It’s possible to defend effectively against contractual penalties | In Principle

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It’s possible to defend effectively against contractual penalties

This is the conclusion flowing from a non-final judgment issued by the Poznań Regional Court on 2 February 2017 in a case involving one of the largest infrastructure projects in Poland, completed in December 2016.

On the factual side, the case leading up to issuance of this judgment did not differ significantly from the typical disputes arising in large construction projects. The contractor accused the designer it hired of delays in providing the design, alleging that the delays were so great they threatened the success of the project. Ultimately, in December 2013 the contractor declared that it was renouncing the contract for reasons solely attributable to the designer, and charged the designer with various contractual penalties: for renunciation of the contract (PLN 12.8 million), for submission of designs behind schedule (PLN 22.02 million), and for late submission of monthly progress reports (PLN 16.38 million). Then the contractor set these penalties off against the designer’s fee, in effect refusing to pay the fee. The contractor also obtained an additional PLN 5.26 million by drawing on the bank guarantee provided by the designer.

Designer sues for fees

The designer did not agree with imposition of the contractual penalties and applied to the court for payment of its outstanding fee (PLN 14.28 million) and reimbursement of the amount drawn under the bank guarantee (PLN 5.26 million). Because the designer’s fee was not disputed by the contractor, the dispute boiled down to determining whether the contractor was owed the contractual penalties and in what amounts.

Two penalties not due at all

The regional court found that two of the three types of contractual penalties charged by the contractor were not owed at all. The penalties for delays in design (PLN 22.02 million) were assessed not on the basis of the schedule enclosed with the contract but on the basis of a schedule that was still open to agreement during the parties’ ongoing cooperation. The court thus found that no penalty could be imposed for failing to meet the schedule.

In turn, the court found that no contractual penalty was owed for renunciation of the contract because the contractor had not effectively renounced the contract—a condition for demanding payment of that penalty.

Third penalty cut

The regional court did accept in principle one of the penalties charged against the designer. It was set by the contractor at PLN 16.38 million (PLN 10,000 per day of delay in submission of monthly progress reports). The court found that there was a delay in submitting these reports, but the amount of the penalty charged was grossly inflated, and thus the court cut the amount to PLN 200,000, on the ground that the contractor had not suffered any loss from failure to receive the monthly reports on time. Consequently, the court issued a judgment in favour of the designer for its full fee, reduced only by the penalty of PLN 200,000, whereas the total penalties charged against the designer had amounted to PLN 51.2 million.

Worth defending against penalties

The judgment of the Poznań Regional Court (still subject to appeal) shows that in any case where one of the parties assesses contractual penalties, a defence can and should be mounted, and may prove highly effective. Such a defence can follow two steps.

First, the party charged with the contractual penalty can demonstrate that the grounds for imposing the penalty did not occur at all—as was the case here with renunciation of the contract and delay in performance. But if a penalty is shown to have a proper contractual basis, the party can seek relief under Civil Code Art. 484 §2, pursuant to which the debtor may demand mitigation of a contractual penalty if the obligation was performed to a significant degree or the penalty is grossly excessive.

Just a decade or so ago, the practice of mitigating contractual penalties was clearly an exception. But since it has been recognised that contractual penalties are sometimes abused by creditors as an easy way to enrich themselves at the debtor’s expense, the courts now decide to cut such penalties in more and more cases. This positive trend can help restore balance when contracts are drafted heavily in favour of one of the parties.

Dr Marcin Lemkowski, Litigation, Arbitration & Mediation practice, Wardyński & Partners