Overview Of Penalties For Breach Of Contract (Part 1)

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Overview Of Penalties For Breach Of Contract (Part 1)

P.1 – Overview and Conditions applicable to the Agreement on Penalties for Breach

Abstract: Penalty for breach is a measure to secure the performance of contractual obligations and applied regularly to civil, commercial and construction transactions for deterrence and handle of the breaches of contract. The penalty for breach also plays a role of a remedy and resolution of parts of the consequences and damages. However, the practice shows that not only business organizations but also jurisdictions face difficulty in determining exactly the legality and validity of the agreement on penalties for breach as well as the penalty amount.

Within the scope of the series of articles on the Agreement on Penalties for Breach, I will present in detail the regulations of the law as well as the practical aspects on the agreement on penalties for breach of contract (“the Agreement on Contractual Penalty”) and on trends of the judicial issuance of awards/decisions of the competent jurisdictions in Vietnam.

1. Overview of the Agreement on Contractual Penalty

The Agreement on Contractual Penalty is one of the prevalent articles/provisions of not only commercial contracts but also of civil transactions, especially being an indispensable article/provision of several contracts where it is difficult to prove and determine factual and direct damages and losses. The Agreement on Contractual Penalty helps the parties avoid prolonged legal proceedings arising from the process of determination of damages and losses and of the corresponding amount of compensation. In addition, unlike Compensation for damages and losses, The Agreement on Contractual Penalty does not just play a role of a common remedy for consequences but a punishment to deter and remind the parties to fulfill their obligations agreed and committed in the Contract.

The Agreement on Contractual Penalty has been prescribed by the laws of Vietnam for a long time from 1989 to the present in the Ordinance on Economic Contracts 1989, the Ordinance on Civil Contracts 1991, the Civil Codes (1995, 2005 and 2015 version), the Commercial Laws (1997 and 2005 version) and the Construction Law 2014. It can be seen that the regulations on the contractual penalty are prescribed in the common source of law, i.e. the Civil Code 2015 (“Civil Code“) (Article 418 of the Civil Code) but also in the specialized sources of law, such as the Commercial Law 2005 (Article 300 and 301)  and the Construction Law 2014 (Article 141.1 and Article 146.2).

Despite the fact that the Agreement on Contractual Penalty is prescribed in many sources of law, the concept and legal mechanism of the Agreement on Contractual Penalty remain unchanged. Accordingly, Contractual Penalty is always an agreement between the parties in a contract, in which the breaching party must pay a sum of money to the aggrieved party. However, for the purpose of imposing the Contractual Penalty in practice, the parties need to understand the conditions applicable to the Agreement on Contractual Penalty.

2. Conditions applicable to the Agreement on Contractual Penalty

Based on the above nature and concept of the Agreement on Contractual Penalty, we may come to a conclusion on the applicable conditions as follows:

(1) The contract shall not be void and dull

The invalid contract does not give rise to, change or terminate civil rights and obligations of the parties as from the time the transaction is made – Article 131.1 of the Civil Code. This means that the parties shall not be bound by the obligations agreed and committed in the contract, including the Agreement on Contractual Penalty.

Therefore, only upon the contract takes effect, the Agreement on Contractual Penalty shall be of full force and effect and legally and contractually bind the parties to each other.

(2) An agreement on penalties for breach of contract must exist

“The existence of an agreement” is considered as a prerequisite condition for imposing the Penalty for Breach of Contract. This is also a crucial distinction between the penalty for breach of contract and the Compensation for damages and losses. While an agreement is not a necessary or sufficient condition for the compensation for damages and losses, the existence of an agreement is a must if wishing to impose the Contractual Penalty. This has been provided by the laws, specifically as follows:

  • Clause 1 Article 418 of the Civil Code stipulates: “Penalty for breach is an agreement between the parties in the contract, whereby a party breaching an obligation must pay a sum of money to the party whose rights are breached. “
  • Article 300 of the Commercial Law stipulates: “Penalty for breach is a remedy whereby the aggrieved party requires the defaulting party to pay a penalty sum for breach of contract if so agreed, except in cases of liability exemption specified in Article 294 of this Law.

Therefore, the Contractual Penalty shall only be imposed if the parties have reached an agreement on the Contractual Penalty. 

(3) The conclusion time of the Agreement on Contractual Penalty must exist prior to the occurrence of the breach of contract

Despite the fact that the prevailing law does not provide or mention the conclusion time of the Agreement on Contractual Penalty, it cannot be understood implicitly and tacitly that the Contractual Penalty is imposed as long as agreed by the parties. The Contractual Penalty shall only be imposed if agreed by the parties prior to the occurrence of the breach of contract of one of the parties.

In essence, the Agreement on Contractual Penalty is that the breaching party must pay the aggrieved party for a sum of money once committing a breach of contract as agreed before. Therefore, we may come to a conclusion that the Agreement on Contractual Penalty shall be limited in terms of the conclusion time. Specifically, the Agreement on Contractual Penalty shall not be imposed on a breach of contract if the agreement is concluded after the occurrence of such breach. Because such Agreement at that time shall not reflect the nature of the Contractual Penalty (i.e. a punishment to deter and remind the parties to fulfill their obligations agreed and committed in the Contract) but only appear to be a remedy and resolution of consequences and damages caused by such breach. Therefore, this agreement shall not be deemed a Contractual Penalty but the compensation for damages and losses. 

Moreover, legislators also clearly express their points of view on the nature of the Contractual Penalty as a measure to secure the performance of contractual obligations rather than as a remedy and resolution of consequences and damages. Specifically, the regulations on the Agreement on Contractual Penalty were provided, classified by and listed in the section on measures to secure the performance of civil obligations (Article 377 – Sub-Section VIII of Section 5 of Civil Code 1995) and in the section on performance of obligations in the successive editions of the Civil Code (2005 and 2015).

However, the parties totally reserve the right to discuss and mutually agree on the Contractual Penalty after the effective date of the contract. As mentioned above, the prevailing law does not provide or mention the conclusion time of the Agreement on Contractual Penalty. However, in my perspective, there is no reason to prohibit the parties from additionally concluding the Agreement on Contractual Penalty to the Contract during the implementation period of the contract. Therefore, at the conclusion time of the contract, if the parties omit to agree on the Contractual Penalty, the parties reserve the right to discuss further and additionally agree on the Contractual Penalty at any time during the implementation period of the contract, provided that this agreement is concluded prior to the occurrence of the breach of contract. If the Agreement on Contractual Penalty is concluded after the occurrence of the breach, such Contractual Penalty cannot be imposed on the breach prior-occurring but only imposed on the future breach. 

(4) The breach must be in accordance with the Agreement on Contractual Penalty

Obviously, a breach is an indispensable element if wishing to impose the Contractual Penalty under the Agreement on Contractual Penalty. However, not all breaches of contract may result in the imposition of the Contractual Penalty. Because in spite of the limitation on the conclusion time, the Agreement on Contractual Penalty is also limited by the object and scope of the breach.

For example, if the parties agree on the Contractual Penalty for being late in the delivery of the seller, this penalty cannot be imposed on the buyer. Because the breach of being late in delivery in this case is limited in terms of the object being the seller and the scope being the act of delivery with delay.

Therefore, based on the content of the Agreement on Contractual Penalty, the parties determine as to whether the breach falls into the scope of the Agreement on Contractual Penalty or not.  

(5) The breach does not fall into cases of exemption from liability

It is unfair if a party is forced to be liable for its breach of contract due to the deliberate obstruction caused by the other party or due to natural or artificial events, such as coups, wars, the changes of laws that occur in an objective manner which are not able to be foreseen and are not able to be remedied by all possible necessary and admissible measures being taken. For the foregoing reason, the law has provided cases of exemption from liability where the parties are not liable for their breach of contract, specifically prescribed in Article 294 of Commercial Law and Article 351.2 of Civil Code. Accordingly, if a breach of contract is due to one of the following events: force majeure, fault of the aggrieved party, changes of law that cannot be foreseen at the conclusion time of the contract, the breaching party shall not be liable for its breach of contract.

Moreover, one of the basic principles of law is to permit the parties to deliberately conclude any agreements and commitments as long as not violating a prohibition by law or not contrary to social morals (Article 3.2 of the Civil Code). Therefore, the parties are able to mutually agree on cases of exemption from liability for one or both parties in the transaction.

In conclusion, the Contractual Penalty is a prevalent and common punishment in contractual relations and also plays a crucial role in cases where the amount of compensation for damages and losses is unable to or difficult to determine. Therefore, in the course of negotiation and implementation of the contract, the parties should be well aware of the conditions applicable to the Agreement on Contractual Penalty to be able to impose the penalty in practice: (i) The contract shall not be void and dull; (ii) an agreement on penalties for breach of contract must exist; (iii) the conclusion time of the Agreement on Contractual Penalty must exist prior to the occurrence of the breach of contract; (iv) the breach must be in accordance with the Agreement on Contractual Penalty; and (v) the breach does not fall into cases of exemption from liability.

See more_Overview Of Penalties For Breach Of Contract (Part 2)

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This article is for general information only and is not a substitute for legal advice.