to small and medium-sized enterprises. Given that the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises" have clear provisions on budget execution for procurement of goods, works and services by organs and public institutions from small and medium-sized enterprises, the prohibition on advancing funds for government investment projects, and payment periods, the "Reply" does not include such situations within its scope of regulation. Such cases should be handled by directly applying the relevant provisions of the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises."

Validity of clauses

Article 6 of the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises" provides that large enterprises may not require small and medium-sized enterprises to accept unreasonable trading conditions such as payment periods, methods, conditions and liability for breach of contract, and may not default on or delay payment to small and medium-sized enterprises. Article 8 provides that large enterprises shall reasonably agree on payment periods and pay amounts promptly. Although the above provisions are directed at performance acts after the conclusion of a contract, their purpose is to promote timely payment by large enterprises of amounts owed to small and medium-sized enterprises, safeguard the fair participation of small and medium-sized enterprises in market competition, and protect the lawful rights and interests of small and medium-sized enterprises in obtaining payment in accordance with the law; in nature, they should be regarded as mandatory provisions under Paragraph 1 of Article 153 of the Civil Code. Therefore, clauses agreed between large enterprises and small and medium-sized enterprises making payment of amounts by a third party a precondition for payment are in substance agreements on unreasonable payment periods, methods and conditions, and clearly violate the above provisions of the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises"; under Paragraph 1 of Article 153 of the Civil Code, such clauses shall be determined to be invalid. However, the invalidation of such clauses does not necessarily lead to the invalidation of other clauses of the contract; where other payment conditions are satisfied, the large enterprise shall perform its contractual obligations and pay the contract amounts promptly.

Payment period and liability for breach of contract after the agreement is invalidated

After the above contractual clauses concerning payment periods, methods and conditions are determined to be invalid, as to the starting date of the payment period, Paragraph 3 of Article 8 of the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises" provides that where the contract agrees on settlement methods such as settlement according to performance progress or periodic settlement, the payment period shall start from the date on which both parties confirm the settlement amount. Article 9 provides that where it is agreed that payment is conditional on goods or other items passing inspection or acceptance after delivery, the payment period shall start from the date of passing inspection or acceptance; where inspection or acceptance is delayed, the payment period shall start from the date of expiration of the agreed inspection or acceptance period. As to the specific payment period, given the complexity of practical situations, the "Reply" does not provide clearly, and the people's court shall, based on the specific circumstances of the case and in light of industry norms, the trading practices of both parties, and other factors, reasonably determine the payment period of the large enterprise.

As to determining liability for breach of contract, in order to safeguard the balance of interests among business entities, the "Reply" requires that the autonomy of will of business entities be fully respected; where business entities have agreed on an interest calculation standard, it shall be handled according to the agreement. Where the agreement is unlawful or there is no agreement, interest shall be calculated, within the scope requested by the party, at the one-year loan prime rate (LPR) published by the National Interbank Funding Center under the authorization of the People's Bank of China. The "Reply" also clarifies that the determination of a large enterprise's liability for breach of contract is mainly based on the principle of compensating losses; where a large enterprise requests a reduction of its liability for breach of contract on the ground that the contract price already includes compensation for overdue payment, the people's court shall review it in accordance with the law and uphold it where the compensation is reasonable, so as to ensure a balance of interests among business entities.

Retroactivity

Because the "Regulations on Ensuring Payments to Small and Medium-sized Enterprises" came into effect on September 1, 2020, under the general principle of retroactivity, the provisions of the "Reply" shall apply to dispute cases arising from such clauses concluded between large enterprises and small and medium-sized enterprises after September 1, 2020. For dispute cases arising from such clauses concluded between large enterprises and small and medium-sized enterprises before September 1, 2020, although the provisions of the "Reply" cannot be directly applied, the Supreme People's Court's attitude toward this issue has been consistent; to ensure the connection with the implementation of the "Reply," the Supreme People's Court has included the case of a Guangxi materials company suing an engineering company over a sales contract dispute, the case of a Shanghai construction company suing a Shanghai company over a construction project contract dispute, and the case of a Beijing construction engineering company suing the Beijing branch of a construction company and a construction company over a construction project subcontract dispute as exemplary cases in the case database, so as to unify adjudication standards.