Liquidated damages and penalty clauses
(Правовое руководство по составлению строительных контрактов)
Liquidated damages clauses and penalty clauses provide that, upon a failure of performance by one party, the aggrieved party is entitled to an agreed sum of money from the party failing to perform. In works contracts, these clauses are usually included in respect of failures of performance by the contractor (paragraph 1).
The clauses have certain advantages. Since the agreed sum is recoverable without the need to prove that losses have been suffered, the expenses and uncertainty associated with the proof of losses are removed (paragraph 2). The sum may also serve as the limit to the liability of the contractor, who will be assisted by knowing the maximum liability to which he is likely to be exposed (paragraph 3).
Many legal systems have rules, which are sometimes mandatory, regulating liquidated damages clauses and penalty clauses. Under some legal systems, only clauses under which the agreed sum serves as compensation are valid. Under other legal systems, clauses under which the agreed sum serves as compensation, or is intended to stimulate performance, or has both those functions, are valid (paragraph 5). The parties may wish to provide that if the failure to perform is caused by an exempting impediment, the agreed sum is not due (paragraph 6).
The law applicable to the contract often regulates the relationship between recovery of the agreed sum and enforcement of the performance of obligations. That law also often regulates the relationship between the recovery of the agreed sum and the recovery of damages. The parties may, however, be permitted by the applicable law to regulate these relationships to some extent, and the parties may wish to do so to the extent permitted by the applicable law (paragraphs 7 and 8).
It is in the interests of both parties to delimit clearly the failure to perform upon which the agreed sum is payable (paragraph 9). In quantifying the agreed sum, if the applicable law so permits, the purchaser may find it beneficial to provide for an agreed sum in an amount which both provides reasonable compensation to the purchaser and puts a moderate pressure on the contractor to perform. Excessive sums should be avoided; under many legal systems those sums would be set aside or reduced (paragraphs 10 and 11).
The agreed sum to be paid is often fixed by way of increments, and a limit may be placed on the amount to which the increments can escalate. A limit may have advantages and disadvantages to the purchaser (paragraph 12). The parties may wish to consider whether the limit is to apply in all cases (paragraph 13), and the remedies which the purchaser might have after the limit is reached (paragraph 14).
In order to facilitate recovery of the agreed sum, the contract may authorize the purchaser to deduct the agreed sum from funds of the contractor in the hands of the purchaser (paragraph 15). The contract may also provide for a guarantee to be given by a financial institution in respect of the agreed sum (paragraph 16).
When an agreed sum is stipulated for delay in performance, the date fixed for performance may become inapplicable in certain circumstances, and this may create difficulties in the operation of liquidated damages clauses and penalty clauses. The parties may wish to include in the contract a mechanism for determining a new date for performance, and provide that delay is to be measured by reference to the new date (paragraph 17).
The parties may wish to consider the circumstances in which the payment of an agreed sum is to be provided for delay by the contractor in completing a portion of the works. The quantification of the agreed sum will depend on those circumstances (paragraphs 18 and 19).
Where the payment of an agreed sum is stipulated by way of increments with a limit on the amount recoverable, the parties should determine the availability of the remedies of termination, damages and the recovery of the agreed sum, and also the relationships between those remedies (paragraph 21).