“Tanking”, when the counterparty breaches the contract

Recently, we received a consultation from company A, stating that its counterparty had breached the contract, whether they could “Tanking”? For example, they can suspend the supply. When there is an economic downturn, defaults become common. Many companies may have the same concern as company A.

From the perspective of litigation, such concern involves the issue of fulfilling the First Performance of the Right of Defense. Article 526 of the “Civil Code” stipulates that, “Where both parties have obligations towards each other and there is an order of priority in respect of the performance of the obligations, and the party which shall first perform its obligations fails to perform the obligations, the other party has the right to reject such party’s request for performance. If the performance of the obligations by the party which shall first perform is not in conformity with the agreement, the other party has the right to reject such party’s corresponding performance request.” Therefore, when a contract stipulates that a party has the obligation to perform first, and it fails to perform such obligation, the counterparty shall determine what obligations could be refused to perform reasonably. For example, in the case (2023) Jing 02 Min Zhong No. 6759, the Beijing Second Intermediate People’s Court held that, “Hu and Chen have the right to defend their performance against the company, if the company fails to fulfill its obligation to pay the equity transfer payment as agreed, Hu and Chen have the right to refuse the company’s request for performance compensation payment.”

In individual cases, the judicial authorities may weigh the following factors in the determining whether the First Performance of the Right of Defense could be supported.

Firstly, the defaulting party shall have a prior obligation to perform. This is a prerequisite for the exercise of such right. In practice, this prerequisite could be determined based on the provisions in the relevant contract, legal provisions, commercial habits, etc. The opinion in the “Collection of Civil and Commercial Precedents of the Supreme People’s Court” could be taken into reference. The opinion stats that, “On the determination of whether the defaulting party has a prior obligation to perform, we shall first check whether the contract clearly stipulates the order of performance of the obligations of all parties; in the absence of an agreed order, we shall check whether there is a legal order of performance; in the absence of a legal order, we shall check whether there are commercial habits and specific content of such habits between the parties or in the locality, whether the contract stipulates the specific time of performance, whether a party’s contractual obligations are agreed upon as a condition for the counterparty to perform its obligations, the overall arrangement of the contract, the nature, aim, purpose, and other factors of the contract, based on which the court could determine the true intention of the parties at the time of signing the contract comprehensively.”

Secondly, the obligations of the parties shall be “equivalence”. In practice, if a party fails to fulfill an incidental/subordinate obligation first, due to which the counterparty refuses to fulfill its main obligation, normally the court would reject the counterparty’s defense. For example, in the case (2022) Jing 03 Min Zhong No.13061, the Beijing Third Intermediate People’s Court held that, “Company M defends that Company X did not issue the invoice first, so the payment terms have not been fulfilled, it has the right of defense first. Regarding this defense, the obligations of the parties shall be “equivalence” under the dispute related to the right of defense first, the obligation to release an advertisement and the obligation of payment are the equivalent. The first instance court determines that Company X has already fulfilled the advertising release obligation. In this case, Company M only assumes that Company X has not issued an invoice, such defense is not enough, so the first instance court could support Company X’s claim of late payment penalty.”

Finally, after the first performing party breaches the contract, the latter performing party shall express its First Performance of the Right of Defense as the case required. In the “Understanding and Application of Contract Compilation of the Civil Code”, the Supreme People’s Court pointed out that, “Whether the exercise of the First Performance of the Right of Defense shall be explicitly stated shall be determined case by case. If the first performing party is unable or refuses to perform, or delays performance, the latter performing party does not need to proactively express such right, as it is presumed that the first performing party shall be aware of the situation (if the first performing party requests performance, the latter performing party should state its First Performance of the Right of Defense). However, when the first performing party has a significant flaw, or has performed partially, the latter performing party should notify the first performing party based on the principle of good faith, and provide the first performing party with the opportunity to provide evidence, explain, and correct its performance, in order to prevent losses from expanding.” This opinion is reasonable, because the first performing party may assume that it has fulfilled all the obligations.

In summary, when a party breaches the contract first, the counterparty can exercise the First Performance of the Right of Defense after carefully weighing the above factors. “Tanking” is not the best choice.