Contractual penalties: Theory and reality
Many contractors, including those involved in public projects carried out under the Public Procurement Law, lose sleep over the theoretically harmless instrument provided for in Civil Code Art. 483 and 484. Contractual penalties are reserved for all manner of breaches of contract and in huge amounts. The time has to come to change that.
Theory
Under Art. 483 §1 of Poland’s Civil Code, contractual penalties are presented as a modest tool to protect the interests of a party to a contract. It provides that the parties may agree that redress of the loss arising out of non-performance or improper performance of an obligation shall be made by payment of a certain amount of money. This amount is referred to as a “contractual penalty” (comparable to the common-law notion of “liquidated damages”), and under the commonly accepted view it is owed only if the other party is at fault in breaching a contractual obligation.
The commentaries explain that this simplified manner of redressing a breach of contract is convenient for the non-breaching party because it does not need to prove that it suffered a loss, as is directly stated in Civil Code Art. 484 §1. The case law has gone a step further, and beginning with the resolution by the Supreme Court of Poland of 6 November 2003 in Case III CZP 61/03 (OSNC 5/2004 item 69) it has consistently been held that a contractual penalty must be paid even if it is proved that the other party did not suffer any loss at all (although the same resolution says that the absence of loss can be a mitigating factor enabling reduction of the penalty).
Reality
Large public projects in Poland, such as construction of roads, rail lines and other infrastructure, are typically carried out on the basis of contracts containing an extensive catalogue of contractual penalties. They are often set at a high level (such as PLN 10,000 per day of the breach) and provided for in situations defined as “missing a deadline,” “delay in carrying out the work,” or “failure to meet a milestone.” Contracting authorities attempt to establish the contractor’s liability in this way even for circumstances beyond the contractor’s control.
The amount of the penalties can also be objectionable. Freely negotiating parties, not operating under compulsion, would be expected to agree on the amount of a contractual penalty that corresponds to the anticipated amount of the loss which the non-breaching party would suffer in the event of a specific breach of the contract. But in practice the amounts of penalties are set arbitrarily, with no rational connection to the actual loss. This is also because in the area of public procurement, the contracting authority has a stronger position and can impose contractual provisions lying solely within its own interest.
The National Appeal Chamber’s view
The overreaching by contracting authorities in the levels of contractual penalties is based on the case law from the National Appeal Chamber (KIO). The predominant position in its rulings is that the contracting authority has discretion in drafting the tender documentation, including the contract, deciding on the subject of the procurement, its type, specifications, scope, performance conditions, and other contractual obligations. But according to the chamber this does not limit freedom of contract, because contractors who do not like the provisions do not have to apply for the contract.
This is an utterly unacceptable approach. First, the conditions for public tenders should be such that they encourage, not discourage, filing of offers. KIO, as the body appointed for ensure legal compliance in the field of public procurement, should not present a position that tends to limit the number of potential bidders, because this contradicts the concept of public procurement. The goal is to enable the contracting authority to make the best choice from the widest range of properly filed bids. Second, many enterprises must offer their goods and services only through public tenders, because they usually have no other customers. After all, there are no private purchasers of trains, trams and municipal buses—to mention just the transport industry. The claim that an enterprise that does not agree with disadvantageous contract language can look for another tender is anti-competitive and again contradicts the assumptions of public procurement.
KIO has also taken the view that the contractor determines what it should receive in return when setting its fee in the price formula, and also has the right to seek mitigation of penalties. Here the chamber overlooks the great cost and risk involved in seeking reduction of an excessive contractual penalty that has already been collected by setoff against the contractor’s fee. Many contractors can’t afford to pursue this relief, or don’t want to waste their time and take on another risk. They would rather absorb a loss on the contract and move on to the next project, hoping the same problem does not arise again.
KIO also asserts that the public interest, represented by the contracting authority, takes precedence over the private interests of the contractor. This distinction has not been founded in the law since elimination of the communist system, when state ownership was privileged.
Primacy of the public interest
For a long time the line of KIO case law approved clauses imposing severe contractual penalties and an extensive system of damages liability, treating this as a justified element of protection of the public interest, sanctions providing incentives and security for proper performance of contracts. Particularly notable was the position taken by KIO in its ruling of 29 October 2009 (Case KIO/UZP 1461/09), stating that the chamber treats high contractual penalties as a guarantee of actual performance and a way to eliminate pathologies existing on the market (for road construction).
But common approval for securing the public interest by introducing excessive liability of contractors and shifting most of the risks onto contractors went beyond the bounds of reason and fairness, and even economic rationality. Instead of encouraging reliable and timely performance by contractors, this practice generated a new and plainly pathological phenomenon on the road construction market in 2011 and 2012. Nearly 3,000 km of express routes and motorways were put into operation in Poland, but none of the projects was completed on time. Many of the contractors went bankrupt, and others, seeking to avoid bankruptcy, abandoned the construction site, harming the public interest, and the courts were swamped by a wave of lawsuits.
Establishing a repressive system of penalty clauses and attempting to shift the widest range of risks onto the contractor is contrary to fair and honest commercial practice and shapes the parties’ contractual relations in a way that offends justice.
Fault or not?
A condition for being charged with a contractual penalty is non-performance or improper performance of an obligation. So in order to impose this sanction, there must be breach of an obligation.
The scope of a contractor’s liability for improper performance of an obligation arises under Civil Code Art. 471, which provides that the contractor is liable for the injury arising out of improper performance of a contract resulting from circumstances for which the contractor is responsible. The parties to a contract may modify the scope of this liability, but they cannot make it unlimited.
This is reflected in a uniform line of case law from the Supreme Court and the lower courts. As the Supreme Court held in its judgment of 27 September 2013 (Case I CSK 748/12), “In expanding the obligor’s liability for a contractual penalty (Civil Code Art. 483 §1) pursuant to Civil Code Art. 473 §1, the parties must expressly define in the contract what other circumstances—not provided for in the code—which the obligor will be responsible for. They cannot be circumstances borne by the obligee (Civil Code Art. 3531). … It cannot be accepted that the obligor will be required to pay a contractual penalty also in a situation where non-performance or improper performance of the obligation is caused by circumstances for which the obligee is responsible. This is because a contractual penalty is a civil sanction for non-performance or improper performance of an obligation by the obligor.”
Thus it is accepted in the case law that “Civil Code Art. 473 §1, permitting contractual expansion of the obligor’s liability to include designated circumstances which the obligor is not liable for pursuant to the code, cannot be understood to mean that it is permissible to shift to the obligor all of the liability for contractual penalties whose occurrence was brought about by the other party. Such a contract would be invalid as contrary to principles of social coexistence (Civil Code Art. 58 §2).” (Supreme Court judgment of 6 May 1970, Case I CR 145/70)
Similarly, the Lublin Court of Appeal held in its judgment of 11 June 2014 (Case I ACa 136/14), “As the improper performance of the obligation (failure to meet the deadline for presenting the works ready for acceptance) was caused by circumstances for which only the obligee (the defendant investor) is responsible, the obligor (plaintiff contractor) cannot be required to pay the contractual penalty.”
The position that a condition for existence of the obligation to pay a contractual penalty is the fault of the contractor as an obligor is universally grounded in the case law and undisputed in the legal literature. Pursuant to Civil Code Art. 471, in order to apply a contractual penalty, the contracting authority must demonstrate breach of the contract. To release itself from the obligation to pay the penalty, the contractor in turn must prove that the breach of contract arises from reasons for which the contractor is not responsible. Therefore, providing that a contractual penalty is payable to the contracting authority when the breach results from reasons for whose existence the contracting authority is responsible clearly conflicts with the nature of the obligation; that is to say, it violates Civil Code Art. 3531.
Problem with public finance discipline
In the Polish public procurement regime, provisions concerning contractual penalties are also relevant under the Act on Liability for Violation of the Discipline of Public Finance of 17 December 2004. Under Art. 5(1)(2) of that act, violation of the discipline of public finance includes failure to charge or pursue amounts owed to the State Treasury, territorial governmental units or other units of the public finance sector, or charging or pursuing such amounts in less than the properly calculated amount.
Therefore, a contracting authority, as a public institution disposing of public funds, is required to pursue contractual penalties if the circumstances provided in the contract entitling the contracting authority to charge such penalties arise. Waiving a penalty or charging less than provided in the contract would thus violate one of the rules of public finance discipline stated in that act.
In this context, the contracting authorities’ zeal at the stage of drafting the terms of reference often ends up working against them, because out of fear of being held responsible under the public finance discipline act, contracting authorities feel forced to charge contractual penalties even when they are framed in the contract in a manner that offends principles of justice. They thus expose the public interest to the negative consequences of a dispute with the contractor. This rule must be changed to remove the obligation to pursue any and all contractual penalties which public entities could pursue and allow each governmental unit to assess the circumstances and decide whether or not to pursue a contractual penalty.
It should also be stressed in this respect that a contractor which has caused a loss may always be required to redress the loss under general rules. If the contractor can restore the situation from prior to the injury, this does not release the contractor from the contractual penalty, but then the contractual penalty should be applied against the damages owed.
Civil law is not enough
Imposing overly oppressive rules of liability is not justified by any provisions of Polish law. Indeed, including clauses in a contract shifting too much of the risk of failure of a project onto the contractor, or including horrendous contractual penalties, could even render the contract invalid as contrary to principles of social coexistence (Civil Code Art. 58 §2), as well as providing grounds for mitigating the contractual penalties (Civil Code Art. 484 §2), but it does not appear that the civil law alone is sufficient to fix the current problems.
A construction in which the contracting authority treats liability clauses as a kind of quasi-insurance was rejected in a recent ruling by the National Appeal Chamber (Case KIO 1123/10), because contractors estimate this risk highly and factor it into their bids, and as a result the contracting authority must choose from among bids that are unnecessarily high.
But because the contracting authority is the stronger party to the legal relationship, and thus there is always a high risk that it will abuse its rights, the solution can only be for contracting authorities to take a rational approach to shaping of the mutual rights and obligations of the parties to public contracts, in a spirit of partnership. Only then can the contracting authority truly ensure protection of the public interest by obtaining offers adequate to the scope of performance without the need to factor into the offer excessive exposure to risk on the part of the contractor.
Time for change
But turning aside from the beaten path when it comes to imposing contractual penalties in public procurement projects may not prove feasible without legislative intervention. This is why it should be considered whether it might be better to make a radical change in the Public Procurement Law to provide that the process for including such contractual penalties would be subject to prior review.
Harking back to previous solutions in force during the era of “units of the socialised economy,” a standard for permissible penalties could be introduced (for example, by establishing maximum percentage values for a given type of breach). Then, if a contracting authority wanted to include a different or higher penalty, it would have to obtain approval from the president of the Public Procurement Office and demonstrate that the penalties normally allowed would not cover the true risk which the contracting authority would be exposed to if the contract were breached. All potential contractors would be permitted to participate in this procedure to ensure that the contracting authority was not exaggerating its potential exposure. This would introduce order and rationality to contractual penalties in the area of public projects, and the resulting allocation of risks could also serve as a pattern for enterprises operating in other fields.
Mirella Lechna, Infrastructure, Transport, and Public Procurement & Public-Private Partnership practices, Wardyński & Partners
Dr Marcin Lemkowski, Dispute Resolution & Arbitration Practice, Wardyński & Partners
