Can a contractual penalty be cut by 99%? When? | In Principle

Contractual penalties are a common instrument for sanctioning failures to perform non-monetary obligations (e.g. completing construction on time). Contractual penalties can be cut by the courts, but generally the Polish Civil Code indicates only the grounds for mitigating a contractual penalty. The details must be sought in the legal literature and the case law. Indeed, the regulations do not even provide guidance on how much contractual penalties can be reduced. Thus each case should be treated individually, guided by the principles discussed below.

Contractual limits

When drafting a contract, on the side of an entity exposed to a potential contractual penalty, it is worth specifying the maximum amount of penalties to be charged (e.g. 20% of the net contractual fee). In principle, the absence of such a reservation will mean that the amount of the contractual penalty is unlimited. This is particularly important in the case of penalties for delays, where the amount of the penalty increases with each passing day, and in the case of penalties for multiple reasons (e.g., delays in completing work, violations of occupational health and safety rules, failure to meet reporting obligations, etc).

Conversely, it will be in the interest of the party that may be entitled to claim such penalties not to contractually limit the amount of potential penalties.

Statutory grounds: Broad judicial discretion

If a contractual limit has not been established, the institution of mitigation may be a lifeline for the party charged with a penalty. According to Civil Code Art. 484 §2, a contractual penalty may be reduced (a) if the obligation has been substantially performed or (b) if the contractual penalty is grossly excessive. The two grounds operate independently.

But the code does not specify the rules for reducing the penalty or the method for determining the final amount. This is determined by broad judicial discretion. The court can intervene extensively in the amount of contractual penalties. It will make its decision based on the circumstances of the particular case demonstrating that the penalty provided for in the contract is inappropriate to the particular situation. There is no single benchmark, and the determination that a contractual penalty should be reduced is the product of many different, case-specific factors.

Mitigation provision can’t be excluded

The provision on mitigation of contractual penalties is mandatory. This means that in the contract the parties cannot exclude the possibility of judicial reduction of penalties. Thus, the parliament recognises the need to protect the obligor’s interest and apply judicial review of the amount of penalties. This is a protection against unduly harsh consequences for the obligor, stemming from the need to restore contractual equity in this area and to exclude a possible advantage for the other party.

Basis for substantial performance of obligation

Substantial performance of an obligation occurs when, despite certain failures by the obligor, the obligee’s interest in performance of the obligation has been satisfied to an extent approaching full satisfaction. This will be the case, for example, when the work has been completed but the debtor is late in handing over the related documentation, the lack of which does not prevent use of the work and is of little practical significance. In this regard, it is also examined whether the resulting delay jeopardised further proper performance of the contract or violated a material interest of the party charging the contractual penalty—for example if there was a slight delay in a partial deadline, which was then made up and did not jeopardise the final deadline or cause further problems for the obligee.

Excessiveness and auxiliary criteria

The notion of a grossly excessive contractual penalty is an undefined term, meaning that the contractual penalty is disproportionate to what should be due to the obligee in the given situation. This should be the assessment of an objective, outside observer taking into account the totality of the circumstances. Due to the breadth of the notion of an abnormally high contractual penalty, a number of auxiliary criteria are adopted in the literature and case law helping to determine whether a contractual penalty should be reduced. The catalogue is open-ended, and below we discuss the most common examples.

• The amount of injury sustained

One of the auxiliary criteria is the extent of the injury suffered by the obligee (or rather the compensation that would be due on general terms if the contractual penalty had not been reserved). Under this criterion, the amount of the contractual penalty charged is compared to the amount of loss incurred by the obligee due to the obligor’s failure. If the contractual penalty is a multiple of the actual financial loss suffered by the other party, this may indicate a disproportion between the two values justifying a reduction of the penalty. This criterion is intended to adjust the amount of the contractual penalty to the reality of the particular case and ensure a reasonable balance between the situations of the two parties.

The contractual penalty cannot cause excessive enrichment of the obligee or give it far-reaching, unjustified financial benefits compared to the situation of redressing the loss on general terms. On the other hand, the views favourable to claimants speak of the need to preserve the sanctioning nature of contractual penalties and to cause a disadvantage to the obligor, which is also intended to deter improper performance of the contract.

• The degree of disadvantage on the claimant’s part

When mitigating contractual penalties, it is also necessary to assess potential negative consequences the claimant may have suffered as a result of improper performance of the contract, such as missing contractual deadlines. If these consequences are negligible and do not result in actual violation of the obligee’s substantial and legitimate interest (monetary or non-monetary), this may constitute a justification for reducing the contractual penalty. In this context, the complexity of the task to be performed by the party charged with the contractual penalty is also assessed, whether performance of the contract was a lengthy process, and how the resulting delay relates to the period of performance of the contract and practical standards in a given industry. A slight delay in performance of a complicated, long-term construction project may justify mitigation of the penalty (if there are no other circumstances indicating that there are obstacles to such mitigation, e.g. loss of EU financing by the investor due to failure to meet completion deadlines).

In this context, it is examined whether there are any additional circumstances indicating that the delay violated the objectives of the task assumed by the creditor, e.g. significantly affected the possibility of using the built facility or significantly impeded the claimant’s ability to carry out its activities. It might be the case that the claimant has another facility with a similar function at its disposal, or there was some other obstacle to its operations. Minor inconvenience to the claimant provides additional grounds for reducing an excessive contractual penalty.

• Degree of obligor’s fault

As part of the basis for finding a contractual penalty grossly excessive, the court will also analyse the degree of the obligor’s fault in breaching its contractual obligations. This requires an examination of whether the obligee or others contributed to the obligor’s improper performance in any way by their attitude. Often, such grounds may lead to a finding that the contractual penalty, in the absence of fault, is not due at all. In assessing the degree of the obligor’s liability, it can be taken into account for example that signing of the final handover protocol was delayed due to prolonged unjustified formalities on the part of the contracting authority. Therefore, in this respect, equitable criteria related to circumstances for which the obligor is not directly responsible and which contributed to prolongation of performance must be taken into account.

This also requires an examination of concurrent events, i.e. external events or events on the part of other parties occurring at the same time and affecting, for example, the resulting delay. This will occur, for example, if a contractor delayed commencement of works due to its poor organisation of the work, but at the same time the work could not be carried out due to unforeseen bad weather conditions or the failure of other contractors to hand over the construction site.

• Financial results from the contract

An important factor influencing mitigation of a contractual penalty is the financial result achieved by the party liable for the contractual penalty. Thus, the contractual penalty should be particularly proportionate to the margin earned on the contract. A far-reaching loss from the contract (resulting from circumstances not attributable to the obligor, such as a sudden and unforeseen increase in prices of materials and labour) may constitute grounds for mitigation of the penalty.

In particular, mitigation of the penalty is justified if the amount of the penalty and the obligor’s loss are grossly disproportionate to the advantage gained by the creditor from the contractual penalties (gaining a significant additional sum of money while at the same time suffering only negligible distress from the obligor’s breach). Therefore, the claimed contractual penalty cannot be grossly punitive for the obligor or unjustifiably attractive for the obligee.

• Double fine for the same thing

Mitigation may be justified if more than one contractual penalty remedies the same breach, e.g. a delay in contract performance where one penalty relates to exceeding a partial deadline and the other to exceeding the final deadline, and the penalty periods overlap. It might happen that in practice, only failure to meet the final deadline is relevant, and in this respect the final delay subsumes the delay occurring at earlier stages of the project. Mitigation may be justified if the contractual penalty is charged twice for the same breach of a contractual obligation (e.g. a penalty for failure to notify the investor of subcontractors and a penalty for allowing third parties to perform work).

Judicial discretion: Scope of mitigation

The recent case law shows that the scope of mitigation can be far-reaching. Penalties are sometimes cut to as low as 1% of the original amount. Judicial discretion is very broad, and each case is evaluated on its own merits.

The table below provides examples of judicial mitigation of contractual penalties in some recent cases.

Agata Jóźwiak, attorney-at-law, Dispute Resolution & Arbitration practice, Wardyński & Partners