Preface

Following the Supreme People’s Court publishing three back-to-back (“背靠背”) clause judicial cases in the People’s Court Case Database on July 26, 2024, the Supreme Court issued the “Reply on the Validity of Terms where Large Enterprises agree that Payment is Conditioned on Third-Party Payment when Contracting with SMEs” (Fa Shi [2024] No. 11) on August 27, 2024, providing judicial interpretation on the validity of back-to-back clauses and related consequences.

Back-to-back clauses are widely used in construction subcontracts and sales contracts. Their judicial application has historically been contentious. Against the backdrop of declining real estate and construction industries, the issuance of the Reply raises critical questions about how general contractors should respond. The authors analyze ten key questions to provide guidance.

1. How Did Courts Determine the Validity of Back-to-Back Clauses Before the Reply?

Before the Reply, when contractors invoked back-to-back clauses as a defense against non-payment, some courts affirmed their validity while strictly applying them based on factors including whether the contractor had fully performed its obligations and actively pursued payment from the project owner.

For example, the Beijing Higher People’s Court’s guidance provides: “If a subcontract agreement stipulates that the general contractor shall pay the subcontractor only after the general contractor settles accounts with the project owner and the project owner pays, such stipulation is valid. If the general contractor delays settlement or is inactive in asserting its claims, causing the subcontractor to be unable to timely receive payments, the subcontractor’s request for payment shall be supported.”

The Henan Higher People’s Court’s guidance similarly states that subcontractors cannot be denied payment when general contractors fail to actively pursue claims against project owners.

The Supreme People’s Court in Case (2020) SPC Civil Final No. 106 held that while the parties agreed general contractor CSCEC was not obligated to pay if the project owner did not pay, CSCEC’s exemption required it to have normally performed its obligations. As CSCEC failed to provide effective evidence of actively pursuing payment, the court applied the doctrine that a party wrongfully preventing a condition from being satisfied is deemed to have waived it.

In summary, even when courts recognized back-to-back clauses as valid, they were restricted if the contractor was inactive in pursuing claims or if the delay was unreasonably prolonged. These clauses were never a “magic shield”—the new judicial interpretation should come as no surprise.

2. Why Was the Reply Issued Now?

Back-to-back clauses originated from the FIDIC “pay-if-paid” provision established in 1994 and were widely adopted in China’s construction subcontracts. In a favorable economic environment, upstream payments were generally timely, so back-to-back clauses did not cause serious social problems.

However, with the downturn in the real estate and construction sectors, upstream owners face financial difficulties or even bankruptcy, making project payment timelines and amounts uncertain. This has led to a surge in construction disputes, making back-to-back clause adjudication particularly contentious.

The Supreme Court determined that if back-to-back clauses completely transferred risk to smaller, less resilient subcontractors or suppliers, it could cause widespread SME bankruptcies, undermine social stability, and contradict the legislative spirit of the “Regulations on Protecting SME Payments.” The Reply aims to unify judicial standards and protect SME legitimate rights.

3. Core Content and Scope of Application

The Reply has two core elements: first, whether using back-to-back clauses to deny payment obligations is supported; second, how courts should determine reasonable payment periods, interest, and liability for breach.

Specifically: Large enterprises in construction procurement or service contracts with SMEs that agree payment is conditioned on third-party payment have such terms ruled void under Articles 6 and 8 of the “Regulations on Protecting SME Payments,” which constitute mandatory provisions under Article 153(1) of the Civil Code. However, voiding this specific clause does not invalidate the entire contract—other provisions remain in force.

Regarding interest and penalties: if the contract specifies rates, those apply; if not specified or illegal, the one-year Loan Prime Rate applies. If the large enterprise argues the contract price already includes compensation for late payment, and this defense is upheld, the court may reduce liability.

The Reply applies to contracts between large enterprises and SMEs in construction procurement or services. Other entity combinations may be handled by reference to the Reply’s protective spirit.

4. Difference Between Void Clause and Void Contract

A void contract means the parties’ intended legal effects are not recognized. Back-to-back clauses specifically violate mandatory provisions of the SME Payment Regulations under Article 153 of the Civil Code. Importantly, voiding a back-to-back clause does not affect the validity of the entire subcontract or sales contract—other provisions remain enforceable.

5. How Is a Reasonable Payment Period Determined?

The Reply does not specify exact payment periods. Courts should determine reasonable periods based on specific circumstances, industry standards, and trade customs. Previously, the construction judicial interpretation provided that for delivered projects, payment is due on the delivery date; for uncollected settlement documents, on submission date; and for unresolved disputes, on the date of lawsuit filing.

The SME Payment Regulations require payment terms from the date both parties confirm settlement amounts, or from quality inspection dates. The standard construction contract templates specify payment within 14 days of issuing the completion payment certificate.

Given significant variability in payment timing across cases, courts will need to exercise discretion based on individual circumstances.

6. Do Interest and Penalty Provisions Also Become Void?

No. The Reply clarifies that if the contract specifies interest or penalty rates, those provisions remain valid. If no rate is specified, the one-year Loan Prime Rate applies. Large enterprises claiming the contract price already included late payment compensation may seek reduced liability.

As illustrated by Supreme Court Case (2021) SPC Civil Retrial No. 238, a clause explicitly waiving interest and penalty rights under certain conditions was found to be a valid exercise of contractual freedom.

7. How Have Late Payment Interest Rules Changed?

Before the Reply, different rules applied to construction versus sales contracts. The Reply now establishes unified rules: agreed rates apply if specified; otherwise, the one-year Loan Prime Rate. Notably, unlike the SME Payment Regulations’ punitive daily 0.05% rate, the Reply’s standard is based purely on loss compensation principles without punitive markup—a relatively favorable outcome for general contractors.

8. How Should General Contractors Revise Contract Templates?

General contractors should avoid language such as “payment per project owner progress,” “payment proportional to owner funding arrival,” or “payment conditioned on receipt of owner payment.” Instead, contractors should negotiate reasonable payment grace periods (e.g., 3-6 months) based on actual project conditions and clearly specify interest rates and penalty terms. Courts will likely defer to clear contractual agreements over judicial discretion.

9. Can Owner Bankruptcy Risk Be Transferred to Subcontractors?

No. Under the Reply, general contractors cannot transfer unpaid amounts to subcontractors. If the owner goes bankrupt, the general contractor faces significant capital pressure. Recommended actions: monitor owner financial health closely, exercise right to suspend work if upstream risk emerges, actively assert construction payment priority rights, and negotiate debt assignments with subcontractors.

10. How to Manage Risk from Owner-Designated Subcontractors?

For owner-designated subcontracting, general contractors typically receive only modest management fees while bearing full payment risk. Recommended approaches: avoid direct subcontract agreements with designated subcontractors where possible; require owner-designated subcontractors to contract directly with the owner; if direct contracts are unavoidable, negotiate tripartite agreements clarifying the owner bears payment obligation, not the general contractor; and maintain clear records of all payment flows involving designated subcontractors.