Overview Of Penalties For Breach Of Contract (part 2)

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Overview Of Penalties For Breach Of Contract (part 2)

P.2 – The amount of a contractual penalty and how to determine it in reality

Abstract. As mentioned in the previous article in the series of articles on the Agreement on Penalties for breach of contract, the contractual breach is one of the commonest remedies for loss and damages as well as a measure to secure the performance of contractual obligations of the parties. As such, the contractual penalties should be under the parties’ care as drafting the agreement on penalties for contractual breach to ensure the most effective imposition of the contractual penalties. However, the prevailing regulations of laws of Vietnam prescribe differently from each other on this matter, causing distinct interpretations when it comes to applying these regulations to reality.

See more_Overview Of Penalties For Breach Of Contract (part 1)

Within the scope of this Agreement on Contractual Penalty article series, the author will demonstrate the legal provisions as well as the practice of contractual penalty in reality and the inclination reflected from judicial opinions of competent tribunals in Vietnam on this matter.

1. The amount of a contractual penalty under the laws of Vietnam

The amount of a contractual penalty is one of the most important contents of the Agreement on penalty for breach of contract. At present, the amount of a contractual penalty is provided in three different regulations of laws, namely, Civil Code, Commercial Law, and the Law on Construction. In essence, all these regulations of laws agree that the contractual penalty is a result of an agreement and the parties reserve the right to negotiate the amount of contractual penalty to impose upon their transaction.

a. Civil Code 2015

Civil Code 2015 (“Civil Code”) is deemed a general law and can govern any type of transactions between individuals and legal entities, including commercial contracts, construction contracts, and other civil transactions. In general, any type of transactions under the jurisdiction of the laws of Vietnam shall be governed by Civil Code.

Regarding the maximum amount of a contractual penalty, formerly Civil Code 1995 provides that the maximum amount of a contractual penalty shall not exceed 5% of the value of the violated obligation. However, from Civil Code 2015 onwards, the parties to a transaction have the freedom to determine the amount of a contractual penalty without any limitation thereto. Civil Code 2015 remains the spirit of respect for the right to make commitments and agreements of the parties on the basis of freedom, provided that such commitments and agreements do not violate a prohibition by law or are not contrary to social morals. Accordingly, the prevailing Civil Code permits the parties to a transaction to negotiate with each other on an amount of a contractual penalty, unless otherwise provided by relevant law. The phrase “unless other provided by relevant law” is an update of Civil Code 2015 compared to its edition 2005. This supplementation is reasonable as the amount of a contractual penalty is also provided in other specialized regulations of laws, such as the Commercial Law and the Law on Construction.

As the prevailing Civil Code does not govern the maximum amount of a contractual penalty but permits parties to negotiate on the basis of free, this lack of regulations causes certain difficulties in the application and handling in reality. As a result, the freedom to negotiate can lead to a manifestly huge amount of the contractual penalty compared to the actual value of the violated obligation. In fact, there have been many similar cases where one party, usually the disadvantaged party to a transaction, commits a breach of contract without any loss or damage but still is suffered a contractual penalty at the amount that is many times as higher as the value of the contract or the value of the violated obligation. Currently, the Civil Code of Vietnam does not propose any specific mechanism to handle cases where an amount of a contractual penalty is too high or too low in a sense of the ridiculous compared to the actual value of the violated obligation. Taking the Civil Code of French 1804 amended by the Ordinance No. 2016-131 as a reference, the parties can agree on the amount of a contractual penalty on a basis of freedom; however, the judge may moderate or increase the agreed penalty if such penalty is manifestly excessive or derisory.

Notwithstanding the above facts, we may resort to several regulations of the Civil Code to modify the amount of a contractual penalty that is too high compared to the value of the violated obligations. Specifically, one of the basic principles of civil law is that “Individuals and legal entities must establish, perform and terminate their civil rights and obligations with good will and honesty. The imposition of an amount of a contractual penalty that is manifestly and unreasonably higher than the value of the violated obligation clearly demonstrates a lack of goodwill to the civil transaction. Moreover, another basis principle is that “all commitments or agreements shall not violate a prohibition by law or is not contrary to social morals”. Where one party with higher status to the transaction imposes an unreasonably huge amount of a contractual penalty, this imposition may be deemed contrary to social morals. In conclusion, although the Civil Code of Vietnam does not put a limitation on the amount of a contractual penalty, the parties can cite and apply the basic principles of civil law to modify the agreed amount of a contractual penalty that is manifestly and unreasonably higher than the value of the violated obligation or the value of the contract.

b. Commercial Law 2005

Commercial Law 2005 (“Commercial Law”) has a narrow scope of application and shall only be applied to commercial relations and activities. In contrast to the Civil Code, the Commercial Law provides that the maximum amount of a contractual penalty to commercial contracts shall not exceed 8% of the value of the violated obligation.

Accordingly, the Commercial Law has put a limitation on the amount of a contractual penalty that the parties are permitted to agree to impose. However, the Commercial Law does not provide any guidance on how to determine the value of the violated obligation. In reality, there are many violated obligations that are very hard to or even impossible to determine or estimate by money. Therefore, the lack of regulations on such matter can cause inconsistency or disagreement between the parties on the value of the violated obligation and pose significant challenges to the jurisdiction due to the lack of grounds for the determination of the value of the violated obligation.

c. Law on Construction 2014

Similar to the Commercial Law, the Law on Construction 2014 (“Construction Law”) is a specialized statutory text and has a narrower scope of application compared to the Civil Code. With respect to the maximum amount of a contractual penalty, Article 146.2 of the Construction Law provides that the amount of a contractual penalty shall not exceed 12% of the value of the violated obligation. However, the said maximum amount shall only be applied to construction works using the state budget.

Not only does the Construction Law omit the determination of the value of the violated obligation, it also does not provide any guidance on the maximum amount of a contractual penalty applicable to commercial construction work not using the state budget. Consequently, where both parties to a transaction are commercial legal entities, it is unclear whether to apply the Civil Code or the Commercial Law to govern the amount of a contractual penalty. 

In conclusion, the maximum amount of a contractual penalty are substantially different between the Civil Code, the Construction Law and the Commercial Law. Although the Construction Law and the Commercial Law are to govern unique relations and prioritized to be applied when it comes to such relations rather than the Civil Code, the lack of regulations and guidance on the determination of the value of the violated obligation causes various difficulties for the parties to agree on impose an amount of a contractual penalty and poses a considerable challenge to the jurisdiction in determining the maximum amount.

2. Determining the amount of a contractual penalty according to the value of the violated obligation under the contract

At the present, the laws have not provided yet any regulation or guidance on determining the value of the violated obligation as well as handling the exceeding amount of the contractual penalty. Therefore, the determination of the value of the violated obligation shall belong to the scope of work of the parties, lawyers as well as jurisdiction. In fact, there are obligations that can easily be determined into money. For example, in the event of sales contracts, where the seller commits a breach of contract by being late in delivery on time as agreed, the determination of the value of the violated obligation can be determined based on the value of the goods being delivered late, thereby determining the maximum amount of a contractual penalty for such breach.

However, there are cases where the value of the violated obligations cannot be determined. Specifically, the obligations that cannot be determined into money are usually not the main obligations of the contract and relate to human labor, such as the obligation to promote and advertise under the hotel management service agreement. Therefore, the failure to determine the value of the violated obligation can cause the lack of basis for the jurisdiction to accept the amount of the contractual penalty being presented by the aggrieved party.

Therefore, the parties can agree on the value of each obligation under the agreement to ensure the basis for the contractual penalty without wasting time and effort to prove the value of the violated obligations to the jurisdiction.

Regarding the handling of the amount of the contractual penalty that exceeds the maximum limit by law, in principle, the lack of regulations can lead to 02 ways of interpretation and resolution as follows: (1) nullifying all the contents of the agreement on contractual penalty due to the violation of the permitted maximum amount of the contractual penalty; and (2) similar to the handling by the Civil Code of the exceeding interest rate, which is only nullifying the exceeding amount and accepting the maximum amount of a contractual penalty of exactly 8% of the value of the violated obligations in terms of the Commercial Law and 12% in terms of the Construction Law. In reality, the jurisdiction tends to embrace the second one when it comes to contractual penalties exceeding the maximum limit by law. In my perspective, this way of handling is completely reasonable and consistent with the general spirit of civil laws. This is also an updated point of the Civil Code 2015 compared to its former versions on how to handle the amount of the contractual penalty exceeding the maximum limit by law. This approach not only ensures the right and interests of the entitled party but also breathes an air of equality and fairness into civil transactions.

In conclusion, apart from the conditions applicable to the agreement on penalties for breach of contract as mentioned in the previous article, the amount of a contractual penalty shall be a noteworthy matter for the parties to a contract. The parties need to determine correctly the governing law for their relations and are well aware of the limitation on the amount of a contractual penalty mentioned hereof. Moreover, the parties should take into consideration cases of the conflict of laws between the regulations of laws mentioned in this article, especially for the sector of commercial construction works not using the state budget.