Legal Framework:

The Chinese Civil Code stipulates that contract parties may agree on liquidated damages payable upon breach or specify a method for calculating compensation for losses. When the stipulated amount is significantly higher than the actual loss, courts or arbitration institutions may reduce the amount upon request. Conversely, if it is lower than the actual loss, the amount may be increased to cover the shortfall. If the breach involves delayed performance, liquidated damages do not exempt the breaching party from fulfilling their original contractual obligations.

Understanding the Nature of Liquidated Damages:

I Distinction Between Liquidated Damages and Compensation:
1. There is a debate on whether compensation for losses stipulated in contracts constitutes liquidated damages. Generally, liquidated damages differ from compensation calculation methods. In Chinese legal history, liquidated damages were not categorized alongside loss compensation methods. While liquidated damages aim to penalize breaches, stipulated compensation primarily focuses on covering actual losses.
2. Compensation can be pre-determined as a fixed amount (compensatory damages) or calculated through specific contractual methods. If the agreed-upon compensation does not cover the loss, courts may adjust the liquidated damages accordingly.
 
II Principles for Adjusting Liquidated Damages:
1. The court may only adjust the amount if a request is made by a party.
2. Over-reliance on judicial discretion in adjusting liquidated damages may result in inconsistent outcomes. Therefore, using both liquidated damages and compensation together may be more precise for covering actual losses, provided the non-breaching party can prove their damages.

III Guidelines for Reduction of Excessive Liquidated Damages:
Legal Standards: The key factor for adjusting liquidated damages is whether the amount is "excessive" relative to the actual loss, which is generally recognized as exceeding 30% of the actual damages. For instance, if a contract's liquidated damages clause stipulates an amount significantly higher than the loss incurred, it may be reduced to ensure fairness.
Contract Performance Status: The extent of contract performance affects the adjustment. For instance, if 95% of a contract has been fulfilled with only a minor delay in the remaining obligations, a significant liquidated damages amount may be deemed unreasonable.
Degree of Fault and Intent: Courts also consider whether the breach was intentional or due to negligence. A higher degree of fault justifies more punitive liquidated damages to deter future breaches. 
Other Considerations:  Courts take into account the predictability of potential losses, the parties' bargaining power, use of standard contract terms, and any offsetting factors (e.g., offsetting rules for gains and losses). For commercial transactions involving business entities, the courts are more cautious in adjusting liquidated damages due to the nature of commercial negotiations.

IV Delayed Performance and Liquidated Damages:

· Payment of liquidated damages for delays does not replace the requirement for actual performance. The damages aim to penalize delayed performance rather than compensate for all losses. Therefore, the non-breaching party may still demand actual performance.

V Burden of Proof:

· When a breaching party requests a reduction in liquidated damages, they carry the burden of proof to demonstrate the amount's excessiveness. However, the non-breaching party is also expected to provide evidence of the actual losses.

VI Distinctions in Commercial Disputes:

Voluntary Agreements and High Liquidated Damages: If commercial parties willingly agree to high liquidated damages during settlement, and one party later defaults without valid reasons, courts may uphold the penalty as a punitive measure. This is particularly true if the breach exhibits severe bad faith.

VII Appeals Regarding Liquidated Damages Adjustment:  
If a party did not request an adjustment during the first trial, the second trial may refuse the appeal for reduction, unless the lower court did not inform the party about the possibility of adjustment.

Requirements for Fault in Liquidated Damages Claims:

· China's Civil Code generally imposes strict liability for breaches, emphasizing compensation for damages rather than requiring proof of fault. Exceptions exist where contracts specifically link liquidated damages to fault, or in cases involving punitive damages intended to punish serious misconduct.

VIII Relationship Between Liquidated Damages and Compensation Claims:
In cases where liquidated damages and compensation claims are both possible under the Civil Code, debates arise regarding whether both remedies can be pursued simultaneously. There are two prevailing views:
1. Exclusive Application of Liquidated Damages:
Liquidated damages clauses take precedence, serving as a pre-determined amount for damages. If the non-breaching party selects this remedy, it becomes the minimum compensation, and any excess loss cannot reduce the liquidated damages.
2. Concurrent Application of Liquidated Damages and Compensation:
Both remedies may coexist if they protect different interests. When the interests align, only one remedy should be pursued. If liquidated damages exceed the actual loss, the non-breaching party may seek additional compensation for the shortfall.

Judicial Practices:

Courts assess various factors, such as the actual loss, the extent of contract performance, and fault levels when adjusting liquidated damages. For example, in disputes involving high-value contracts where liquidated damages are linked to significant penalties for delay, courts may use interest rates or loss calculations to determine reasonable amounts.

For more information, please contact David Gao, Attorney at Law
Email: gaohexin@163.com