When can the substitute transaction rule be applied?

Company A and Company B signed a contract stipulating that Chinese cabbage would be priced at CNY130 per ton. However, when A came to pick up the goods for the second time, B increased the price to CNY 350 per ton. A refused B’s proposal and eventually had to purchase from other sellers at a price higher than the original price. Afterwards, A filed a lawsuit against B, demanding the price difference. Whether A’s claim will be supported by the court? (2024) Lu 0283 Min Chu No. 12625

Article 60 of the “Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of the General Principles of Contract Part of the Civil Code” stipulates, “Where the non-defaulting party which exercised the right to rescind the contract according to law and implemented a substitute transaction claims that the benefits receivable after the performance of the contract shall be determined according to the difference between the price of the substitute transaction and the contract price, the people’s court shall uphold such claim according to law; the people’s court shall also uphold the claim of the defaulting party that the benefits receivable after the performance of the contract shall be determined according to the difference between the market price and the contract price if the price of the substitute transaction obviously deviates from the local market price at the time when the substitute transaction occurs.”

This is the substitute transaction rule. According to this rule, when the non- defaulting party rescinds the contract due to the counterparty’s material breach and concludes a contract with others for this reason, if the price of the substitute transaction is unfavorable compared with the original contract, it can request the defaulting party of the original contract to compensate for the price difference.

However, although the aforementioned judicial interpretation has stipulated such rule, in judicial practice, the court would judge the case based on 3 aspects: whether the defaulting party has committed a fundamental breach of contract, and the necessity and reasonableness of the substitute transaction.

First, the defaulting party should have committed a fundamental breach of contract, that is, the basic purpose of the non-defaulting party will not be achieved.

Second, the necessity of the substitute transaction. It is mainly reflected in whether the non-defaulting party has reasonably urged the defaulting party to correct its behavior, the scarcity of the subject matter, and the urgency of conducting the substitute transaction. For example, in the case of (2023) Hu 0115 Min Chu No. 101370, the court held that after the non-defaulting party had urged the defaulting party multiple times and given a reasonable performance period, but the defaulting party still failed to perform, and since the subject matter was a customized product that could not be resold, the court supported the non-defaulting party to sell such product as waste.

Third, the reasonableness of the substitute transaction. It is mainly reflected in the price, subject matter, and timing of the substitute transaction. If the price is significantly higher than the market price, the subject matter is quite different from the original transaction, or the timing is seriously delayed, the reasonableness of the substitute transaction would not be supported. In the case of (2024) Yu 0153 Min Chu No. 3594, the court held that the market price evidence provided by the plaintiff was only a one – line inquiry which could not fully reflect the universal characteristics of the market price, and finally determined the loss amount at its discretion. In the case of (2024) Ji 0402 Min Chu No. 1397, the non-defaulting party claimed that the change in market price had led to a significant reduction in the rent of the substitute transaction, but later, when it rented out a store in the same location and with the same area to others, the stated price was still twice the price of the substitute transaction. The court held that the price change was manipulated by itself and had great flexibility, and finally did not support it. In the case of (2024) Nei 04 Min Zhong No. 3196, the court held that the type and quality standard of coal purchased in the substitute transaction were consistent with those in the Coal Sales Contract signed by the parties involved, so the coal in the substitute transaction should be determined to be consistent with that in the involved sales contract. In the case of (2024) E 0106 Min Chu No. 13668, the court held that the evidence showed that Zhang had known about Xiong’s fundamental breach of contract in July 2024 and could have conducted the substitute transaction in a timely manner, but he sold the involved house to a third party in November 2024, so the timing of the substitute transaction was not sufficiently reasonable.

To sum up, when encountering a breach of contract by the other party and trying to choose a substitute transaction, it is recommended to pay attention to the following issues:

1.To preserve evidence, which could prove the defaulting party has committed a fundamental breach of contract, the non-defaulting party has fulfilled obligation to mitigate losses, and the necessity and reasonableness of the substitute transaction, such as breach notices, notices for performance within a time limit, price comparison documents, substitute transaction contracts, and performance certificates.

2.The content of the substitute transaction should be equivalent/consistent with the original transaction, and should not exceed the original scope. If it is necessary to exceed the original scope, the non-defaulting party could split the order.

3.The substitute transaction should be conducted in a timely manner.

4.To reflect the non-defaulting party’s good faith, especially when it involves transactions with affiliates or the price of the substitute transaction has a significant change in price.