Tales from the National Appeal Chamber: Differences between material and immaterial defects during handover of construction works | In Principle

Flawless performance of a public contract is very rare. Therefore, the case law has adopted the principle that contracting authorities may refuse the final handover only if there are material defects. But what is the nature of material defects, and how can the procedure for handover of works be properly defined in a public contract? These issues were recently considered by the National Appeal Chamber (KIO) in its ruling of 1 December 2020 (KIO 2965/20), which additionally took a stand on the issue of allegedly grossly excessive contractual penalties and limits on such penalties.

State of facts

A contractor filed an appeal against the terms of reference for a procurement, accusing the contracting authority of including in the model agreement a discretionary right to refuse the final handover in the event of any defects. According to the contractor, the contracting authority should have such a right only in the event of material defects, while if only immaterial defects were found, the contracting authority has to accept delivery. According to the contractor, the contracting authority failed to comply with the statutory requirements and de facto allowed handover only when the work was utterly free of defects, which is contrary to Art. 647 of the Polish Civil Code.

The contractor alleged that the contracting authority had included in the model agreement grossly excessive contractual penalties, for failure to provide notice of subcontracts, failure to pay subcontractors on time, and failure to submit documentation on time necessary for the final handover. The contracting authority also failed to include in the model agreement an upper limit for contractual penalties for improper performance of the contract, which in the contractor’s view could lead to unjustified enrichment of the contracting authority at the expense of the contractor.

Obligation to accept handover of construction works with immaterial defects

The chamber entirely rejected the contractor’s claim that, contrary to Civil Code Art. 647, the contracting authority had introduced into the model agreement the possibility to refuse the final handover in the event of any defects at all. Moreover, it was not established that it lay within the contracting authority’s arbitrary determination whether defects prevented final handover, or that these provisions of the contract amounted to a requirement of handover without any defects.

First, the chamber cited the wording of Civil Code Art. 647. According to this provision, under a contract for construction works, the contractor undertakes to deliver the structure provided for in a contract, executed in accordance with the design and principles of technical knowledge, while the investor undertakes to perform the activities required by relevant provisions related to the preparation of works, in particular to hand over the construction site, provide the design, accept handover of the structure, and pay the agreed fee. This provision indicates that one of the basic obligations of the contracting authority under a contract for construction works is to accept handover of works, which in a way constitutes a receipt for the performance of the service by the contractor and entitles the contractor to receive its fee.

In this context, the chamber pointed out that at the final stage of the handover, disputes often arise between the contracting authority and the contractor over defects in the executed works, ultimately leading to refusal to accept handover of the works. To counteract this, a concept was developed in the case law and the legal literature according to which the contracting authority is entitled to refuse acceptance of handover of the works only in the case of material defects. In this respect, the chamber cited the oft-quoted judgment of the Supreme Court of 22 June 2007 (case no. V CSK 99/07), holding: “In light of Art. 647 of the Civil Code, the investor cannot make the final acceptance of the handover and payment of the fee dependent on the absence of any defects in the completed structure, but only in the event of material defects, i.e. when the contractor has failed to perform its obligations. The refusal to accept a handover is justified only if the subject matter of the procurement may be qualified as performed inconsistently with the design and principles of technical knowledge, or the defects are so significant that the structure is not fit for use. However, if the defects are insignificant, we are dealing with incorrect performance of an obligation, which obliges the investor to accept the final handover and set a deadline for the contractor to remove the identified defects.”

In view of that judgment, the chamber turned to an examination of whether the contracting authority had correctly distinguished between material and immaterial defects affecting the handover of construction works. The chamber found that the contracting authority had correctly adopted acceptance of the handover of construction works as the rule. Specifically, §16(14) of the model contract described the handover procedure where defects are discovered which, in the opinion of the contracting authority, do not prevent the final handover (i.e. immaterial defects). On the other hand, in §16(15) of the contract, the contracting authority was allowed to refuse the handover in the event of material defects, i.e. defects rendering acceptance of the facility impossible due to the condition of the subject matter of the contract. As a result, in the opinion of the chamber, “§16(14)–15 of the model contract allow for an objective evaluation, and thus do not grant the contracting authority discretion in determining whether the defects identified during the final handover of works make the final handover possible or impossible, much less formulating in the model contract the rule of ‘defect-free’ handover.”

When may the contracting authority refuse to accept the handover of construction works?

The chamber pointed out that Civil Code Art. 647 does not oblige the contracting authority to accept the handover of the subject matter of the contract when it has not been executed to an extent permitting handover, i.e. when, in accordance with the purpose of the contract, its normal use is not possible or when it does not have the qualities that are inherent or expressly reserved in the contract. In the opinion of the chamber, “If such circumstances are found and the significance of the defects found is such that the contract has not been performed or has not been performed properly, the contracting authority will have the right to discontinue the handover procedure.”

Thus, contracting authorities are entitled to refuse acceptance of handover of construction works whenever material defects are found in the subject matter of the contract. But which defects are “material”? Again, in this respect, the chamber turned to the case law of the Supreme Court, which in its judgment of 27 June 2018 (case no. V ACa 1302/17) held that material defects are defects making it impossible to make proper use of the subject matter of the contract, excluding its normal use in accordance with the purpose of the contract, or depriving it of features that are proper or expressly reserved in the contract, significantly reducing the value of the subject matter of the contract. In itself, the assessment of whether a defect is material or immaterial is a matter for the contracting authority, which must be guided by objective principles. Here, §16(15) of the model contract stated rules making refusal to accept handover of the construction works dependent on the occurrence of defects material to the subject matter of the contract, i.e. defects resulting from performance of the contract in a manner inconsistent with the design or principles of technical knowledge, and making handover of the facility impossible.

Obligation to include in the model contract penalties from Art. 143d(1)(7) of the Public Procurement Law

Referring to the contractor’s allegations of the grossly excessive amount of contractual penalties, the chamber first pointed out that the contractual penalties provided for by the contracting authority in the contract template were related to the obligations arising from Art. 143b–143d of the Public Procurement Law. According to Art. 143d(1)(7), the contracting authority is required to include in the contract provisions concerning the amount of contractual penalties for:

1. Non-payment or untimely payment of fees due to subcontractors or sub-subcontractors
2. Failure to submit for approval a draft subcontract the subject matter of which is construction works, or draft amendment of such subcontract
3. Failure to submit a certified true copy of a subcontract or amendment to a subcontract
4. Failure to amend a subcontract with regard to the payment deadline.

As a result, the provisions of the model agreement in question met the requirements of the Public Procurement Law, and failure to include them would constitute a violation of the applicable law on the part of the contracting authority. In this respect, the chamber shared the view stated in the legal literature that the amount of contractual penalties is not dependent on the occurrence of actual damage. The contractual penalty provided for in Art. 143d(1)(7) of the Public Procurement Law does not fulfil a compensatory function, but a preventive function aimed at disciplining entities responsible for payment of fees under subcontracts.

As a result, it should be recognised that the chamber was correct when it ruled: “The amount of penalties must ensure that the contractor is motivated and disciplined in fulfilling the obligations incumbent on it in the event of subcontractors’ participation in performance of the contract, especially when the contractor’s liability in this respect is dependent on circumstances for which it is responsible.”

Grossly excessive contractual penalties

As regards to the inadmissibility of stipulating a grossly excessive contractual penalty, the contractor failed to prove that the contracting authority misused its right to frame the contractual provisions.

In the opinion of the chamber, “One cannot assume automatically, i.e. disregarding the analysis of the amount of specific penalties in the circumstances of the given case, in the context of the nature, value and conditions for performance of a specific public contract, that a given amount of contractual penalties is excessive. Setting a contractual penalty at a high level does not in itself mean that the penalty is grossly excessive. Additionally, the size, cost and importance of the subject matter of the contract must be taken into account.”

In this context, it should be agreed, as stated by the National Appeal Chamber, that the competence to determine whether a contractual penalty is grossly excessive belongs to the common court at the stage of contract execution, and not to the chamber.

In this case, Civil Code Art. 353¹ should apply, according to which the parties entering into an agreement may arrange the legal relationship as they see fit, as long as the substance and purpose of the relationship are not inconsistent with the nature of the relationship, the law, or principles of social interaction. Nevertheless, in the case of public procurement, the principle of freedom of contract has been modified, as only the contracting authority is obliged to determine the wording of a future public contract, while the contractor is entitled to estimate the contract value and submit a bid accordingly. As the chamber pointed out, “The contracting authority has the right to frame the content of the future obligation in its favour, given its statutory position in the process of awarding and performance of public contracts, and a contractor is not obliged to enter into a given contractual relationship (submit a bid) if it does not like the provisions of the contract or the terms and conditions for performance of the contract.”

Moreover, the chamber pointed out that the contractual penalty provisions of the model agreement here referred to a delay in performing an obligation, i.e. a circumstance for which the contractor is responsible. Thus, the contractor has a direct influence on the final value of contractual penalties, as well as being able to calculate the risk connected with signing the public contract.

No obligation to set a limit on contractual penalties

The chamber held that the failure to specify a limit for contractual penalties in the model agreement did not violate the principle of proportionality or make the contract one-sided. In its opinion, contracting authorities are not obliged to set such a limit, so the justification for imposing a limit on contractual penalties should appear from the arguments and evidence submitted by the contractor, who derives certain legal effects from such a claim. As the chamber noted, “In such a state of facts, where the contractor is liable only for circumstances attributable to it (delay), setting an upper limit on contractual penalties would result in an unjustified limitation of the contractor’s liability for its own failure to exercise due diligence.”

The ruling was made under prior law (the Public Procurement Law of 29 January 2004, which as of 1 January 2021 was superseded by the Public Procurement Law of 11 September 2019).

Cyprian Herl, Infrastructure, Transport, Public Procurement & PPP Practice, Wardyński & Partners