A contractual penalty in public procurement is not damages | In Principle

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A contractual penalty in public procurement is not damages

The Public Procurement Law of 11 September 2019 improperly implements the exclusion ground for improper performance of a former contract, as it ignores the specifics of the Polish public procurement market. This error can be corrected by a legislative change or by a pro-EU interpretation of the existing law.

Contract history as the basis for trust

Part of the public procurement process is eliminating contractors who do not have the capacity to guarantee proper performance of the contract. In this regard, based on the grounds for exclusion, the reliability of the contractor is examined to verify that it will perform the contract properly and legally. The rules are set out in detail in the Classic Procurement Directive (2014/24/EU), and national law cannot make fundamental changes in this regard. However, in implementing the directive, national law may frame the grounds for exclusion more clearly in order to minimise interpretative doubts when applying them, as the EU directive necessarily uses a certain universal language that will not always function effectively and harmoniously within the national legal system of a member state.

The ground in question concerns exclusion from participation in a procurement procedure of any contractor who “has shown significant or persistent deficiencies in the performance of a substantive requirement under a prior public contract, a prior contract with a contracting entity or a prior concession contract which led to early termination of that prior contract, damages or other comparable sanctions” (Art. 57(4)(g) of the Classic Directive).

This ground for exclusion is based on a fundamental element in the relationship between the contracting authority and the contractor, namely the reliability of the contractor, which is the basis for the trust placed in it by the contracting authority (Meca, C-41/18). Thus, contractors in whom the contracting authority has lost confidence due to improper performance of a previous contract may be excluded from access to a new contract (Delta, C-267/18).

How to understand “leading to damages”

The former Polish Public Procurement Law of 2004 implemented the ground for exclusion due to deficiencies in performance of a former contract in such a way that it was necessary for damages to be awarded against the contractor to the contracting authority (former Art. 24(5)(4)).

A contractual penalty, i.e. an amount of compensation due to the obligee in the event of non-performance or improper performance of an obligation by the obligor, determined at the time of conclusion of the contract, constitutes a surrogate for damages, in the sense that it compensates the obligee for the negative consequences resulting from breach of an obligation (Supreme Court of Poland resolution of 6 November 2003, case no. III CZP 61/03). Thus, there was no doubt that when a contractual penalty was awarded, it fell within the notion of awarding “damages.”

In this respect, Art. 109(1)(7) of the current Public Procurement Law basically employs the language of the Classic Directive, and states that for an exclusion ground to exist, the improper performance of the contract must “lead to damages.”

In the Polish legal tradition, in the process of interpreting the law, the principle of legalism and legal certainty gives priority to linguistic rules of interpretation (Supreme Court judgment of 20 June 2000, case no. I KZP 16/00). This results in the understanding of Art. 109(1)(7) of the Public Procurement Law being substantially expanded from the previous law.

As a result of the change in law, any exercise of the contracting authority’s power to demand that the contractor pay contractual penalties will be understood as “leading to damages” and could potentially constitute grounds for excluding such a contractor from access to future public contracts. This interpretation is also supported by the Public Procurement Office, which in a commentary to the provision indicates that in Art. 109(1)(7), the word “damages” (odszkodowanie) refers to “a broad category, including also surrogates for damages, including a contractual penalty under Art. 483 of the Civil Code, and charging a contractual penalty, even if disputed, or payment of a contractual penalty, meets the criteria for a ground for exclusion.”

From a civil-law point of view, it is difficult to argue with this interpretation of the Polish law. However, from the perspective of the Classic Directive, such an interpretation of Art. 109(1)(7) of the Polish act indicates inadequate implementation of EU law. This arises from the failure to consider a number of aspects that, in the reality of the Polish public procurement market, are associated with the application of contractual penalty provisions. As a result, in the process of investigating the contractor’s reliability, an inconspicuous legislative change acts as a barrier to accessing public contracts.

Contractual penalties and conduct inconsistent with material requirements of a prior contract

Arguments in support of this thesis are provided by the Public Procurement Office, which prepared a report in 2018 on the use of contractual penalties in public procurement. It is a source of statistical information on the practical functioning of contractual penalties in public procurement, including with regard to the reasons for and frequency of their imposition. The study included contracts entered into between January 2015 and October 2017.

The summary of the report first shows that the clause concerning a contractual penalty for non-performance or improper performance of the contract can be found in all or almost all public procurement contracts. Further, the report states that two out of three contracting authorities actually impose contractual penalties on contractors. This statistically indicates the enormous scale of a phenomenon that potentially justifies excluding contractors from accessing the public procurement market.

It should be mentioned that the report was based on only 61 responses from contracting authorities (out of 199 surveyed). This might lead one to question the reliability of the data obtained indicating that the frequency of contractual penalties to be imposed on contractors is high, were it not for the fact that one reason for failing to respond was that respondents would have had to report up to several thousand cases of contractual penalties they had imposed in just one year. Thus, it can be supposed that the results in the report are actually understated, as the high frequency of contractual penalties may have discouraged contracting authorities from completing the survey.

Relying on a statistical picture of contractual penalties in Polish public procurement, one cannot help but notice that an examination of the performance history of previous contracts in Poland will most often reveal that a contractual penalty has been imposed (this conclusion does not differ from the personal observations of participants in the procurement market, including the author). This circumstance alone calls into question the validity of excluding a contractor because a contractual penalty was previously assessed against it. It seems readily apparent that excluding contractors from public procurement on the basis of a phenomenon that commonly occurs in this market may lead to a distortion of competition.

Further, the report indicates that the irregularities for which contractual penalties were imposed most often had little or no impact on contract performance (80% of cases). Also, very often the contracting authorities did not pursue payment of contractual penalties in court if they did not obtain payment from the contractor, and voluntary payment of contractual penalties occurred in 40% of cases.

In the context of the Act on Liability for Breach of Public Finance Discipline, which obliges public officials to enforce receivables, the lack of compulsory enforcement of contractual penalties causes one to assume that the contractual penalties were imposed in circumstances in which no injury was suffered by the contracting authority.

This would not be surprising information. For many years, the jurisprudence and practice of public procurement in Poland have perpetuated the use of contractual penalties in isolation from their basic function, which is to compensate for injury suffered by the obligee due to non-performance or improper performance of the contract. In the rulings of the National Appeal Chamber, contractual penalties are treated as an element of protection of the public interest, a punitive measure, an incentive, security for proper performance of the contract, or an instrument for disciplining contractors. At the same time, contractual penalties are reserved in public procurement contracts in incidental amounts not based on estimates of the potential negative consequences of improper performance. It should also not be overlooked that in the decisions of the civil courts, a view prevails which also disregards the compensatory function of contractual penalties. According to this view, proving that the obligee did not suffer any injury at all does not release the obligor from the duty to pay a contractual penalty (e.g. legal principle adopted by the Supreme Court in case no. III CZP 61/03). Thus it can be seen that in many cases, imposition of contractual penalties does not necessarily mean that the interest of the contracting authority as an obligee has been injured at all, and that the contractual penalty has “led to damages.”

Also, it is worth pointing out that since a contractual penalty arises exclusively as a result of conclusion of a contract, the obligation to pay it constitutes an element of the contractor’s liability, a contingency that is fulfilled upon occurrence of certain circumstances (in the event of non-performance or improper performance of the contract). The civil law literature regards this as a case of changing the substance of the original obligation, as a consequence of non-performance by the obligor, into an obligation to pay a contractual penalty. In such a case, from the perspective of Art. 109(1)(7) of the Public Procurement Law, one should conclude that payment of the contractual penalty by the contractor brings the contractor’s behaviour into compliance with the contract. Only failure to pay the contractual penalty owed to the contracting authority could be the basis for finding the contractor unreliable and losing trust in the contractor.

This is also how the Classic Directive understands the basis for excluding a contractor from a contract. Indeed, recital 101 refers to conduct that shows “major deficiencies with regard to substantive requirements, for instance failure to deliver or perform, significant shortcomings of the product or service delivered, making it unusable for the intended purpose, or misbehaviour that casts serious doubts as to the reliability of the economic operator.” Therefore, the basis for excluding a contractor from the procurement should be an entirely exceptional situation in which the interest of the previous contracting authority as an obligee was not satisfied, as a consequence of which the contracting authority would seek damages.

As the data collected by the Public Procurement Office shows, assessment and payment of contractual penalties does not fall within such situations, and additionally, in principle, payment of the contractual penalty does not release the contractor from performance of the contract in its entirety (Civil Code Art. 483 §2).

Very practical consequences

This problem is not only theoretical. How we understand the term “leading to damages” has a major impact on how a contractor bidding for a public contract should complete the European Single Procurement Document (ESPD). When the contract documents provide for the exclusion ground from Art. 109(1)(7), the contractor is required to state in the ESPD the facts referred to in this provision, under pain of being deemed to have misled the contracting authority if it concealed them. According to some courts and commentators, the obligation to disclose these facts applies even if, as a result of their occurrence, the ground for exclusion does not arise at all (e.g. if the breach was not material). Therefore, as a precaution, contractors report extensively their history of contract performance in the ESPD whenever contractual penalties were assessed or paid, and contracting authorities are forced to analyse this data. All of this goes against the principle of proportionality, as the practice with respect to the imposition of contractual penalties in Polish public procurement shows that a contractor’s liability for a contractual penalty does not demonstrate that the contractor is unreliable.

The Public Procurement Law Association has made a sound proposal to amend Art. 109(1)(7) of the Public Procurement Law by restoring the wording of the exclusion ground from the former act. However, the president of the Public Procurement Office has announced that a review of the functioning of the new Public Procurement Law will not be held until after 2023. The market cannot wait that long. In this situation, the only solution is to argue for interpretation of Art. 109(1)(7) based on the principle of proportionality and the purposes this provision is designed to serve. Under this approach, assessment or payment of a contractual penalty in the course of performance of an earlier contract does not constitute a case of “leading to damages” and thus is not subject to disclosure in the ESPD.

Mirella Lechna-Marchewka, attorney-at-law, Infrastructure, Transport, Public Procurement & PPP practice, Wardyński & Partners