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Common Law Review - 12: Filip Balcerzak & Dariusz Gereta - “Make Them Bleed!”: Penalty Clauses and Liquidated Damages
Domù Èlánky Issue 8 - Contract Law 12: Filip Balcerzak & Dariusz Gereta - “Make Them Bleed!”: Penalty Clauses and Liquidated Damages
12: Filip Balcerzak & Dariusz Gereta - “Make Them Bleed!”: Penalty Clauses and Liquidated Damages
“Make Them Bleed!”
Penalty Clauses and Liquidated Damages in English and Polish Law
Filip Balcerzak & Dariusz Gereta
Assessment of damages can be a difficult process and the governing rules make references to concepts, such as “remoteness” in English Common Law, not entirely clear. This makes their application, to a large extent, unpredictable and leaves a great deal to the discretion of the presiding judge. As a result, the English common law and continental legal systems should, and indeed do, welcome solutions that offer measures designed to simplify them. One such measure is the liquidated damages clause, which will be discussed in this article by way of comparison between related features of English and Polish contract law.
2. Definition and function
Before comparing the institution of liquidated damages in English and Polish contract law, we must first explain the meaning given to liquidated damages in both legal systems. In English law, liquidated damages are defined as a sum of money payable by a party upon his breach of a contract, provided that their amount, or manner in which they were stipulated, does not make them penalty clauses. In fact, English case law makes a distinction between “liquidated damages clauses” and “penalty clauses.” The latter are clauses designed to punish the party in breach and are unenforceable. Several tests have developed, which enable judges to differentiate between “liquidated damages clauses” and “penalty clauses”.1
In Polish law, the definition of liquidated damages is provided by Article 483 § 1 of the Act of 23 April 1964 – Civil Code (hereinafter referred to as “the Civil Code”), which states that “[i]t may be stipulated in a contract that redress of damage resulting from non-performance or undue performance of a non-pecuniary obligation shall be effected by the payment of a specified sum (liquidated damages)”. The Polish Civil Code uses the term “kara umowna”, which literally translates as “contractual penalty”, whereas academic lawyers also use the term “odszkodowanie umowne”, whose literal translation is “liquidated damages”. However, unlike in English common law, these terms are used interchangeably and views arguing that they should be distinguished have been rare.2 Therefore, for the purpose of this article, whenever Polish contract law regulations relating to the subject in question are discussed, the expression “liquidated damages” will be used.
In order to describe the extent of the liability of the party in default under liquidated damages clauses, we must also consider the type of events which create that liability, which, as already indicated, is “a breach of contract” in English law and “non-performance or undue performance of obligations” in Polish law.
As to the former, according to a definition formulated by Professor Treitel,3 a breach of contract occurs “… when a party without lawful excuse fails or refuses to perform what is due from him under the contract or performs defectively or incapacitates himself from performing.”
Therefore, a factor limiting the obligor’s liability in cases of unsatisfactory or non-performance are events which constitute “lawful excuse” under English contract law. As for Polish law, since rules on liquidated damages are contained in Section II of the Civil Code entitled “Effects of non-performance of obligations”, it is considered that liquidated damages replace damages due under general principles and reference should be made to Articles 471-473 in that Section. These Articles state that the obligor is not liable for damage resulting from non-performance or undue performance of his obligation, if he has exercised due care, unless statutory law or a contract provide otherwise.4 It follows, therefore, that liquidated damages will only be due to the innocent party in the circumstances which make the other party liable for damages due under general principles.
However, it must be emphasised that in both systems of law – continental and common – the freedom of contract principle allows the contract itself to set liability. Under both systems, parties may also agree to liquidated damages clauses, different from the presumption, which become an alternative to “standard” damages, instead of their usual, conclusive character.5
A more detailed discussion on this subject is outside the scope of this article. It must be observed, however, that Polish contract law shows more readiness to relieve the obligor from his liability. For instance, the exercise of due care releases a person from his obligations in the event of a force majeure (vis maior), which is defined in Polish law.6 Under English law, there is no general definition for such an event. As a result, a party is required to foresee such circumstances and include them in a definition contained in a contract.
Another important aspect is that Polish law excludes non-pecuniary obligations from the domain of liquidated damages clauses,7 whilst English law allows them to be covered by such a clause, albeit with restrictions (described below).
In general, liquidated damages clauses can play two basic functions. As indicated in the introductory remarks, they can play a compensatory function, in which case their aim is to compensate the innocent party for his loss, resulting from the other party’s default, without the need to engage in the difficult process of assessing actual damage. They can also be punitive in nature and thus aimed at punishing a contractual party or preventing him from defaulting on his obligations. While the Polish contract law generally recognises the importance of both functions, the punitive function is not allowed under English law.8 In the subsequent paragraphs, we shall try to determine what sort of impact, if any, that different approach has on the situation of contractual parties in the English and Polish contract law.
The English law on liquidated damages developed primarily through case law, except for such clauses in consumer contracts, which are also regulated in the Unfair Terms in Consumer Contracts Regulations 1999. In contrast, the related Polish rules are derived entirely from statutory law, and specifically, the Civil Code, with the Supreme Court being able to influence interpretation to a certain degree. We will discuss in more detail the consequences of such a state of affairs below.
The most significant consequence of including a liquidated damages clause is that it precludes the innocent party from seeking damages exceeding the actual loss he has suffered. In English law, this rule was established in the case of Diestal v. Stevenson,9 whereas in Polish law it is specified in Article 484 § 1 of the Civil Code, which provides that “[t]he demand of damages exceeding the amount of the stipulated damages shall not be admissible, unless the parties decided otherwise.”
Both English and Polish contract law provide the courts with the power to modify the contents of a contract in respect of liquidated damages. As for Polish law, the relevant rules are contained in Article 484 § 2 of the Civil Code, which states that “If the obligation was performed in a considerable part, the party in breach may demand a reduction of the contractual penalty; the same shall apply where the contractual penalty is grossly excessive”. As already mentioned, English contract law distinguishes liquidated damages from penalty clauses. The objective of liquidated damages is a genuine attempt to pre-estimate the loss which could be caused by a breach of contract.
The test enabling the court to properly classify a particular contractual clause has been known at least since Kemble v. Farren.10 However, Dunlop Pneumatic Tyre Co Ltd v. New Garage & Motor Co Ltd gave the test its most comprehensive and frequently cited form.11 In his judgment in the case, Lord Dunedin held that penalty clauses are dealt with, if:
“the sum stipulated is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”, which is to be assessed taking into account the time when the contract was made, not when it was breached;
the breach involves failure to pay an amount of money and the sum stipulated exceeds the sum to be paid (as indicated above, Article 483 § 1 of the Civil Code (cited above) excludes “non-pecuniary obligations” from the application of rules relating to liquidated damages); and
the identical sum is to be paid upon one or more or several events, where the level of harm which could be caused by them is not the same, unless the loss for each breach is impossible or difficult to estimate in advance.
It must be observed that, in determining the allowable amount of liquidated damages, Lord Dunedin held that damages should be assessed by reference to the greatest possible loss, which could be suffered by the innocent party. On the other hand, the Polish Civil Code is silent on that, although it has been claimed that reference should be made to the actual loss rather than estimated loss.12 It is clear that the permissible level of liquidated damages under English law is higher than under Polish law, so in this respect, the former tends to be more favourable to the innocent party than the latter. On the other hand, if a clause is considered a penalty clause, then it is enforceable only to the extent of the actual loss sustained by the innocent party, whereas under the Civil Code, it will only be lowered and can still be higher than the actual damage (and even excessive, provided it is not grossly excessive). Therefore, it seems that, on the whole, the position of the parties is roughly the same under Polish and English law, shifting in one or the other direction as regards its particular aspects.
The wording of Article 483 § 1 of the Civil Code, which uses the term “redress of damage”, has provoked a debate among judges and academics on whether the innocent party must suffer any loss to be entitled to liquidated damages, in view of Article 484 § 1 of the Civil Code, which provides that the innocent party is entitled to the amount stipulated “ … regardless of the damage suffered”. Over the last forty years, the Polish Supreme Court has issued a number of contradictory rulings on the subject. However, in its recent decision dated 11.06.2003 the Court held that the party in default is not released from his obligation to pay liquidated damages merely because the other party has suffered no loss, and established this rule as a so-called “legal principle”.13 As opposed to judicial rulings in common law jurisdictions, decisions made by the Polish courts are only binding in a particular case, although certain decisions adopted by higher courts, most notably those of the Polish Supreme Court, may have persuasive authority. However, an aspect of the judicial powers of the Supreme Court bears a certain similarity to the doctrine of binding precedent. Namely, pursuant to Article 13 of the Supreme Court Act, the Supreme Court’s powers include “… passing resolutions for the purpose of explaining legal provisions which have produced doubts in practice or those whose application has caused inconsistencies as between judgements …”. Such resolutions may be passed by a bench of seven judges (as in the case of the above-cited decision), the whole Chamber, joint Chambers or the entire Supreme Court and enjoy the status of legal principles.14 Their significance is that they must be followed by the Supreme Court in deciding any future cases, although they may be departed from in a resolution passed by the Chamber, joint Chambers or the entire Supreme Court, depending on which bench originally passed the resolution.
In both systems, a different legal regime exists with respect to consumer contracts, which is provided for in Articles 385(1) – 385(3) of the Civil Code and in the Unfair Terms in Consumer Contracts Regulations 1999. The relevant provisions in both regulatory instruments were adopted to implement the European Community Directive on Unfair Terms in Consumer Contracts (93/13/EEC). In accordance with the above-mentioned Articles of the Civil Code, a term in a contract concluded between a consumer and a business entity will be deemed unfair, if:
(1) it has not been individually negotiated;
it specifies the consumer’s rights and obligations in a manner contrary to good customs and thus causes a gross detriment to his interests,
certain arrangements, regarding, for example, the nature of the goods and services, are such that they do not exclude unfairness; and
among other things, it imposes on a consumer who fails to perform his obligation, or avoids the contract, a duty to pay grossly excessive liquidated damages.
Conditions (1), (2) and (3) are basically identical in the Unfair Terms in Consumer Contracts Regulations 1999. Both regulations also provide that an unfair term is not binding on the consumer. However, regarding condition (4), Schedule II para 1(e) provides that a consumer who fails to fulfil his obligation must pay a disproportionately high sum in compensation, whereas its Polish counterpart is more complex (as indicated above). It should be noted that, whereas the effect of these regulations should not have a major impact on liquidated damages in English law, in Polish contract law the level of protection afforded under Articles 385(1) – 385(3) is greater than in the case of liquidated damages under Articles 483-484. First, it covers not only non-performance, including non-performance of pecuniary obligations, but also avoidance of a contract. Secondly, if found unfair, a liquidated damages clause is removed from the contract, instead of a reduction in the amount of liquidated damages, which would mean, pursuant to Article 484 § 2, that their amount could still be excessive, though not grossly excessive. In such a case, the seller or supplier may only seek damages in accordance with general principles.
Although there are visible differences between the way liquidated damages are regulated in Polish and English law, it appears that the overall balance of the parties’ freedom to determine their contractual relations and the protection against the excessive use of that freedom is basically the same in both legal systems.
Filip Balcerzak is a third-year law student at the Faculty of Law, Adam Mickiewicz University in Poznan, Poland.
Dariusz Gereta, M.A. is a fourth-year law student at the Faculty of Law, Administration and Economics of the University of Wroclaw. He also holds an M.A. in English Studies from the University of Wroclaw.
Abbott K.R., Pendlebury, N., Business Law, 6th ed., 1994
Gerard Bieniek (ed.), Komentarz do kodeksu cywilnego. Ksiêga trzecia. Zobowi¹zania. Tom 1, 6th ed., 2005
Czachórski W., Zobowi¹zania. Zarys wyk³adu, 9th ed., 2004
McKendrick, E., Contract Law, 5th ed., 2003
O’Sullivan, J. Hilliard, The Law of Contract, 2004
Pietrzykowski K., Kodeks cywilny. Komentarz. Tom I, 2nd ed., 1999
Radwañski, Z., Olejniczak A., Zobowi¹zania – czêœæ ogólna, 6th ed., 2005
1 See McKendrick, E., Contract Law, 5th ed., 2003, p. 441.
2 Supreme Court Decision dated 06.11.2003, III CZP 61/03, OSNC 2004/5/69, p.5
3 McKendrick, E., Contract Law, 5th ed., 2003, p. 393
The obligor shall be obliged to redress the damage resulting from non-performance or undue performance of his obligation, unless such non-performance or undue performance were due to circumstances for which the obligor is not liable.
If nothing else follows from a special provision of statutory law or an act in law (e.g. a contract – authors’ note), the obligor shall be liable for failure to exercise due care.
5 The Civil Code, article 484 §1
6 Zbigniew Radwañski, Adam Olejniczak, Zobowi¹zania – czêœæ ogólna, 6th ed., 2005, p. 82-83
7 The Civil Code, article 483 §1
See Supreme Court Decision dated 06.11.2003, III CZP 61/03, OSNC 2004/5/69, p. 3, see also See McKendrick, E., Contract Law, 5th ed., 2003, p. 441
9 [1906] 2 KB 345
10 [1829]
11 [1915] AC 79.
12 Radwañski, Z., Olejniczak A., Zobowi¹zania – czêœæ ogólna, 6th ed., 2005, p.325
13 Supreme Court resolution 6.11.2003 III CZP 61/03, OSNC 2004/5/69.
14 Article 16 § 1 of the Supreme Court Act.