LIQUIDATED DAMAGES under Vietnamese and International Law |

LIQUIDATED DAMAGES under Vietnamese and International Law

A liquidated damages clause is a commonly used remedy in commercial contracts to deal with a breach of contract and to allocate risks according to the parties’ commercial intentions. Accordingly, a specific, agreed amount of compensation may be received by one party for damages caused by the other party’s breach of contract.

A liquidated damages clause is widely used in both common law and civil law jurisdictions around the world and in international treaties such as the UNIDROIT Principles of International Commercial Contracts (PICC), the United Nations Convention on Contracts for the International Sale of Goods 1980 (CISG).

2.1. Benefits of the liquidated damages clause

This remedy is widely applied in commercial contracts, because it provides specific benefits in terms of dispute resolution in the event of contractual breach.

When a party breaches the contract, in many cases it is very difficult for the aggrieved party to enumerate and prove all the losses it has suffered, especially for reduction in revenue, profit, expected future profit, but for the breach, damages to intangible assets such as intellectual property rights, goodwill, reputation, trade secrets;

The aggrieved party may waste a significant amount of time and effort in gathering evidence for the losses. Expenses such as counsel’s fees may be excluded by the court;

As a result, in a commercial contract, the parties usually agree upon the liquidated damages as a fixed amount, as a specific percentage of the contract value, or by a formula with agreed variables to provide the parties with an easy and quick damages calculation mechanism.

Therefore, a liquidated damages clause, contributes to strengthening and promoting free trade in the market, as well as attracting foreign investment to Vietnam. However, a liquidated damages clause is not a perfect mechanism as it also has certain shortcomings.

2.2. Disadvantages of the liquidated damages clause

Unfair bargaining and illegal profiteering

Even though a contract is a voluntary agreement between the parties based on the party autonomy principle, in many cases, a party may abuse its stronger market position, financial strength, commercial advantage, etc. to offer unfavorable terms to the other party. As a result, even a minor infringement can enable a liquidated damages clause and the breaching party may be subject to pay high compensation amount which may be several times larger than the contract value.

The weaker or disadvantaged party, due to a lack of legal knowledge, failure to carefully read the terms of the contract, or just because of its difficult circumstances and position, signs the contract containing an unfavorable liquidated damages clause. These are situations which need legal intervention.

“Circumventing” the regulations on contract penalty

Vietnamese law limits the penalty rate for a contract.
(a) For example, according to Article 301 of the Commercial Law 2005, “the penalty rate for a breach of a contractual obligation or the aggregate penalty rate for more than one breach shall be agreed upon by the Parties, but not exceed 8% of the value of the breached contractual obligation”; or,

(b) according to Article 266.1 of the Commercial Law 2005, “Traders that provide inspection services must pay penalty to clients if their inspection certificates are inaccurate as a result of their accidental errors. The parties may seek agreement upon the amount of penalty but not exceeding 10 times of the assessment service charge”;

(c) Similarly, according to Article 146.2 of the Law on Construction 2014, “for construction works using state capital, the penalty for a breach of contract shall not exceed 12% of the value of the breached contractual obligation”;

The penalty clause is set out as a deterrent purpose. Meanwhile, a compensation clause aims to compensate for loss and to restore the damage which has occurred. Presumably, the legislators decided to limit the penalty rate in order to prevent the above-mentioned abuse by unfair negotiation and illegitimate profiteering;
However, in practice, the distinction between a penalty clause and a liquidated damages clause is unclear and blurred. They are both (i) pre-breach agreements, (ii) only applicable for breach of contract, and (iii) the breaching party is required to pay the aggrieved party a fixed amount of compensation regardless of the actual damage occurred;
In many commercial contracts, the drafting party can certainly circumvent the limitation of a penalty clause by applying a liquidated damages clause. As a result, the regulations on the limit of penalty rate are rendered useless.
Current Vietnamese laws, including both legislation and precedents, do not provide a clear and proper concept of liquidated damages.

Civil transactions: Article 360 of Civil Code 2015 stipulates that In case there is damage caused by breach of contractual obligation, the obligor must compensate for all damage, unless otherwise agreed or otherwise provided by law. Thus, in civil transactions, the liquidated damages clause is legal.

Commercial transactions: Article 302 of the Commercial Law stipulates that “The value of damages covers the value of the actual and direct loss suffered by the aggrieved party due to the breach of the breaching party and the direct profit which the aggrieved party would have earned if such breach had not been committed.” Accordingly, this provision shows that the aggrieved party is entitled to compensation and the amount of compensation can only be actual direct loss and direct profit that would have been gained; at the same time, the requesting party is obliged to prove the losses, the extent of the losses and direct profit.

Recent decisions of the Supreme People’s Court (SPC) show that the Supreme People’s Court does not accept the liquidated damages clause.

4.1. Decision on cassation review No. 15/2016/KDTM-GDT dated September 7, 2016 of the SPC (dispute between Technical and Service Joint Stock Company A and Company B)

According to the contract signed in 2007, Technical and Service Joint Stock Company A (“Company A”) provided the 3B bidding package “Electrical Services” for the project invested by Company H, Company B was the main contractor. The contract value was about 5.1 million USD; the expected completion date of the project was in May 2008. In case of failure of the completion time, Company A must pay the investor for losses caused by this error, which is equivalent to 5% of the contract value;

Company A completed the project 288 days behind schedule; Company B made late payments which were not in line with the contract;

Among other requirements, Company A required Company B to pay the outstanding amount. Company B argued that Company A had violated the construction schedule, so it should be liable for the compensation amount equivalent to 5% of the contract value, this amount would be offset against the payment obligations of Company B;

The first instance court declined the claim of Company A on forcing Company B to pay the outstanding amount. The appellate court decided to uphold the first instance court’s judgment. Company A submitted an application to revoke the decision of the appellate court according to cassation procedure;

According to the cassation decision, the liquidated damages clause applied for the violation on schedule shall be recognized as a penalty clause under Vietnamese law. Accordingly, the penalty amount for violation shall be based on value of the breached obligation, not of the entire contract. According to Article 301 of Commercial Law 2005 on penalty, the penalty amount must not exceed 8% of the value of the breached contractual obligation. Thus, the penalty shall be 5% of the breached contractual obligation, not 5% of the entire contract value as agreed by the parties.

In other words, the SPC considered the liquidated damages clause as a penalty clause and therefore the penalty should not exceed 8% of the value of the breached contractual obligation.

4.2. Decision on appeal against cassation No. 11/2020/KN-KDTM dated June 9, 2020 of the SPC (dispute between Yen Sao Sai Gon Company Limited and Yen Viet Joint Stock Company).

According to the decision to appeal against cassation, the SPC identified that Yen Viet Joint Stock Company must compensate for Yen Sao Sai Gon Company Limited based on the compensation rate set forth in the contract according to the judgment of the first instance court and the cassation decision was not appropriate. Compensatory damages must be calculated based on actual and direct losses in accordance with the provisions of the Commercial Law 2005.

The two cases above indicate that the SPC declined the validity of the liquidated damages clause. A liquidated damages clause might be considered as penalty clause, or not a recognized commercial remedy under Vietnamese laws.

4.3. At the VIAC, the decision on applying the liquidated damages clause is a substantive matter and will depend on the substantive law applicable to the settlement of disputes.

If the applicable laws allow the agreement of a liquidated damages clause, the principles set forth in such laws shall be applied. In the event that the applicable law is Vietnamese law and the contract has a liquidated damages clause, this clause will not be applicable, as explained above. The Commercial Law 2005 – the law governing commercial disputes – does not provide any provision on liquidated damages. Therefore, the arbitral tribunal can only issue an award requiring the aggrieved party to prove its actual losses and the violating party shall compensate accordingly.

It is difficult to explain why the Civil Code 2015 allows the parties to agree on an unlimited amount of compensation for damages and contractual penalties, but the Commercial Law 2005 sets out a limitation on the compensation for damages and penalties in case of violation. Perhaps it is time to amend the Commercial Law 2005 with provisions on compensation for damages and penalties so that the law is consistent with the Civil Code 2015 and international treaties that Vietnam has entered into.

It is justifiable to be concerned about the inadequacies of the liquidated damages clause. In such a case, lawmakers may refer to the approach of the legal system of some of the developed countries in the world. For example, under Articles 2-718(1) of the United States’ Uniform Commercial Code (UCC), the estimated damages settlement may be admissible if (i) the amount of compensation agreed upon by the parties is reasonably close to actual damage, (ii) it is difficult to prove the loss, or the application of other remedies is inconvenient or impracticable in practice, and (iii) a liquidated damages clause with high but unrealistic compensation amount will be regarded as a penalty and become invalid.

Thus, the problem in the current legal practice of Vietnam is that there needs to be a more appropriate and harmonized approach between (i) the principle of the parties’ freedom and voluntary agreement to promote the positive aspects of the liquidated damages clause, and (ii) a necessary limitation to restrict the shortcomings of the liquidated damages clause. The UCC approach is a very good example to refer to and learn from.


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