Perspective | Practical Changes That May Arise for Large Enterprises and Small and Medium-sized Enterprises Under the "Approval"

1. General contractors should conduct necessary screening of the enterprise scale of their trading partners, and if there may be situations where "back-to-back clauses" are invalid, they should sign supplementary agreements with downstream units in advance to change the payment terms.
 

According to the interpretation of the Second Civil Division of the Supreme Court, the retroactive effect of the Reply can be traced back to the implementation date of the "Regulations on Ensuring Payment to Small and Medium Enterprises" (hereinafter referred to as the "Payment Regulations"), which is September 1, 2020. We can reasonably predict that the vast majority of disputes over signed but unfulfilled subcontracting contracts that occur in the future will inevitably involve the effectiveness judgment of "back-to-back clauses." Therefore, it is recommended that general contractors, in accordance with Article 23 of the Payment Regulations, the "Standards for Classifying Small and Medium Enterprises" (Ministry of Industry and Information Technology [2011] No. 300), and the "Statistical Classification of Large, Medium, Small, and Micro Enterprises (2017)" issued by the National Bureau of Statistics, timely verify whether the contracting party in signed and ongoing subcontracting contracts, procurement contracts, and service contracts is a small or medium enterprise. If necessary, they can require the contracting party to provide evidence or issue a commitment.

If, after screening, the general contractor can identify the trading partner as a small or medium enterprise, they will generally negotiate and agree on supplementary clauses with the other party, proactively deleting clauses such as "conditional payment of contract price (where the contractor pays the contract price to the subcontractor only after the client pays the contractor according to the terms of the general contract)" and agreeing on reasonable payment periods and liability for breach of contract to increase the certainty of performance. Otherwise, once the original "back-to-back clause" is deemed invalid, the adjudicating authority will directly apply the stipulated payment deadlines and interest payment standards based on the actual situation, which will inevitably lead to unforeseen economic losses. The specific adjustments to relevant clauses are detailed below and will not be elaborated here.

2. During the performance of the general contract, the general contractor should strictly fulfill its obligations according to the settlement terms, avoid neglecting to assert its claims against the construction unit, and restore the factual state of prudent performance as much as possible to collect evidence for potential future disputes.

Referring to the provisions of the Supreme Court's adjudicative opinions, such as Article 22 of the "Answers to Several Difficult Issues in the Trial of Construction Engineering Contract Disputes" by the Beijing High People's Court and Article 11 of the "Guiding Opinions on the Application of Law in the Trial of Construction Engineering Contract Disputes (II)" by the Anhui High People's Court, the defenses of general contractors in the application of "back-to-back clauses" often point to whether the general contractor has delayed settlement with the upper level or neglected to exercise its due claims against the construction unit. If there is evidence proving that the general contractor has timely submitted settlement requests and claimed payment without subjective fault or maliciously obstructing the fulfillment of payment conditions under the subcontract, the general contractor can still attempt to assert a defense against the payment of project funds.

Additionally, the group most affected by the Reply should be large construction enterprises, with pressure being transmitted from the bottom up. The issuance of the Reply will also compel more general contractors to "have to" push for settlements and payment requests with the owner units, even resorting to litigation to assert their rights. We can foresee that the number of cases where owner units become defendants will increase in a short period. From this perspective, the issuance of the Reply is also an opportunity for general contractors to "defend their rights."

1. Under the premise of compliance with procurement regulations, general contractors should reasonably select large enterprises with good credit status or long-term stable strategic partners to minimize potential litigation risks.
 

While "back-to-back clauses" are widely criticized in the construction field, they are indeed a common practice. Although the original intention and guiding value of the Reply is to legally ensure that small and medium enterprises can participate fairly in market competition and protect their legitimate rights and interests, it cannot be ignored that after the issuance of the Reply, large general contractors may exhibit a market preference for selecting large enterprises as trading partners when choosing subcontractors, aiming to avoid risks. This article also believes that corresponding supporting policies will be introduced in the future to ensure that this does not lead to a decline in the market competitiveness of small and medium enterprises in practical terms. However, from the perspective of general contractors, they are likely to prefer selecting large enterprises with good credit status and performance capabilities or long-term stable small and medium enterprises as subcontractors, which can indeed achieve the goal of excluding the application of the aforementioned Reply or reducing potential litigation risks in the future.

2. If conditions permit, general contractors can establish subsidiaries to avoid being identified as large enterprises.

The scope regulated by the Reply pertains to construction, procurement, or service contracts concluded between large enterprises and small and medium enterprises. Contracts signed between small and medium enterprises are clearly not subject to the constraints of the Reply. We can foresee that, provided that project acquisition and qualification requirements are met, general contractors may attempt to comply with the definitions of revenue, total assets, and other standards in the "Standards for Classifying Small and Medium Enterprises" by establishing multiple subsidiaries to legally split their existing market share and avoid being classified as large enterprises.

3. Clearly stipulate reasonable and feasible alternative and supplementary clauses.

The general contractor will also adjust the existing contract text from the perspective of different contractual entities, establishing reasonable alternative clauses regarding payment deadlines and conditions. Possible scenarios include: (1) as much as possible, combining the payment terms of the general contract and directly incorporating equivalent agreements into the subcontract; (2) specifically agreeing on payment milestones in the contract, in conjunction with the progress and acceptance processes in the general contract; (3) for payment methods, agreeing to use bank acceptance, bank financial products, etc., with the discount fees incurred to be borne by the subcontractor; (4) delaying the progress payment cycle as much as possible in terms of payment ratios and milestones, binding the main payment milestones to after completion acceptance to alleviate capital occupation pressure; (5) according to Article 2 of the "Approval", "Large enterprises requesting to reduce liability for breach of contract on the grounds that the contract price includes compensation for overdue payments may be supported by the people's court if the defense reasons are established upon review." It is recommended that the composition of the contract price realistically and objectively reflects that it already includes compensation for longer payment periods or compensation for overdue payments, and necessary evidence collection should be conducted during the negotiation and performance stages to avoid being recognized as exempt format clauses; (6) The "Approval" specifically regulates "payment time and payment conditions", but if the "back-to-back clause" is reflected in the form of pricing standards, for example, specifically agreeing in the pricing standards that a certain percentage of rate reduction will be applied based on the owner's payment to the general contractor, there is some room for discussion regarding the applicability of the "Approval" document; (7) According to the opinions in the "Approval", if the agreed clauses are deemed invalid, the people's court must reasonably determine the liability for breach of contract. If both parties have agreed on the interest payment standards for overdue payments, they should be handled according to the agreement, and it is recommended to clearly and specifically agree on the liability for breach of contract, especially regarding the interest payment standards for overdue payments.

4. Further strengthen and clarify the delivery standards and conditions for subcontractors.

The construction, procurement, or service contracts involved in the "Approval" must require subcontractors to deliver quality-compliant projects, goods, or provide services that meet the agreed standards. Even if the "back-to-back clause" is deemed invalid, the general contractor still enjoys the statutory right to defense for prior performance, and can claim specific defense reasons such as the project not being completed and accepted, quality issues with the goods, or services not meeting contract standards. These claims clearly depend on setting detailed and clear delivery standards and conditions in the relevant contracts.

5. Require small and medium-sized enterprises to inform in writing and promise their specific enterprise scale type before bidding or signing.

Article 3 of the payment regulations stipulates that small and medium-sized enterprises must actively inform that they belong to small and medium-sized enterprises when entering into contracts with government agencies, public institutions, and large enterprises. In the judicial practice after the issuance of the payment regulations, many courts believe: 1. The indicators for determining enterprise scale types are difficult for external parties to obtain, and it is often challenging for one party in a transaction to judge whether the counterparty belongs to a small or medium-sized enterprise. To protect the legitimate rights and interests of both parties in equal transactions, small and medium-sized enterprises should fulfill their obligation to actively inform. If small and medium-sized enterprises do not actively inform, government agencies and large enterprises are not obliged to verify and will not be bound by the payment regulations and relevant laws and regulations; 2. According to Article 584 of the Civil Code, the compensation for losses due to breach of contract shall not exceed the losses that the breaching party could foresee or should have foreseen at the time of contract formation. Based on the principle of trust protection in the civil law field, if small and medium-sized enterprises do not clearly and actively inform during the signing, they cannot impose excessively heavy review obligations on the good-faith counterparty.

As a general contractor of a large enterprise, it can require the trading partner to provide a written statement regarding whether it is not a small or medium-sized enterprise and provide appropriate documents (such as the balance sheets of the past three years) for formal review, while also agreeing on specific liability for breach of contract in case of untruthfulness in the commitment letter.

Of course, whether the view that "small and medium-sized enterprises are not bound by payment regulations if they do not actively inform" can be applied to the determination of the effectiveness of the "back-to-back clause" in the "Approval" remains to be verified in future judicial practice. Some courts also believe that if the small and medium-sized enterprise identity of the relevant entity can be obtained through public channels, there is no need for active notification, or that regardless of whether there is active notification, it does not change the identity of the small and medium-sized enterprise and the legislative intent to be protected.

6. Agree to transfer the construction unit's engineering payment claims to the subcontractor when payment cannot be made.

According to the Supreme Court's ruling opinions, even if the construction project claims have not been settled, they essentially belong to monetary claims. If there are no prohibitions on transfer in the general contract between the contracting parties, the construction project claims can be transferred externally. To offset the risk of the invalidity of the "back-to-back clause", general contractors may agree on "debt transfer clauses" in the subcontract, such as agreeing that under certain specific circumstances, the general contractor has the right to transfer its claims against the owner to the subcontractor. Once the debt transfer is completed, it is deemed that the general contractor has fulfilled its debt to the subcontractor within the corresponding amount range. After the subcontractor acquires the claims, it will assert rights against the owner and will no longer have claims against the general contractor.

7. As much as possible, select arbitration institutions as the dispute resolution agency to seek greater commercial resolution space.

According to Article 2 of the "Decision of the Standing Committee of the National People's Congress on Strengthening Legal Interpretation Work", "All issues related to the specific application of laws and regulations in court trials shall be interpreted by the Supreme People's Court..." The "Approval" is essentially a judicial interpretation made by the Supreme Court, and the binding scope of judicial interpretation should be the judicial trial work of the people's courts, which does not necessarily include arbitration institutions. There are indeed certain differences in the values of commercial arbitration and court trials; courts emphasize fairness and justice and pay more attention to the social attributes of judgment documents, while arbitration focuses more on autonomy of will, freedom of contract, and emphasizes economic attributes such as commercial efficiency and party autonomy. Therefore, if arbitration is agreed upon as a dispute resolution method, it may theoretically be more beneficial to the general contractor. However, this article also believes that before issuing the "Approval", the Supreme Court has clearly conducted extensive research and solicited opinions from market participants and legislative bodies. The "Approval" itself possesses considerable credibility, and its impact on the arbitration institution's rulings will inevitably be significant.

As mentioned earlier, considering that the "Approval" retroactively applies to the subcontracting contracts from September 1, 2020, to the present, it is foreseeable that large enterprises will actively communicate with small and medium-sized enterprises during the cleanup process involving "back-to-back clauses". They may change the contract payment terms by signing supplementary agreements to avoid adverse legal consequences that may be deemed invalid in the future. At this time, small and medium-sized enterprises can gain a certain degree of contractual bargaining power to seek more reasonable payment terms. Possible scenarios include: 1. Establishing a clear payment schedule; 2. Requiring the general contractor to provide corresponding credit enhancement measures to reduce reliance on the owner's payments; 3. Resetting breach of contract terms to increase the penalty costs for overdue payments by the general contractor; 4. Setting a "latest payment time" clause in the relevant payment terms to neutralize, balance, or counter the general contractor's proposed "back-to-back clauses" (such as extended payment periods, milestone nodes, etc.).
 

As mentioned earlier, small and medium-sized enterprises have the obligation to actively inform others of their status as small and medium-sized enterprises when participating in market activities and signing contracts. It is first recommended to clarify their enterprise classification through contract terms. If disclosed in other ways, it is advisable to ensure proper evidence collection and preservation.
 

Additionally, when disputes arise regarding the validity of "back-to-back clauses", small and medium-sized enterprises should actively bear the burden of proof based on the "Standards for Classification of Small and Medium-sized Enterprises" and the relevant provisions of the "Statistical Classification of Large, Medium, Small, and Micro Enterprises (2017)" published by the National Bureau of Statistics. They should prove that they meet the classification standards for small and medium-sized enterprises from three dimensions: operating income, number of employees, and total assets. Direct evidence should include financial reports or accounting statements, certification of small and medium-sized enterprise status issued by the competent authority, annual corporate income tax returns, social insurance payment certificates, etc.

According to the provisions of the "Approval", after the "back-to-back clauses" are deemed invalid, the people's court should reasonably determine the payment period and corresponding breach of contract liability for large enterprises based on the specific circumstances of the case, combined with industry norms and the trading habits of both parties. The invalidity of the "back-to-back clauses" should be regarded as the payment period not being agreed upon or being unclear. According to Article 511 of the Civil Code, if the performance period is unclear, the debtor may perform at any time, and the creditor may request performance at any time, but must give the other party necessary preparation time.
 

As a subcontractor of small and medium-sized enterprises, one can advocate for the re-determination of payment terms and the start and end times of overdue interest from the perspectives of industry practices, trading habits, and fairness principles, according to a logic that is more favorable to oneself.

As mentioned earlier, based on the fact that small and medium-sized enterprises hold the "sword of Damocles" of the invalidity of "back-to-back clauses", it may lead to large enterprises being wary of trading with small and medium-sized enterprises in reality. Therefore, we predict that there may be a wave of phased integration and mergers among small and medium-sized enterprises in the future, with many seeking to grow stronger and further expand market scale and operating income, thereby obtaining more market resources.