Limit on contractual penalties in public procurement – where to draw the line?

The concept of contractual penalties has earned thousands of studies, both academic and more popular ones. In this article, we do not want to repeat well-established views on the function and nature of such penalties themselves. We became interested in a judgment of the National Appeals Chamber of August 22, 2023, case files no. KIO 2327/23 (the “KIO Judgment”), in which the Chamber had to address an issue known only in the public procurement law, i.e. the value of the contractual penalty limit in the draft contract.

In this context, it is necessary to begin by quoting the provision of the Public Procurement Law Act (“PPLA”), on which our article is based:

Article 436 item 3) of the PPLA – “The contract shall contain provisions specifying, in particular, the total maximum amount of contractual penalties that may be sought by the parties.”

National Appeals Chamber, accusing the Contracting Authority of (among others) violating article 436 item 3 of the PPLA, in connection with article 3531 of the Civil Code Act [1](‘KC”)(the “Civil Code”), article 484 § 2 of the Civil Code [2] and article 483 of the Civil Code [3] w związku z art. 8 ust. 1 PZP[4] in connection with article 8 section 1 of the PPLA [4], through the Contracting Authority’s defective determination of the total value of contractual penalties.

The Contracting Authority included the following clause regarding the total amount of contractual penalties: “The total maximum value of contractual penalties which the Contracting Authority is entitled to impose will correspond to the net value of the Agreement, as specified in § 3 section 1.” The appellant noted that the Contracting Authority’s right regulated in this way may lead to unjust enrichment, and violates the principle of proportionality, as discussed in the article 16 of the PPLA. The appellant demanded that the total value of contractual penalties should be reduced to 20% of the agreement’s net value.

In its response to the appeal, the contracting authority disputed the allegation and pointed out that applicable laws did not determine what limit of contractual penalties was adequate. The introduction of such a single limit was considered in the course of legislative works but finally did not take place.[
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The contracting authority also stated that the adoption of a contractual penalties limit does not affect the balance of power between the parties; instead, it only introduces an upper limit for the contracting authority to seek compensation in an easier manner.

In the contracting authority’s opinion, setting a total limit on contractual penalties is intended to help the contractor estimate risks, and allows all contractors to submit a bid upon the same conditions.

In the KIO Judgment, the National Appeals Chamber upheld the appeal with regard to the aforesaid allegation, and requested the contracting authority to amend the provisions of the terms of reference by reducing the total maximum value of contractual penalties to a level that does not exceed 30% of the contractor’s gross fee.

The Chamber decided that “the maximum amount of contractual penalties cannot be set at a level that could be considered grossly excessive in relation to the amount of the fee or potential risks associated with non-performance or improper performance of the contract, including the possibility of the emergence of damage or its extent. Contractual penalties should be reasonably severe, but not to the point where it might seem futile to perform the agreement.”

It should be borne in mind that although the KIO Judgment has been widely commented and the has evoked hopes for a general change in the Chamber’s (and, ultimately, contracting authorities’) approach to the value of contractual penalties, the position of the National Appeals Chamber in the legal system means that the judgment may, unfortunately, be disregarded by contracting authorities, at least for as long as it is not followed by consistent judicial practice in this regard.

The National Appeals Chamber is not divided into levels, meaning that it is impossible to determine that a particular judgment is more important than others. And while it remains obvious that in the Polish legal system, as a general rule, the doctrine of legal precedent does not apply, the reference to judicial practice plays a substantial and irreplaceable role in the application of legal regulations. At the same time, with regard to the rulings of common courts of law, it is more than likely that we will approach a judgment of an appellate court with greater “respect” than one issued by a district court. On the other hand, when it comes to the judgments of the National Appeals Chamber, there is no priority rank because all these rulings are equal in theory. In practice, this means that in response to judgments such as the one discussed in this article and referred to by a potential contractor either before the National Appeals Chamber or when attempting to change the provisions of the contract at the tendering stage, contracting authorities can present a similar (or an even bigger) number of rulings confirming that the determination of the limit on contractual penalties is an autonomous decision of the contracting authority.

In our opinion, contracting authorities seem to overlook a certain solution that
successfully functions in commercial contracts, i.e. the possibility of dividing contractual penalties into categories and defining separate limits for them.

As a general rule, based on the common approach adopted in legal theory and judicial practice, a contractual penalty constitutes a substitute for compensation. However, it may be charged even if the party entitled to impose it has not suffered any actual damage. This is what the Supreme Court specified in its resolution of November 06, 2003 (case files no. III CZP 61/03): “If a contractual penalty is due for non-performance or improper performance of an obligation, the debtor will not be exempt from the obligation to pay it even if the creditor has not suffered any damage.” By giving this resolution the status of a legal principle, the Supreme Court emphasized that a contractual penalty may be charged whenever the relevant criteria have been met, irrespective of whether the other party has suffered any negative consequences.

Although contractual penalties may be applied regardless of whether the contracting authority has suffered damage or other negative consequences, the type and nature of the penalties most often included in agreements by contracting authorities indicate that they are divided based on the extent to which the contracting authority may be adversely affected by the emergence of the circumstances for which such penalties are due.
Thus, the contractual penalties used by contracting authorities can be divided into three basic categories:

• Penalties for culpable delay / non-culpable delay – the emergence of circumstances that serve as the basis to impose such penalties results in postponement of a given contract, which
  (in extreme cases) may lead to the loss of importance of that contract for the contracting authority’s (e.g. the construction of a Christmas installation in a market square, which will be delayed until March of the following year), the loss of financing (including EU funds), or incurring substantial costs (e.g. the need to maintain a temporary power line instead of launching the target one). Contractual penalties applicable in such circumstances are characterized by the fact that up to a certain critical point, they act as a tool for the contracting authority to “motivate” the contractor, while after that point, the penalty is intended to compensate the contracting authority for the damage incurred. In other words, the same penalty will accrue without damage up to a certain point, whereas afterwards the damage becomes real and measurable. Thus, it is common practice among contracting authorities to use clauses specifying that after exceeding a certain value of contractual penalties or after a given number of days of a delay, the contracting authority becomes entitled to rescind the contract. Such penalties are usually charged for the duration of the delay.
• Penalties for qualitative or quantitative deficiencies – the circumstances in which such penalties apply concern situations where the contracting authority receives an incomplete or defective object of the contract (but still wants to acquire it). These penalties are typically intended to compensate such deficiencies to the contracting authority.
• Administrative penalties – ones which apply in circumstances that usually do not result in any damage on part of the contracting authority, and do not have a major impact on the performance of the contract. Examples could include the lack of protective helmets at the construction site, failure to place the required marks/signs at the construction site, etc. It is worth noting that such penalties are usually charged as unit amounts.

Referring to article 436 item 3) of the PPLA, it should be noted that this provision in no way determines the structure or model for defining a limit on contractual penalties, other than the “total maximum amount of contractual penalties”. This means that contracting authorities can effectively adopt a mechanism for calculating contractual penalties, according to which a separate limit will apply to each category of contractual penalties (e.g. the three basic ones described above), and all sub-limits will be covered by a single aggregate limit.

This will make it possible to regulate contractual penalties in such a way that in the case of serious deficiencies (e.g. significant quality deficiencies or delayed milestones), the contracting authority will be able to make the most of the available penalty limit.

On the other hand, the emergence of minor deficiencies (e.g. a delay in providing employee records of a staff member) will not trigger any significant penalty.

The use of such a solution appears to be an effort to strike the right balance between the interests of contracting authorities and contractors. With the use of such a model, a contracting authority has the opportunity to indicate which areas of the contract are most important to it, whereas contractors can estimate and calculate contractual risks in a more detailed way.

We have a favorable opinion of the KIO Judgment, including with respect to its justification. It seems advisable to resume the discussion about the need to clarify article 436 of the PPLA. However, there are already solutions, which we tried to present in the final part of the article, and which, in our opinion, enable the structuring of a contractual relationship in such a manner that it will be compliant with PPLA and will at the same time reflect the actual interest of the contracting authority. The division of contractual penalties into categories depending on the nature of the deficiencies, and the identification of the areas of the contract scope, which are most important for the contracting authority, will most likely also contribute to the calculation of bids in a more effective manner.

We are awaiting further judgments of the National Appeals Chamber, hoping that they will be equally accurate.

1. Parties entering into a contract may arrange the legal relationship as they see fit, as long as its content or purpose do not contradict the properties (nature) of the relationship, applicable laws or the principles of social conduct.
2. If an obligation has been substantially performed, the debtor may seek a reduction of the contractual penalty; the same applies if the contractual penalty is grossly excessive
3. § 1. It may be stipulated in an agreement that compensation for damages resulting from non-performance or improper performance of a non-financial obligation will be made by payment of a specific amount (contractual penalty). § 2. Without the creditor’s consent, the debtor cannot exempt themselves from the obligation through payment of a contractual penalty.
4. The Civil Code Act of April 23, 1964 (Journal of Laws of 2022, items 1360, 2337 and 2339, and of 2023, item 326) shall apply to the actions taken by the contracting authority, contractors and contest participants in the public procurement procedure and the contest, as well as to agreements related to public procurement, unless the Act expressly provides otherwise.
5. Indeed, in the course of legislative works, there was a suggestion to adopt a limit of 20%. In our opinion, this solution was by all means adequate, and we are convinced that the lawmaker should consider introducing this limit directly into the PPLA.

The article, “Limit on contractual penalties in public procurement – where to draw the line?”, was published in ZAMAWIAJĄCY magazine. Feel invited to download the full article as a PDF file.