Author: Mr. Vo Quoc An | ALB & Partners Law Firm
Source: The Saigon Times – https://thesaigontimes.vn/phat-vi-pham-hop-dong-thuong-mai-thuc-tien-giai-quyet-tranh-chap/
(KTSG) – Penalty for breach is a measure to handle contractual breaches that is often agreed upon by the parties, especially in the commercial field. This article would like to clarify some important legal aspects of agreements on penalty for breach in commercial contracts, through the practice of dispute resolution in court and arbitration.
The Civil Code 2015, Commercial Law 2005 and specialized laws all have provisions on contractual penalties, however, some legal aspects of penalty agreements have not been specifically regulated, leading to many different explanations when a dispute arise.
Penalty levels for breach are determined by interest rate
- To identify the agreement
In many contracts, the parties agree that the penalty for breach is determined by a certain interest rate, calculated on the value of breached contractual portion and corresponding to the duration of breach. Specifically: [Penalty for breach] = [value of breached contractual portion] * [interest rate] * [duration of breach]. For example, the parties can agree: “In case Party A is late in paying for purchases to Party B, Party A must pay a penalty at the interest rate of 10%/year for the late payment, respectively with duration of late payment”.
In practice, the parties often dispute about: is this an agreement on penalties for breach or an agreement on interest due to late payment? Because if the agreement is a penalty for breach, Party B has the right to request Party A to pay both the penalty for breach and the interest; or if the agreement is on interest due to late payment, Party B only has the right to request Party A to pay the interest without requesting on penalties, because there is no agreement on penalties for breach.
- Application in practice
According to the Commercial Law, penalty for breach means a remedy whereby the aggrieved party requests the breaching party to “pay an amount of fine” (Article 300) and the penalty level is “not exceed 8% of the value of the breached contractual obligation portion” (Article 301). This regulation leads to a viewpoint that fines for breach can be calculated in a specific amount of money or in proportion to the value of the contract (1). Thus, the penalty for breach is not determined by interest rate, therefore, the illustrative agreement mentioned above is determined to be an agreement on interest due to late payment.
In the practice of resolving disputes, both courts and arbitration councils tend to define an agreement on penalty for breach calculated based on interest as an agreement on penalty for breach, not an agreement on interest due to late payment.
Specifically, in a case on construction contract disputes, the court considered that the contract term with the following content: “In case company A is late in acceptance of final settlement or late in payment, the contract penalty level is 0.5% of the total unpaid value for each day of delay” is the agreement on penalty for breach. Because the application of interest rates to calculate fines for breach is consistent with the principle of “respecting contractual agreements and commitments during contract implementation, ensuring equality and cooperation” (clause 8, Article 146 of the Construction Law 2014)(2).
In another dispute, the contract sale of goods between the parties stipulates: “Party B’s overdue payment will be fined with interest for the overdue amount according to the list below: overdue payment from 61 days onwards, the penalty interest rate is 1.5%/month”. The arbitration council determined: “This is essentially an agreement on penalties for breach of contract”(3).
It is completely convincing that the court as well as the arbitration council considering the above agreements to be penalties for breach. Since the concepts used in the contract such as “contractual penalty”, “fined”, etc. show that the true will of the parties is to apply penalties for breach, not interest due to late payment. The interest rate agreed upon by the parties is the method to calculate fine for breach. We should not misunderstand that if there is an agreement on the interest rate, it is an agreement on interest due to late payment.
However, the fine for breach of contract must not exceed the maximum amount allowed by law, i.e. 8% of the value of the breached contractual obligation portion (for commercial contracts, Article 301 of the Commercial Law) or 12% of the value of the breached contractual portion (for construction contracts, Article 146 of the Construction Law). Therefore, even if the duration of breach is long and the interest-based fine exceeds the level allowed by law, the court and arbitration council will only accept the violated party’s request for the maximum fine in line with the regulations of the governed laws.
- To identify the part of the breached contractual obligation
The maximum penalty level for commercial contracts is “not exceed 8% of the value of the breached contractual portion”, but the Commercial Law and specialized laws do not explain or give the instructions on how to determine the value of breached contractual portion.
In practice, “the value of breached contractual obligation portion” is determined by the court as the difference between the value that the violating party should have performed and the value of the portion that was actually performed. For example, Company K and Company U entered into a contract sale of goods with a value of 1,890,000,000 VND. To perform the contract, K has delivered all the goods to U, but U has only paid K the amount of 623,700,000 VND. When a dispute arose, the court determined “the value of the breached contractual portion is [1,890,000,000 – 623,700,000 = 1,266,300,000 VND]”(4).
In another case about a construction contract disputes, the total value of the contract that the parties signed was 171,025,017,406 VND, but the defendant had only constructed a number of items with a value of 36,036,561,604 VND. Therefore, the court determined that the remaining value that the defendant had not yet performed was [171,025,017,406 – 36,036,561,604 = 134,988,455,802 VND as “the value of the breached contractual obligation”(5).
However, for construction contracts, there are also cases where the arbitration council determines the value of breached contractual portion to be equal to the entire value of the contract, because the contractor has not completed some project items and the contractor cannot put the entire project into use. “Therefore, we cannot separate the contract obligations into separate parts to consider the breached obligation portion… The defendant must be responsible for the entire unfinished project for the plaintiff. Therefore, the plaintiff’s request to fine for breach on the total value of the project has grounds for acceptance” (6).
- To reduce the agreed penalty level for breach
In practice, it is not uncommon for one party to breach the contract due partly to the other party’s fault. In this case, the Civil Code stipulates that the breaching party only be required to compensate for damages corresponding to the level of its fault (Article 363). However, both the Civil Code and the Commercial Law do not regulate the issue of reducing penalty level for breach and the cases in which the breaching party is entitled to a reduction in fines for breach.
Practice of disputes resolution shows that courts accept reductions in fines for breach, and the amount of fine reduction is decided on the level of fault of the parties. For example, in a case on dispute from a contract sale of goods, the plaintiff delivered the goods to the defendant many months late, but the defendant was also partly at fault for the plaintiff’s late delivery, such as not paying in full, not appointing personnel to accept and test the machine. Based on the finding that “the plaintiff is 70% at fault and the defendant is 30% at fault”, the court forced the defendant and the plaintiff to pay fines corresponding to the level of their fault (7).
In another case about a construction contract dispute, the parties agreed that in case the contractor was behind schedule, they would have to pay a fine of 12% of the value of the breached contractual portion. In fact, the contractor was behind schedule, but the client was also partly at fault for causing the landslide and the contractor must level the ground to compensate for the landslide volume, leading to a delay in progress. The court reduced the penalty level for the contractor from 12% to 8% of the value of the breached contractual portion (8).
The fact that the courts reduced partially the penalty level in these cases is quite convincing, although this solution has not been recorded in legal documents. Each party in a commercial relationship must exercise its rights and obligations in good faith (clause 3, Article 3 of the Civil Code) in order to create favorable conditions for the other party to fulfill its obligations under the contract. According to fairness, the aggrieved party does not have to pay fine for violations that are caused by the fault of the violated party.
(1) Institute of Legal Sciences (2009), Binh luan khoa hoc Bo luat Dan su 2005 (volume 2), National Political Publishing House, page 265;
(2) Judgment No. 18/2018/KDTM-PT of the People’s Court of Da Nang City;
(3) Vietnam International Arbitration Center (VIAC) (2019), Giai quyet tranh chap hop dong: nhung dieu doanh nhan can biet, Thanh Nien Publishing House, page 167;
(4) Judgment No. 08/2021/KDTM-PT of the People’s Court of Da Nang City;
(5) Judgment No. 296/2020/KDTM-PT of the People’s Court of Ho Chi Minh City;
(6) Arbitration Award in dispute No. 67/18 HCM of VIAC;
(7) Judgment No. 80/2017/KDTM-PT of the People’s Court of Hanoi City;
(8) Judgment No. 10/2018/KDTM-PT of the People’s Court of Ba Ria – Vung Tau province.