Contractual penalties in international contracts

It is observed in trading practice that B2B contracts in the international trade include provisions for imposing a contractual penalty for failing to perform or improperly performing an obligation far less frequently than in the domestic trade.

Contractual penalties in international contracts – is it worth introducing them to the contract?

A contractual penalty is a form of lump sum compensation that the other party is obliged to pay in case of circumstances specified in the contract. Most often, they refer to non-performance or improper performance of an obligation under the contract, including delays in the performance of the subject or its individual stages (so-called milestones).

The content of the concluded contract, as well as the law applicable to it, are of primary importance for determining the effects of stipulating a contractual penalty and its consequences for the parties.

It should be remembered that the source of the contractual penalty is the contract between the parties, and not the provisions of laws or other legal acts. If the parties do not agree that in case of certain circumstances they are obliged to pay a contractual penalty, it should be assumed that there is no such penalty, because the parties did not stipulate it.

The main purpose of introducing a contractual penalty to the contract is to secure the effects of non-performance or improper performance of the obligation. In this way, the parties immediately agree in the contract that binds them that in case of such occurrence, the other of them will be obliged to pay a certain amount. In this situation, the party to whom the contractual penalty has been stipulated does not have to prove why it is demanding such and not another amount resulting, for example, from a delay in the performance of the subject of the contract. The contractual penalty is therefore intended to simplify the damages repairs.

Provisions regarding contractual penalties are included in international contracts many times also to mobilize the other party to efficiently and correctly perform its subject, in order to avoid financial consequences agreed by the parties.

The amount of the contractual penalty may be specified in the amount or percentage form (e.g. 1% of the remuneration agreed between the parties).

It should be noted that the law applicable to the contract may provide various types of requirements for determining the amount of contractual penalties, including, for example, the upper limit.

Popular provisions specifying contractual penalties in international contracts include, for example:

• CAP – a provision specifying the maximum amount of contractual penalties that may be jointly imposed on a party to the contract.
• NO HARM NO FAUL – provisions of this type refer to situations in which, although there has been a breach of contract, which in principle would entitle a given party to claim a contractual penalty, however, due to the fact that no damage has occurred on the part of the contractor, this penalty will not be imposed.
• Provisions for claiming supplementary damages if the damage suffered by a party exceeds the amount of the stipulated contractual penalty.

What should be remembered while constructing provisions on contractual penalties is that these penalties secure non-performance or incorrect performance of a non-pecuniary obligation, i.e. resulting from a delay in the performance of the contract.

In cases where there is a delay in meeting a monetary obligation such as paying the price or agreed remuneration, interest is used to ensure that the payment is made in a timely manner. However, stipulating a contractual penalty in case of non-payment of the contractual remuneration is not valid as interest serves this purpose.

Making this decision depends on a large extent on the specificity of the contract concluded between the parties, the type of business relation and the possible negative consequences that may be associated with a breach by one of the parties. The answer to this question may therefore be different for different contracts.

Contractual penalties are a useful provision in international contracts that incentivize the other party to complete the contracted project or subject within the agreed-upon timeframe. In practice, even when such provisions are included in the contract, parties often do not enforce them, preferring to reach their intended cooperation outcome even if there is some delay. However, it happens when there is no alternative but to refer to the contract and claim the reserved contractual penalties. At such times, the inclusion of such provisions in the contract becomes crucial.

Joanna Lubecka
attorney