This article first appeared in China Law & Practice, September 2004, 18(7), pp. 23-27. It is reprinted with the permission of Euromoney Publications (Jersey) Ltd. All rights reserved.
Debevoise & Plimpton LLP, New York
With an increasing volume of trade between China and the US in the recent years, transactions between commercial parties of the two countries are worthy of very close attention. A Sino-US contract of sale can be governed by any of three statutes: the Uniform Commercial Code (UCC), the United Nations Convention on Contracts for the International Sale of Goods (CISG) or the PRC Contract Law. Each statute contains a form of insecurity rule. For lawyers handling Sino-US transactions, it is necessary to gain a deep understanding of the suspension issue in the different systems, not only for the purpose of litigation but also to avoid pitfalls in the drafting of legal documents. Here we will explain insecurity rules under the three statutes, and compare their different operation requirements, burdens of proof and legal effects. A practical suggestion will also be made for practitioners.
The promisee in a contract faces uncertainty when the other side (the promisor) indicates a degree of insecurity, which is, nonetheless, not yet sufficiently clear to constitute an anticipatory repudiation. The difficulty in judging the promisor's position here places the promisee in a difficult position. If the promisee treats the promisor's indication as an anticipatory repudiation, he is in danger of being found to have breached the contract if the court determines that the signal did not amount to an anticipatory repudiation justifying non-performance. If, on the other hand, the promisee continues to perform after perceiving such a signal, and it is subsequently determined that an anticipatory repudiation took place, the promisee may be denied recovery for post-repudiation expenditures because of his failure to mitigate the damages after the repudiation.
To resolve this dilemma, a right of suspension is created in contract law. The right functions as a clarification procedure. Whenever there arises a reasonable ground for insecurity, the promisee may assert this right suspending his performance and requesting assurance from the promisor until the uncertainty is clarified.
The Uniform Commercial Code: Black Letter Rule
UCC 2-609 provides that a contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party, the other may in writing demand adequate assurance of due performance and until he receives such assurance may, if commercially reasonable, suspend any performance for which he has not already received the agreed return.
-What Triggers Suspension Rights?
The UCC takes a lenient approach as to the requirements for assertion of the suspension right the promisee only needs to show there have arisen "reasonable grounds for insecurity". The coverage of "reasonable grounds for insecurity" is wide. Basically, any justified doubt about the promisor's ability or willingness to perform his obligation would be sufficient. The court allows such a ground to arise solely because the promisor's willingness, not ability, becomes doubtful. For example, in a case where the promisor questioned the validity and binding nature of a contract, the promisee was held to have grounds for insecurity because the promisor's willingness to perform was put into doubt. Likewise, when the promisor asked for a modification of the contract, it also put his willingness into question and the court allowed the promisee to suspend the performance.
-The Burden of Proof
The promisee, who asserts the suspension right, has the burden to prove that there exists a likelihood that the promisor may breach the contract. The critical issue here concerns how likely the promisor's potential breach is that the promisee needs to prove. The UCC requires proof of lower likelihood than that of the anticipatory repudiation. The rationale is that the suspension procedure is meant to save the promisee from a dilemma because of the difficulty in proving anticipatory repudiation. If the assertion of suspension required the same degree of likelihood of a breach, the procedure becomes practically meaningless. Therefore, the purpose of proof, under UCC 2-609, is not so much the objective truth of the facts purporting to give rise to the insecurity, but the insecure promisee's reasonable belief that they could be true. For example, if the information about the potential breach comes from a reliable source, the promisee has already met his burden of proof and shall be under no duty to further investigate the accuracy of the information before making his demand for assurances, although the same information may not entitle him to treat the contract as repudiated.
-Legal Effects of the Assertion of Suspension Rights
First, if UCC 2-609 is justifiably invoked, the promisee has the right not only to suspend performance but also to hold up the preparatory action. He is excused from any resulting necessary delay.
Secondly, the promisee has the right to demand, in writing, adequate assurance from the promisor for the exchanged performance.
Thirdly, the promisor's failure to give such assurances within a reasonable time, after receiving the demand, constitutes the anticipatory repudiation and the promisee could walk away from the contract then.
United Nations Convention on Contracts for the International Sale of Goods: Black Letter Rule
CISG 71 provides that a party may suspend the performance of his obligations if, after the conclusion of the contract, it becomes apparent that the other party will not perform a substantial part of his obligations as a result of: (a) a serious deficiency in his ability to perform or in his creditworthiness; or (b) his conduct in preparing to perform or in performing the contract.
- What Triggers Suspension Rights?
Under CISG 71, suspension can be asserted when it becomes apparent that the promisor's ability to perform may be seriously jeopardized. This may either be the result of the conduct of the promisor in preparing to perform or in performing the contract as under CISG 71(b), or in the case of serious difficulties experienced by the promisor that may give rise to a loss of ability or creditworthiness as under CISG 71(a).
The interpretation of "conduct" in CISG 71(1)(b) is a subject of some controversy. Some writers believe that it refers only to the promisor's conduct directly connected with the current contract, while others, in a more expansive view, argue that it also covers the promisor's fulfilment of other contracts. For example, if it is found that the promisor has used certain unsuitable raw materials (let's say in a hypothetical manufacturing enterprise) in performing obligations under similar contracts, the expansive view will consider it falls under CISG 71(1)(b), while the restrictive view will say that it doesn't. The expansive view may be in line with the spirit of some domestic laws, like the UCC. However, there is nothing in the text of the CISG that can support this view. More importantly, in practice, it seems that most courts have adopted the "directly related" theory. In almost all reported cases where CISG 71(1)(a) was applied, "conduct" has been interpreted as those actions directly related to the current contract. By contrast, in cases where buyer's non-payment of previous orders was in question, the court applied a "creditworthiness" standard of CISG 71 (1)(a), rather than CISG 71(1)(b).
Compared with CISG 71(1)(b), the coverage of "ability" and "creditworthiness" in CISG 71(1)(a) is broader: it is applicable to the promisor's conduct in other contracts as well as to his general financial condition. But, on the other hand, the threshold to trigger CISG 71(1)(a)'s suspension right is higher. CISG 71(1)(a) requires that the promisor's trouble has reached such a serious degree that he may lose the ability to perform. For example, in a case where the purchase price for a previous contract was unpaid, the seller suspended the performance for subsequent contracts. The court applied CISG 71(1)(a) to the case and denied the seller's assertion of a suspension right, because the seller's failure to pay single instalments is not in itself sufficient to meet the requirements of CISG 71(a). In the court's opinion, such loss of creditworthiness may be given only if the party becomes subject to an insolvency procedure, or if a party has completely stopped payment or delivery of goods under the contract.
To determine whether the grounds of insecurity fall under 71(1)(a) or (1)(b) is tricky. [In] the process of analysis for such a determination, when there arises the likelihood of a promisor's breach, the first step is to determine whether the conduct in question is directly related to the current contract. As "directly related" is strictly construed, even the promisor's conduct performing the previous contracts between the same parties may not meet the requirements of CISG 71(1)(b). The reported cases show that the following have been held to constitute 71(1)(b)'s grounds: a promisor's supply of non-conforming goods in the current contract, failure to provide a bank guarantee as agreed, and non-payment of a contract price. If the conduct is not directly related, then the promisee can only rely on CISG 71(1)(a), which requires that the promisor's conduct be indicative of the promisor's loss of performance ability or creditworthiness. The reported cases so far show that the situations held to satisfy this requirement are extremely rare. A case where, for example, furniture to be sold under a sales contract has disappeared from its storage place may arguably fall under this category. The promisor's subjection to an insolvency procedure may also be sufficient.
It should be noted that, unlike the UCC, CISG 71 does not allow doubt about the promisor's willingness to be a grounds for suspension. The promisor's contract modification request or questioning of a contract's validity does not meet CISG 71's requirement. Even the seller's suggestion that he may simply refuse to deliver the goods does not give the promisee the right to assert suspension.
- Burden of Proof
As under the UCC, the promisee bears the burden of proof. However, the likelihood of breach the promisee is required to prove is a controversial subject under the CISG. The majority academic view seems to take the position that the UCC's suspension assertion requires a lighter burden of proof than that of contract avoidance. However, it should be noted that, in practice, a very harsh standard has occasionally been applied. In one case decided by the Austrian Supreme Court, the buyer did not pay for two deliveries. Upon the seller's request for payment, the buyer showed the seller a copy of a bank payment order. The buyer then cancelled the bank payment order without informing the seller. Lacking liquidity, the seller could neither produce nor deliver goods ordered. The seller, therefore, suspended performance of the contract and sued the buyer. If the case had been governed by UCC 2-609, this buyer would undoubtedly have been entitled to suspension, but he lost under CISG 71 because the court held that "neither the fact that the buyer had not paid the purchase price for a number of deliveries nor the cancellation of the bank payment order indicated with a sufficient degree of probability a serious deficiency in the buyer's ability to perform the contract or in its creditworthiness in keeping with CISG article 71(1)(a)". In other words, the court here required the promisee to prove with an extremely high degree of certainty that the promisor would breach the contract.
- Legal Effects of the Assertion of Suspension Rights
CISG 71 gives the promisee the right to suspend performance and demand adequate assurance. The effects are basically similar to the UCC, but there are two issues worthy of attention.
First, the promisee's right to suspend the preparation for performance is not clearly provided. UCC 2-609's official commentary clearly indicates that preparation is subject to suspension. However, CISG is silent on this point. Even though the prevailing view among commentators suggests that preparation can be suspended, it is still safer for a lawyer to specify this effect in the agreement in advance.
Secondly, the legal consequences of the promisor's failure to provide the adequate assurance, after the assertion of a suspension right, are unclear. The text of the CISG says nothing about the consequences in this situation. This troubling loophole, if not filled by contractual agreements, is a trap that may create a big mess. Imagine a case where a promisee sends the demand letter for assurance, but receives no reply from the promisor. Without a contractual provision giving him the right to cancel the contract, he would probably have to resume the contract performance even after asserting the suspension right.
Chinese Contract Law: Black Letter Rule
In Article 68, the PRC Contract Law provides that the party required to perform first may suspend its performance if it has conclusive evidence establishing that the other party is in any of the following circumstances:
- What Triggers Suspension Rights?
The requirements to invoke suspension rights under the Contract Law are in some way similar to the CISG. It lists four categories of insecure situations. Like the CISG, it has the ability and creditworthiness categories, but drops the conduct category. It includes two other grounds: business deterioration and debt evasion acts. The willingness-based doubt does not constitute grounds for insecurity under the Contract Law. Like the CISG, none of the four categories under Article 68 of the Contract Law can be used as grounds to challenge a promisor's willingness to perform the contract.
The most striking feature of Article 68's requirements is that it cannot be asserted until after the promisee is requested to render his performance by the promisor. In other words, the suspension right under Article 68 can only be used as a shield, rather than a sword. For example, suppose that A and B enter into an agreement on January 10, whereby A agrees to provide machinery on July 10 and B agrees to pay on July 15. On March 15, A learns that B is involved in deep financial difficulty and may not be able to fulfil the contract. Under the UCC or the CISG, a suspension right can be used both as a shield and sword, so A can suspend the production process right away and demand the assurance from B. However Article 68 only permits shield use, so even though A knows of B's situation and it is likely that B will never take or use the machinery in production, A has no way to assert suspension until July 10. What is worse, he still has to continue production in spite of the risk.
Besides the shield element, the order of performance as stipulated in the contract also plays an important role. Since the drafters of the Contract Law believed only the promisee whose performance obligation arises before the promisor needs the protection of the suspension rule, Article 68 makes the suspension right only available to "the party required to perform first" in the contract.
- Burden of Proof
Of the three statutes, Article 68 of the Contract Law imposes the heaviest burden of proof on the promisee. It requires the promisee to show "conclusive evidence" to prove that the promisor is in one of the four listed situations stated above. To some extent, this burden of proof almost presents a mission impossible for the promisee. If he could prove by conclusive evidence, he would not need the clarification procedure of a suspension rule because he should be able to cancel the contract right away. In a few reported cases, in which Article 68 was applied, the court did apply the harshest standard.
- Legal Effects of the Assertion of a Suspension Right
Two features should be noted about the legal effects for assertion contained in Article 68 of the Contract Law.
First, the preparation for performance is not subject to suspension. Article 68 is a shield and cannot be invoked until a promisee's own performance is due. Consequently, the promisee will never have the chance to assert the suspension right during the preparation period.
Secondly, a promisor's failure to provide the assurance does not automatically entitle the promisee to cancel the contract. If the promisee does not receive the assurance as requested, Article 69 directs him to make the second judgment whether the promisor has regained the ability to perform. Only when the promisor has not, can the promisee cancel the contract.
Summary of the Differences between the UCC, CISG and Chinese Contract Law
- What Triggers Suspension Rights?
|UCC||CISG||PRC Contract Law|
|Grounds of insecurity directly connected with current contract?||No|| No (for ability / creditworthiness);
Yes (for conduct)
|Shield (assert as a defence, and only when a promisee’s own performance is due)||Yes||Yes||Yes|
|Sword (assert as a claim, whenever the insecurity arises)||Yes||Yes||No|
|Order of performances in the contract||No relevance||No relevance||First performer.|
- Burden of Proof
|UCC||CISG||PRC Contract Law|
|Burden of proof||Promisee’s reasonable belief, not objective truth||Arguably lower degree of certainty than contract avoidance||Conclusive evidence. Very harsh standard.|
- Legal Consequences
|UCC||CISG||PRC Contract Law|
|Suspend performance and demand assurance.||Yes||Yes||Yes|
|Can suspend preparation for performance?||Yes||Yes||No|
|Can cancel the contract if promisor fails to provide assurance?||Yes||Unclear||Yes, if promisor does not regain the performance ability|
Issues in Practice
The suspension rule merely establishes a default rule that supplies a contractual term in circumstances where the parties have failed to agree otherwise. It is always advisable for the parties to provide, at the time of contracting, the specific operation requirements, burden of proof and the legal effects of the suspension rule in the current contract to override the default doctrine. The practitioners shall especially be aware of some common business scenarios, which tend to cause problems in the recourse to suspension rules, as shown below.
- Parties Engaged in a Series of Transactions
Lawyers should take precautions if clients are engaged in a series of transactions, because the grounds of insecurity may turn out to be too narrow under the CISG and the Contract Law in this situation. One of the common reasons for the promisee to suspend the performance here is the promisor's failure to fulfil the previous order. Because of CISG 71(1)(b)'s "directly related" requirement, the promisor's suspicious performance in the previous deal can only go through CISG 71(1)(a) to be considered as grounds of insecurity, which nevertheless is much tougher. Under the Contract Law, the grounds related to the previous deal will be hampered by shield and first performer requirements. Even if the promisee is first performer in the current deal, he cannot assert the suspension until his performance is due, although the promisor may have already defaulted in the previous deal.
- Market Change
Market change is one of the most common causes for contract disputes. When the promisor finds that market dynamics work against him and the contract is no longer profitable, he will naturally seek to escape from the obligation. If he is foolish enough to repudiate the contract, the promisee can easily terminate the contract. However, under most circumstances, a well-advised promisor will try other means. For example, he may try at length to question the validity of the contract or request modification of the contract. These probably do not amount to anticipatory repudiation, but may very well be grounds for insecurity. However, the default scopes of suspension under both the Contract Law and the CISG are too narrow to cover the insecurity purely out of the promisor's willingness. The justified doubt about a promisor's willingness to perform the contract shall be specifically provided in the contracts governed by the Contract Law or the CISG.
- Information from Buyers of Similar Goods
Among business people in the same industry, rumour usually spreads quickly of trouble, or rumours of trouble, at a particular firm. It often happens that a promisee will start to worry about a delivery well before the performance time, because he heard that the promisor had failed to comply with a similar contract with another buyer. If the promisee wishes to assert a suspension in such a case, one obstacle would be the burden of proof. It will be extremely difficult to argue that a promisor's failed transaction with another buyer constitutes "conclusive evidence", as under Article 68 of the Contract Law, that the promisor will fail in his ability to perform the current contract. If the burden of proof, especially for the Contract Law, is not relaxed to a reasonable degree, the promisee will virtually lose the right to assert suspension in many situations.
1. See generally, James J. White & Robert S. Summers, Uniform Commercial Code § 6-2 (West Publishing Company, 5th ed., 2000).
2. See UCC 2-609 Official Comment, 1.
3. Copylease Corp. of America v. Memorex Corp. 403 F Supp 625 (SDNY 1975); Financial Bldg. Consultants, Inc. v. St. Charles Mfg. Co. 145 Ga App 768 (1978).
4. Gutor International AG v. Raymond Packer Co. 493 F2d 938(CA1 Mass1974); Louisiana Power & Light Co. v. Allegheny Ludlum Industries, Inc. 517 F Supp 1319 (ED. La 1981).
5. Matthew C. Brenneman, "Sales: What constitutes "reasonable grounds for insecurity" justifying demand for adequate assurance of performance under UCC 2-609," 37 A.L.R.5th 459 (1996).
7. UCC 2-609 Official Comment, 2.
8. UCC 2-609 (4).
9. Harry Flechtner, "Remedies under the new international sales convention: The perspective from Article 2 of the UCC," 8 Journal of Law and Commerce 53-108 (1988).
10. See, e.g., Fritz Enderlein & Dietrich Maskow, International Sales Law. Oceana Publications, 1992.
11. Case No. 52 S 247/94, Landgericht Berlin (1994); Case No. VB/94124, Hungarian Chamber of Commerce and Industry Court of Arbitration (1995); Case No. VB/94131, Hungarian Chamber of Commerce and Industry Court of Arbitration (1995), available at <http://www.unilex.info>.
12. Case No. 2Ob 328/97t, Austria Supreme Court (12.02.1998) available at <http://www.cisg.law.pace.edu>; J.P.S. BVBA v. Kabri Mode BV, AR 3641/94 (1995), available at <http://www.unilex.info>.
14. Case No. 52 S 247/94, Landgericht Berlin (1994), available at <http://www.unilex.info>.
15. Case No. VB/94124, Hungarian Chamber of Commerce and Industry Court of Arbitration (1995), available at <http://www.unilex.info>.
16. Case No. VB/94131, Hungarian Chamber of Commerce and Industry Court of Arbitration (1995), available at <http://www.unilex.info>.
17. Case No. 19 U 127/97, Oberlandesgericht Hamm (1998) available at <http://www.unilex.info>.
18. Case No. 2 Ob 328/97t, Oberster Gerichtshof (1998) available at <http://www.unilex.info>.
19. Harry Flechtner, "Remedies under the new international sales convention: The perspective from Article 2 of the UCC," 8 Journal of Law and Commerce 53-108 (1988).
20. See, eg., In re Amica 135 BR 534, 17 UCCRS2d 11; Kunian v. Development Corp. of America 165 Conn. 300 (1973).
21. Neither the fact that the buyer had not paid the purchase price for a number of deliveries nor the cancellation of the bank payment order indicated with a sufficient degree of probability a serious deficiency in the buyer's ability to perform the contract or in its creditworthiness in keeping with CISG article 71(1)(a). See <http://cisgw3.law.pace.edu/cases/980212a3.html>.
22. Fritz Enderlein & Dietrich Maskow, International Sales Law, Oceana Publications, 1992.
23. For this reason, there is a view in Chinese judicial circles that suspension rights under Article 68 are redundant and shall be merged into the anticipatory breach. See, e.g., Li Qiankang, "Improving our contract law's anticipatory breach rules," China Court Newspaper, September 10 2003. The author is a judge at the Siyang County Court in Jiangsu province.
24. For example, in Hangzhou Lide Machinery & Electronic Research Institute v. Gao Jinhai, Zhe Jing Zhong Zi, No.279 (2000), after the purchase agreement of cutting-edge machinery was concluded, the buyer learned that similar machinery delivered by the seller in another contract turned out to have been defective. He invoked Article 68 of the Contract Law to suspend the performance. The court ruled in favour of the seller and found the evidence provided by the buyer irrelevant, as it was of exactly the same machine.
25. Article 69 of the Contract Law provides that after performance has been suspended, if the other party fails to regain its ability to perform and fails to provide appropriate assurance within a reasonable time, the suspending party may terminate the contract.