China Construction Disputes Involving Subcontractors: To Arbitrate or To Litigate?

by Yi Dai, Julian Chow, and Yuxuan Tian

Here is a classic problem in the construction industry: an owner fails to pay a contractor, who in turn fails to pay its subcontractor. How can subcontractors protect themselves?

Under PRC judicial practice, subcontractors can directly sue owners for payment. However, it is unclear whether subcontractors may do so via arbitration by relying on arbitration agreements in contracts that subcontractors are not a party to. In Yueyang Branch of Industrial and Commercial Bank of China Co., Ltd. v. Liu Youliang ((2018)湘06民特1号), a PRC intermediate court made determinations that reaffirmed the principle of privity of contract in arbitration agreements, deciding that third-party subcontractors cannot rely on arbitration agreements they are not a party to.

The Supreme People's Court later selected this case as Guiding Case No. 198 on 27 December 2022.

Factual and Procedural Background

On 30 August 2012, the Yueyang Branch of the Industrial and Commercial Bank of China Co., Ltd. (“ICBC”) and Hunan Baling Construction Co., Ltd. (“Baling”) signed a construction contract for Baling to decorate and renovate ICBC’s office building (“Contract”). The Contract stipulates: "In the event of a dispute in this contract, it shall be resolved by negotiation between the two parties first. If the negotiation fails, apply to Yueyang Arbitration Commission for arbitration.”

On 10 September 2012, Baling and Liu Youliang (“Liu”) signed a Contract of Responsibility for Internal Projects (“Subcontract”), in which Baling subcontracted the renovation, interior decoration, and warranty work to Liu. While the case does not mention whether the Subcontract contained a dispute resolution or arbitration clause, experience suggests that such clauses are rare in subcontracts signed with individual subcontractors, making PRC courts the default solution.

When ICBC failed to pay Baling, Baling failed to pay Liu. Liu then applied to initiate arbitration in the Yueyang Arbitration Commission against ICBC based on the arbitration clause in the Contract. On 22 December 2017, the Yueyang Arbitration Commission rendered an arbitral award, ordering ICBC to pay Liu the project payment as well as liquidated damages (“Award”).

ICBC applied to the Yueyang Intermediate People's Court of Hunan Province (“Court”) to set aside the Award on the basis that there was no arbitration agreement between ICBC and Liu. On 12 November 2018, the Court ruled in favor of ICBC, setting aside the Award.

Issues

The arbitration agreement is the basis for the arbitration institution or tribunal’s jurisdiction over a claim. In this case, the Contract between ICBC and Baling contained an arbitration agreement. The subcontractor, Liu, was not a party to the Contract and therefore was not a party to the arbitration agreement.

The main issue before the court was therefore whether Liu had the right to initiate arbitration proceedings against ICBC according to the arbitration agreement in the Contract.

Arguments

The parties focused their arguments on whether Liu inherited Baling’s rights and obligations under the Contract, including the right to commence arbitration against ICBC.

ICBC argued that the Subcontract was signed without ICBC’s knowledge and Baling attempted to assign its rights and obligations under the Contract to Liu without ICBC’s consent. Therefore, Liu cannot enjoy the rights and obligations Baling is entitled to under the Contract.

Liu argued that because he voluntarily replaced Baling in performing the Contract, Liu inherited Baling’s rights and obligations under the Contract. Thus, he was entitled to rely on the arbitration clause under the Contract and initiate arbitration proceedings against ICBC.

Findings and Rulings

The Court set aside the award and made the following key findings:

• The arbitration agreement is the basis for the arbitration institution’s jurisdiction. In this case, Liu was not a party to the Contract between ICBC and Baling, and therefore there was no arbitration agreement between Liu and ICBC. Moreover, the Subcontract was neither "inheritance" of the arbitration clause[1] nor a change in the parties to the contract [2] per Articles 8 and 9 of the Judicial Interpretation on the Arbitration Law, respectively. Therefore, Liu is not bound by the arbitration clause under the Contract that he was not a party to.
• The Judicial Interpretation on the Application of Law in the Trial of Contract Disputes for Construction Projects allows subcontractors to exercise rights against an owner, however, this is limited to claims for payment through litigation.[3] As such, Liu was barred from pursuing his claim via arbitration in the absence of a binding arbitration agreement.

Takeaways

Article 465 of the Civil Code of the People’s Republic of China establishes the doctrine of privity of contract, i.e., a contract is only legally binding on the parties who sign it.[4]

In construction projects, subcontractors are often unable to exercise their rights against owners, which can result in social problems stemming from workers’ wages not being paid on time. To mitigate these issues, the Supreme People’s Court issued an interpretation that allows subcontractors to overcome privity of contract and grants them the right to sue the owner directly.[5] However, this guiding case clarifies that this additional protection does not apply to arbitration. This finding is not a surprise to arbitration practitioners and it seems unlikely for the status quo to change. The 2021 draft amendment to the PRC Arbitration Law did not change the non-binding effect of arbitration agreements on third parties, i.e., third parties are still unable to invoke arbitration clauses in contracts they have not signed.

However, the problem is that an owner may have to appear before both an arbitral tribunal and a court for the same claim. What if the tribunal and the court issue conflicting decisions for the same dispute?

This is not a new problem, and in practice, parties will normally try to include identical arbitration clauses in both the main contract and subcontract (so-called “back-to-back arbitration clauses”). In a dispute, the subcontractor will initiate arbitration proceedings with the contractor and the contractor will initiate arbitration proceedings with the owner (“back-to-back arbitration”). Although this will result in two separate arbitration proceedings (or more, in a chain of multiple sub-subcontracts), most mainstream arbitration institutions typically have provisions allowing the arbitral tribunal to consolidate separate proceedings that arise out of the same set of facts.

Businesses in the construction industry and other companies that rely heavily on contracting and subcontracting should pay serious attention to the dispute resolution clauses in project contracts. Subcontractors would do well to remember that they cannot rely on arbitration agreements that they are not a party to.

Footnotes

[1] Article 8 of the Interpretation of the Supreme People’s Court on Certain Issues Concerning the Applicability of the Arbitration Law of the People’s Republic of China (最高人民法院关于适用《中华人民共和国仲裁法》若干问题的解释), promulgated by the Supreme People’s court on 23 August 2006 and effective as of 8 September 2006. Article 8 provides, “In case an interested party is merged or divided after concluding an arbitration agreement, the arbitration agreement shall be binding upon the successor of its rights and obligations.

In case an interested party is dead after concluding an arbitration agreement, the arbitration agreement shall be binding upon the inheritor that assumes his rights and obligations in the matter to be arbitrated.

The circumstances as stipulated in the preceding two paragraphs shall be applicable unless the interested parties have otherwise agreed between each other when concluding the arbitration agreement.”

[2] Article 9 of the Interpretation of the Supreme People’s Court on Certain issues Concerning the Applicability of the Arbitration law of the People’s Republic of China. Article 9 provides, “In case the credits or debts are completely or partly assigned, the arbitration agreement shall be binding upon the assignee, unless the interested parties have otherwise agreed, or the assignee objects specifically to the assignment of the credits or debts or is unaware that there is a separate arbitration agreement.”

[3] Article 26 of the Interpretation of the Supreme People's Court on Issues Concerning the Application of Law in the Trial of Construction Project Contract Dispute Cases (《最高人民法院关于审理建设工程施工合同纠纷案件适用法律问题的解释》), promulgated by the Supreme People’s court on 25 October 2004 and effective as of 1 January 2005. Article 26 provides, “Where the actual constructor brings a lawsuit against the contract assignor or the illegal subcontractor, the people's court shall accept the lawsuit in accordance with the law.

Where an actual constructor makes its claims by considering the contract letting party as the defendant, the people's court may add the contract assignor or the illegal subcontractor as the party in the case. The contract letting party may only need to be liable to the actual constructor within the scope of the construction cost in arrears.”

[4] Article 465 of the Civil Code of the People’s Republic of China (中华人民共和国民法典), promulgated by the National People’s Congress on 28 May 2020 and effective as of 1 January 2021. Article 465 of the PRC Civil Code provides, “A contract formed in accordance with law is protected by law. A contract formed in accordance with law is legally binding only on the parties thereto, unless otherwise provided by law.”

Furthermore, privity of contract, especially for arbitration agreements, is emphasized in article 4 of the Arbitration Law of the People’s Republic of China, promulgated by the Standing Committee of the National People’s Congress on 31 August 1994, most recently revised on 1 September 2017, and effective as of 1 January 2018, which provides, “The parties settling disputes by means of arbitration shall reach an arbitration agreement on a mutually voluntary basis. An arbitration commission shall not accept an application for arbitration submitted by one of the parties in the absence of an arbitration agreement.”

[5] Article 26 of the Interpretation of the Supreme People’s Court on Issues Concerning the Application of Law in the Trial of Contract Disputes for Construction Projects. See footnote [3] for the full provision.