Penalties for breach of contract, what is a legal penalty agreement?

Parties commonly use the contractual penalty as an indispensable part to secure the performance of obligations under a contract. However, not everyone understands regulations on penalty levels for breach of contract. Through this article, BLawyers Vietnam will introduce notable points as to the penalty agreement.

penalty contract

1. Conditions to impose contractual penalties

According to the prevailing Civil Code and Commercial Law, three important conditions must be satisfied to impose the contractual penalties.

  1. Firstly, contracting parties must have an agreement on the penalties. If there is no agreement on penalties, the aggrieved party is not allowed to impose the penalties even though the breaches of contract occur.
  2. Secondly, the breach must exist and be a condition to impose penalties as agreed upon. Thus, not all breaches result in the imposition of penalties. Only those specified in the penalty agreement may result in such imposition.
  3. The breach must not fall into cases of exemption from liability under the laws.

Read more our series of contract laws:

Conflict of laws regarding contracts pursuant to Vietnamese laws and 4 conflict resolution principles

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How to determine overdue payment interest, fine for breaching contract and compensation in commercial relation under Judicial Precedent No. 09/2016/AL?

2. Limitations on levels of contractual penalties

The Civil Code 2015 provides: “The penalty levels shall be agreed among the parties, unless otherwise prescribed by relevant laws”. Thus, in principle, there is no limitation on levels of penalties. Contracting parties are free to agree on the penalty levels unless otherwise prescribed by specialized law.

Currently, only the Commercial Law and the Construction Law impose the limitation on contractual penalty levels. The Commercial Law 2005 regulates the maximum penalty levels for commercial contracts is 8% of the value of the breached contractual obligation, except for cases of incorrect assessments caused by unintentional faults. Specifically, the penalty level must not exceed ten times the assessment service charge.

Regarding Construction Law 2014, the maximum penalty level for works using public investment funds, non-public investment state funds is 12% of the value of the breached contract.

It is essential to have a clear distinction between “the value of the contract” and “the value of the breached contractual obligation” to impose penalties legally.

An illustration of the difference between such concepts is as follows:

On 01 January 2021, company A entered into a contract for the purchase and sale of goods with company B under Commercial Law 2005. Accordingly, after the receipt of goods, company B had an obligation to make a payment to company A with the total amount of 3 billion VND. On 01 May 2021, company B received goods in full as agreed but only paid 2 billion VND to company A. Thus, the value of the contract, in this case, is 3 billion VND but the value of the breached contractual obligation is only 1 billion VND – equivalent to the amount which has not been paid by company B.

However, it is not always easy to identify the breached contractual obligation, e.g., violations of the obligation to provide documents or obligation to hand over assets. Such obligations cannot be valued in money, so it is hard to identify the value of the breached contractual obligation.

3. Legal consequences in case of the penalty agreement exceeding the capped amount

The prevailing law does not have any regulations as to the way to resolve in case contracting parties agree on penalty levels exceeding the maximum prescribed by law. However, based on the practice of adjudicating commercial contracts, the Court normally settles the case by reducing penalty levels to 8% to be in accordance with the Commercial Law.

Thus, the penalty agreement is still valid and contracting parties are not subject to any sanctions, even if parties agree on the penalty higher than the capped amount. This leads to the fact that contracting parties just regulate the amount they want, disregarding the capped amount. Only when a dispute arises and parties come to the Court will they agree to adjust the penalty to the amount prescribed by laws.

In conclusion, the penalty is a common punishment used in contractual relations. Contracting parties should apprehend the law to reach an agreement on a penalty legally, which will help to mitigate future disputes.

Should you have any questions about the above contents, please revert to BLawyers Vietnam at consult@blawyersvn.com. We are more than happy to hear from you!

Date: 25 March 2022

Writers: Quang Nguyen & Thao Nguyen

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