Will you set an automatic renewal clause?

An automatic renewal clause is very common in the commercial contracts, in which the parties plan to keep a long-term cooperation, such as strategic cooperation agreements, lease contracts, intellectual property licensing agreements, and so on. Normally, such clause is a standardized clause, and many companies are used to ignore it.

Take the case (2019) Jing 0108 Min Chu No. 22059 for example, Company J signed a “Cloud Service Agreement” with Company K. The agreement states that J provides cloud service to K; the agreement is valid for 1 year, if either party does not intend to extend the agreement, it shall send a written notification of termination to the other party 3 months before the expiry date, otherwise, the agreement will be automatically extended; and a clause on the penalty for breach of contract for early termination of the agreement. K sent a termination notification to J in the 6th months after the expiry date. Then J filed a lawsuit against K, and required K to pay the service fee and the penalty for breach of contract. In the end, the court held that the agreement had been automatically extended. The court ordered K to pay the service fee, and partial of the penalty for breach of contract (the amount of the penalty for breach of contract is agreed too high in the agreement, and the court lowered the amount based on the application of K). In view of this case, the automatic renewal clause is beneficial to J, but unfavorable to K.

How to make reasonable use of such clause?

From the perspective of function, in a cooperation/transaction, such clause could fix most of the substantive clauses, such as the subject matter, performance method, liability for breach of contract, dispute resolution and etc.; or fix some of the substantive clauses, or at least fix the variables, such as in a lease contract, both parties may agree that the rent shall not rise by more than 5% after the automatic renewal, and so on. The negative impact is that if a party does not want to continue the cooperation/transaction, but it forgets to notify the counterparty in accordance with the agreement, it may undertake the liabilities for unilateral terminate the agreement. In addition, where there is a due diligence to be carried out due to an acquisition, or an investment, and etc., if the company has not implemented some agreements, which are still effective due to such clause, the company shall explain the reason for the relevant risks.

After explaining the function of such clause, it would be easier to make reasonable use of it.

Firstly, if you have to set such clause, it is recommended to state a fixed renewal frequency, such as “……the agreement is automatically extended once”, instead of an unfixed one, such as “……The validity period of the contract is automatically extended, and so on in the future.”, or “the frequency of extension is not limited”, or “repeatedly” and etc.. It is also recommended to adjust the statement of a normal renewal clause, such as “……The validity period of the contract is X years. After the expiration, if both parties still deal in accordance with the contract, the relevant terms could be applied to the transaction after the expiration.” With such adjusted statement, the contract becomes an indefinite period contract, and normally, the unilateral termination party does not have to undertake the relevant penalty for breach of contract.

Secondly, if such clause has been set, it is recommended to establish an internal reminder system, that is, a company could assign an employee to follow up with the relevant contracts, and remind the relevant departments about the time requirement and methods for a written notification of non-renewal in accordance with the contracts before the deadline. Where a party failed to notify the counterparty by the method agreed by both parties, and it notified the counterparty again by the method agreed by both parties, if the counterparty received the second notification before the expiry date, normally the court would reject the claim for the penalty for breach of contract for unilateral termination due to the principle of fairness, for example, (2019) Jing 0108 Min Chu No. 22059, (2019) Hei 0691 Min Chu No. 170, (2017) Hu 01 Min Zhong No. 7833, and etc. However, if the termination notification requirement for such clause is set because of the cooperation/transaction involves a large amount of preliminary preparation and investment, we think the court shall support the claim for compensation of damages, and may support the claim for penalty for breach of contract. For example, if a party provides website operation and maintenance services, and it set the termination notification requirement for an automatic renewal clause because it has to rent the server for a special period.