Continuing the topic of construction contracts, in today's article we will explore the issue of contractual penalties. A contractual penalty , pursuant to Article 483 § 1 of the Civil Code, is simply an additional contractual provision that, in accordance with the principle of freedom of contract, the parties may include in the contract.
A contractual penalty is intended to protect the entitled party in the event of non-performance or improper performance of a non-monetary obligation. The obligated party should be more inclined to strictly fulfill their obligation, knowing that a breach entails the obligation to pay a contractual penalty. It is irrelevant whether the obligation consisted of an act or omission. Therefore, contractors should remember that contractual penalties are not reserved for late payment of remuneration, and the appropriate security is an obligation to pay interest, e.g., statutory interest for late payment or statutory interest for late payment in commercial transactions.
The essential elements of a valid clause creating an obligation to pay a contractual penalty are: (i) specifying the obligation (or a single obligation) whose non-performance or improper performance will result in the obligation to pay the penalty, and (ii) specifying the amount of money intended to compensate for the damage resulting from the non-performance or improper performance of the obligation . Their terms must be precise enough to allow for an objective determination of the specified elements. Violation of this principle may result in the invalidity of such a contractual provision.
It's important to remember that a contractual penalty is only a specified sum of money , which, however, doesn't necessarily mean that a contractual penalty payment must specify its exact amount. The amount of a contractual penalty can be determined by specifying criteria based on which the amount of the contractual penalty can be calculated. It's important that both the parties to the contract and the court hearing the case be able to calculate the amount of the contractual penalty. It's permissible to stipulate a contractual penalty as a fraction (percentage) of the value of the service for each unit of delay. The basis for calculating the contractual penalty must be known to the parties at the time the contract is concluded and cannot be assumed to be determined in the future.
We draw your attention to the recent resolution of the Supreme Court of December 9, 2021 (reference number III CZP 16/21), which indicated that it is permissible to reserve a contractual penalty for delay in performance of an obligation in the form of a specific percentage of the agreed contractual remuneration for each day of delay, even if no deadline for calculating the contractual penalty or its maximum amount was specified . The resolution was adopted after resolving a legal question submitted by the district court examining a claim under a subcontract, in which the parties included a provision according to which the defendant agreed to pay the plaintiff a contractual penalty for delay in performance of the subject matter of the contract in the amount of 2% of the gross remuneration of the contract value for each day of delay. In its justification for the resolution, the Supreme Court pointed out that there is no general provision that explicitly prohibits the imposition of a contractual penalty without specifying its maximum amount. Since it has generally been recognized that determining the penalty by specifying (a percentage or directly) the amount due for each day of delay is sufficient, a specification that is not limited by the final date for calculating the contractual penalty or its maximum amount must also be deemed sufficient . We also point out that it is worth clarifying whether contractual penalties are to be calculated based on the gross or net amount of remuneration.
It should also be remembered that in the event of a breach of an obligation for which a contractual penalty has been stipulated, the creditor is entitled to it regardless of the amount of the damage suffered . This damage could be smaller or greater. In the latter case, if the damage exceeds the amount of the contractual penalty, the right to claim compensation exceeding the amount of the stipulated penalty is only possible if the parties have included such a provision in the contract . Therefore, such provisions can be found in construction contracts.
However, if the obligation has been substantially fulfilled, or if the contractual penalty is grossly excessive, the party obligated to pay will be entitled to request a reduction of the contractual penalty – known as abatement of the contractual penalty . Of course, the abatement of the contractual penalty depends on the debtor's request. Determining the extent to which the obligation has been fulfilled will be subject to individual assessment in each specific case – in the event of a court dispute. It is assumed that the obligation has been substantially fulfilled when, despite the debtor's default, the creditor's interest is substantially satisfied. In practice, the court will decide and determine the final amount of the contractual penalty.
In practice, construction contracts often provide for many circumstances in which contractual penalties are stipulated. Primarily, it seems necessary to stipulate a contractual penalty in the event of withdrawal from the contract for reasons attributable to the other party . Such clauses typically amount to a specified percentage of the contractor's remuneration and are intended to protect the parties in the event of the contract being unable to continue.
Another significant contractual penalty that should not be omitted from a construction contract is a penalty for late performance . This penalty may apply to failure to meet the entire obligation on time (e.g., completion of construction or obtaining an occupancy permit) or to milestones agreed upon by the parties (e.g., completion of the shell, assembly or completion of specified equipment or installations, or landscaping). Here, the investor should consider which of these milestones is significant.
Among the common contractual penalties imposed on the contractor, there are also those reserved for accidents strictly related to the execution of construction works, such as compliance with fire and health and safety regulations, order on the construction site, a ban on the consumption of alcohol and other prohibited substances by employees, participation in coordination meetings or preparation of reports.
Another group of circumstances that may be secured by contractual penalties are: (i) failure to obtain construction insurance – often combined with the investor’s right to purchase an insurance policy for the contractor, (ii) failure to submit security documents (e.g. a bank guarantee) or (iii) violation of the procedure for reporting subcontractors or introducing a contractor to the construction site who has not been reported at all.
In summary, whether and what type of contractual penalty clauses will be included in a construction contract depends on the parties' agreements. Therefore, when preparing for such negotiations, it's worth defining your priorities and minimum thresholds, particularly regarding the amount of contractual penalties. In our experience, it's the amount, not the circumstances, that constitutes the main focus of the parties' negotiations.
In just one week, we will remind you what the difference is between a delay and a default and what circumstances can be classified into a given category in practice.
This article is for informational purposes only and does not constitute legal advice.
Legal status as of April 4, 2022.
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