• To Pre-Lease or Not to Pre-Lease? China's Supreme Court Issues an Interpretation on the Application of Law in Disputes Arising from Lease Contracts
  • October 27, 2009 | Author: Edward J. Epstein
  • Law Firm: Troutman Sanders LLP - Shanghai Office
  • It has become common practice in China for commercial and industrial premises to be leased before the building has been certified for occupation. This usually happens because the legal procedures for certifying the completion of a building cannot keep up with the high demand for new space in a rapidly growing economy. The result, however, is that premises are often fitted-out by tenants only to discover later that they cannot move in because the building has not been certified for occupation. Who then is responsible for the tenant’s losses?

    This problem has become so prevalent that China’s Supreme Court has specifically addressed it in its Judicial Interpretation On Several Issues on Application of Law In Trials of Disputes Arising From Lease Contracts, which came into effect in September 2009 ("the Interpretation"). Unfortunately, the Interpretation adds little clarity to the general law and does not improve the tenant’s vulnerability to taking pre-leases from unscrupulous or careless landlords. What should prospective tenants know before taking a lease of uncompleted premises?

    Rule Number 1: a Pre-Lease is Invalid where the Premises Infringe Planning Regulations

    The Interpretation has made it clear that a lease contract shall be invalid if there is no construction planning permit for the development of the premises pre-leased under the lease contract or the premises are not developed in accordance with the construction planning permit. Unfortunately, it is still common for premises to be built without a permit in China, especially in second and third tier cities, or for the conditions of permits to be exceeded. The Supreme Court has said that a lease of such premises will be invalid because it violates mandatory provisions of law (see Contract Law §52v). The rationale for this interpretation is that it would be a violation of planning regulations to use premises built without or in contravention of a planning permit.

    Rule Number 2: an Invalid Pre-Lease May Not be Worth the Paper it is Written On

    Where a pre-lease is invalid, it is void ab initio. Unfortunately, this means that even if the tenant negotiated favorable representations, warranties and indemnities concerning the landlord’s compliance with planning regulations, these terms would also be as invalid. The Supreme Court does not suggest that any of these terms could be severable from the rest of the invalid terms of the contract and the tenant must therefore rely on general law remedies.

    In certain major cities, for example in Shanghai, it is possible to register a pre-lease as a real estate transaction. Registration will usually ensure that the planning permit has been obtained (it must be registered too) but registration will not protect the tenant against breaches of the permit that may render the lease invalid.

    Rule Number 3: General Law Remedies for Invalid Contracts are Uncertain

    In civil law countries, the remedies for an invalid contract do not depend on the terms of the contract but on “fault”. Fault is either the intentional or negligent conduct of the parties. The Interpretation confirms that who pays for the wasted fit-out will depend on the parties’ respective fault but this is often difficult to assess. If both landlord and tenant sign a lease knowing that the planning permit has not yet been issued, are they both at fault? Probably. But how do you apportion blame? 50:50? 75:25? This will always be arguable. In this respect, a representation and warranty from the landlord that he has obtained a valid planning permit is helpful because it may establish that the tenant was innocent.

    Rule Number 4: the Interpretation Provides Further Remedies

    The Interpretation provides that where a lease contract is found to be invalid, the landlord and tenant may agree that the tenant’s fit-out of the premises be assigned to the landlord. However, if they cannot reach an agreement on the assignment of the fit-out of the leased premises, the fit-out shall be dealt as follows:

    • if it is economically impractical to remove the fit-out from the premises, the landlord and tenant shall share the costs of the fit-out based on fault (see “Rule 3” above).
    • if it is economically feasible to remove the fit-out from the premises, the tenant shall be responsible for doing so.

    The Interpretation does not make it clear whether the tenant is entitled to claim the costs of the fit-out in the latter case. It seems not because the tenant is required to remove it. This result is consistent with the general rule is that property transferred under an invalid contract must be returned to its original owner. The Supreme Court’s thinking seems to be that if the tenant can take back its fit-out without a disproportionate loss to itself, it should do so.

    If the landlord is wholly at fault for the invalid lease contract, for example, for violations of the planning permit, the tenant should be entitled to claim the whole of the cost of the fit-out based on fault liability (see “Rule 3” above).

    Rule Number 5: Do’s and Don’ts if You Pre-Lease

    If you do lease uncompleted premises, it is recommended that you do not start fit-out before the premises are certified for occupation.

    If you wish to commence early fit-out, it is recommended that you perform due diligence to confirm that the premises have a construction planning permit and that the landlord give clear representations and warranties that the premises have been developed according to the construction planning permit.