Can penalties in public procurement exceed the contract price?
The Polish Public Procurement Law does not specify an upper limit for contractual penalties. However, if the penalties are out of line with the realities of the contract, the contractor can seek review by the National Appeal Chamber. In a recent ruling, the chamber cut the penalties to 30% of the contractor’s gross fee.
A cap on contractual penalties is a mandatory provision that must be proposed by the contracting authority in a public contract, regardless of the value or subject of the contract (Art. 436(3) of the Public Procurement Law).
It may come as a surprise that no limit was not set by the parliament. Undoubtedly, it would be problematic to create a properly functioning legal standard in this respect to cover all cases. It would have to take into account the subject of the contract, the nature of the fee, optional tasks, and other legal aspects regulated differently in each public contract. But the current wording of the law allows for distortions in application, such as setting the total maximum of contractual penalties at a level at or above the overall contract price.
Nonetheless, in the Public Procurement Law there is a provision mandating a cap on contractual penalties, even if it not perfect. Previously, when there was no such rule, contractual penalties were sometimes unlimited. Now, depending on how the contracting authority implements this rule in a particular contract, results may vary.
Fundamentally, the parliament did not prohibit setting a limit on contractual penalties in a public contract as high as the value of the entire contract (or even higher). But, conversely, this does not mean that the limit can be set arbitrarily.
The purpose of a contractual penalty
A contractual penalty is a surrogate for damages (and thus is sometimes referred to as “liquidated damages”), so in accordance with Art. 483 §1 of the Civil Code, when provided for in a contract, it is intended to secure the redress of an injury resulting from breach of a non-monetary obligation through the payment of a specified sum. In practice, a stipulated contractual penalty facilitates the contracting authority’s enforcement of potential claims for damages. Just as it is standard to reserve penalties (although there is no obligation to do so), the contracting authority (or other creditor) may also reserve the right to seek additional damages, above and beyond the contractual penalties, up to the amount of the actual damages.
The Civil Code provides that in the event of non-performance or improper performance of an obligation, a contractual penalty is due to the creditor in the amount reserved in the contract for this instance, regardless of the amount of injury suffered (Art. 484 §1). The wording of this provision raises a dispute as to whether any injury at all is necessary for the obligation to pay contractual penalties to arise. But without deciding this issue at the moment, we can add that a creditor demanding payment of contractual penalties does not have to prove the amount of the injury or even its existence. This is largely the point of including a contractual penalty in the contract, and in this respect is vital for evaluating the amount of contractual penalties and the contractual limit on penalties.
We should not rely solely on a linguistic interpretation of Art. 436 (3) of the Public Procurement Law. Indeed, if we stopped there, then any limit, however absurdly high, would in theory meet the requirements of the law and could not be challenged. But contractual penalties should primarily serve a compensatory and disciplinary function. Thus, the point of these penalties is not just to the facilitate the collection of damages by the contractual authority, but also to sanction potential risks arising out of breach of the contract, taking into account the possibility of the injury and its potential extent.
When the contracting authority reserves excessive contractual penalties
Unfortunately, some contracting authorities distort the purpose of this provision and apply it in isolation from systemic principles, introducing provisions in draft contracts that do set a cap for contractual penalties, but at the level of the overall contract fee (or even higher)—and without justifying in any way why they are setting the limit so high.
The ruling by the National Appeal Chamber of 22 August 2023 (KIO 2327/23) confirms that this practice cannot be condoned without a clear justification arising from the nature of the specific procurement. In this ruling, the chamber pointed out that setting the limit on potential penalties does not lie within the contracting authority’s unfettered discretion. The maximum amount of penalties cannot be set at a level that could be considered grossly excessive in relation to the amount of the fee or the potential risks associated with breach of the contract, including the possibility of occurrence of injury or the extent of the potential injury.
Under the facts in that case, the National Appeal Chamber found that setting the total cap on contractual penalties at 100% of the contractor’s net fee constituted an abuse of the contracting authority’s right to unilaterally frame the public contract, and violated public policy (Civil Code Art. 353¹). The chamber went on to explain that facilitation of the contracting authority’s claim for damages should not result in the contractor being obligated to pay contractual penalties in an amount close to the contractual fee, when the injury to the contracting authority is significantly less. The contracting authority should be entitled to obtain full coverage of the injury caused to it by the contractor as a result of breach of its obligation, but this is served by stipulating in the contract that in addition to the contractual penalty, the contracting authority can seek further damages up to the amount of the actual injury.
The National Appeal Chamber further reasoned: “In view of the above, the chamber found it warranted to order the contracting authority to amend the terms of reference (draft contract) by reducing the total maximum value of contractual penalties. It should be pointed out that in public procurement practice, this value generally ranges from 10% of the contractor’s net fee to 30% of its gross fee. In determining the upper limit of contractual penalties, the contracting authority should take into account the scope and type of breach of contractual obligations, the nature and scale of the subject matter of the contract, as well as the principles of proportionality and fair competition.”
In this ruling, the chamber found that the appellant had failed to demonstrate the factual basis for determining an appropriate limit of contractual penalties. Therefore, the chamber ordered the contracting authority to reduce the limit to no more than 30% of the contractor’s gross fee.
Summary
It is not legally forbidden for the contracting authority to set a limit on contractual penalties equal to (or higher than) the contractual fee, but there should not be complete freedom in doing so. Contracting authorities should be guided by the nature and scope of the potential breach, the nature and scale of the subject of the procurement, as well as the principles of proportionality and fair competition. Otherwise, they risk opposition from contractors. Moreover, it is very likely that, at least financially, such a decision will rebound negatively against the contracting authority. Setting a limit on combined penalties helps potential bidders estimate their risks, and the higher the risks, the more they drive up prices. Contracting authorities must expect that setting the cap on penalties too high will be reflected in inflated bids.
This ruling by the National Appeal Chamber shows that contractual penalty limits out of proportion to the contract are included in contracts, but this does not yet mean that they will remain in them. On the other hand, if the deadline for challenging the draft contract has already passed, the only remedy is to appeal to the contracting authority’s common sense.
Karolina Parcheniak, attorney-at-law, Infrastructure, Transport, Public Procurement & PPP practice, Wardyński & Partners
