Contractual penalties and their limits

VÕS § 158 defines a contractual penalty as a sum fixed in the contract that the party in breach of the contract must pay. A contractual penalty is therefore a consequence of a breach: it is paid not because a deadline has passed, but because a party has breached the contract. Under subsection 3 of the same section, the provisions on contractual penalties also apply to an agreement by which the parties have fixed the amount of compensation for loss.

Two practical conclusions follow. First, the label does not help: if the contract calls a sum "agreed damages", the rules on contractual penalties still apply to it, including the possibility of reduction. Second, a claim for the penalty depends on the existence of a breach. If the reason for the delay is the client's own delay, for example a late decision or late material, the dispute starts with the question whether the töövõtja (the contractor) breached the contract at all. The consequences of client delay are covered in the article on delay caused by the client.

VÕS § 162 is headed "Reduction of contractual penalty" (unofficial translation), and its three subsections limit freedom of contract as regards the amount of the penalty.

The criteria are substantive, not mathematical. The Act gives no percentage or daily rate above which a penalty becomes unreasonable. The court looks at the extent to which the obligation was performed (whether the work was left unfinished or only slightly late), the other party's legitimate interest (what loss the client actually feared) and the parties' financial situation. A client who can show that the amount of the penalty matches its actual interest is in a stronger position in a dispute over reduction than one who picked a round figure.

This article does not recommend any daily rate or percentage, because no generally reasonable amount can be derived from published official sources. Each penalty must be calculated from the loss on the specific project.

A high contractual penalty looks like protection for the client, but it often works the other way round. There are three reasons, and all of them affect the final cost.

1. The penalty becomes a dispute. With an unreasonably high penalty, the contractor has a reason to seek a reduction in court. A client who has counted on the penalty in its cash flow has to wait for the dispute to end and bear its costs, and the outcome is uncertain.

2. The penalty finds its way into the prices. A bidder who sees a large penalty risk in the contract builds it into its tender price or contingency. The client then pays for the penalty risk even if the building is finished on time.

3. The penalty gets in the way of a sensible solution. When the penalty is high, a contractor running late has less interest in cooperating and more interest in looking for client delays that would rule the penalty out. The relationship on site turns into evidence gathering.

A proportionate penalty, by contrast, is easier to claim and harder to challenge. Its purpose is not to intimidate but to compensate the client's actual loss without the client having to prove that loss separately each time.

A contractual penalty clause is a tool for managing the final cost if it answers four questions. The questions follow the structure of a penalty clause: the breach, the amount, the cap and the link with damages.

1. Which breach? The penalty must be linked to a specific obligation: the completion date, an interim deadline, the deadline for remedying defects, the handover of documents. A general penalty for "breach of contract" is harder to justify than one linked to a specific obligation.

2. How much, and calculated from what? The sum should be derived from the client's actual loss: lost rental income, a lease that cannot begin, loan interest and additional charges, the cost of replacement premises, extra time for the client's own team, the cost of extending supervision. If this calculation is made and documented when the contract is drawn up, the client can show its legitimate interest in a dispute over reduction (§ 162(1)).

3. What is the cap? A cap, for example a fixed sum or a share of the contract price, makes the contractor's risk predictable and reduces the temptation to add it to the price. For the client, the cap is also a signal: if it is reached, the delay is probably so great that other steps must be considered, for example leaving the contract because of a fundamental breach.

4. How does the penalty relate to damages? The contract should state clearly whether the contractual penalty is the fixed compensation for the loss (§ 158(3)) or whether the client may also claim a loss greater than the penalty in addition to it, and how the two are set off against each other. If the contract does not answer this, the question is left to interpretation and dispute.

Penalties for interim deadlines need separate thought. Missing an interim deadline does not always cause the client a loss if the contractor catches up by the completion date. If the contract provides for penalties both for interim deadlines and for the completion date, it is worth stating whether interim penalties are later counted towards the completion penalty or refunded if the completion date is met. Without such a rule, the same delay can give rise to two penalties, which makes it harder to defend their reasonableness.

The following example is entirely fictitious and only shows the logic of the calculation, not a recommended rate. The client is building a commercial building whose premises have already been let from a fixed date. The contract price is €2,400,000. Before concluding the contract, the client calculates what each month of delay will cost it.

The client writes into the contract a penalty of €800 for each day by which the completion date is exceeded, with a cap equal to 60 days of loss, that is €48,000 (60 × €800), which is 2% of the contract price (48,000 / 2,400,000). The calculation, together with the terms of the leases and the loan agreement, is kept in the contract file.

If the contractor later seeks a reduction, the client can show its legitimate interest (§ 162(1)) with documents, not just with an assertion. The bidder, for its part, sees at the tender stage how large its maximum risk is, and does not have to add it to the price as an unknown. If the delay exceeds 60 days, the client has reason to ask whether this is still a delay or already a fundamental breach of contract, and to calculate the price of ending it.

A penalty presupposes that the breach is the contractor's. If the contractor is late because the client provided a decision, material or access later than agreed, a dispute over whether the contractor breached the contract is unavoidable. In addition, the contractor may itself claim compensation for the loss caused by the client's delay (VÕS § 652(1)).

That is why a contractual penalty goes hand in hand with a schedule of the client's decisions. If an annex to the contract states what the client provides and when, and the construction records show that it provided it on time, the basis for the penalty is clear. Without a schedule, the reason for every day of delay is open to argument.

The penalty is not the only answer to a long delay. If the client ends the contract because of the contractor's breach, the compensation rule for free termination does not apply (VÕS § 655(2)). If, however, it ends the contract without cause, the compensation under § 655(1) applies, and what happens to a penalty claim that has already arisen has to be assessed according to the wording of the contract. The financial comparison of the different bases is covered in the article on the client's right to terminate at any time.

The practical order is as follows: record the delay in writing as soon as the deadline passes; notify the contractor that the client intends to claim the penalty; calculate the penalty under the contract, up to the cap; as the cap approaches, consider the basis for ending the contract and its price. That way the client keeps a choice, not just a claim.

The contractual penalty is one of the contract terms the client can set out to bidders in advance, but it is not part of the price quotation. What the client can require regarding the content and form of a tender is covered in the budgeting guide's article on what a client can require. From the point of view of this article, what matters is that the penalty clause, the cap and the link to damages are written into the procurement documents before tenders are submitted. All bidders then price the same risk and the tenders remain comparable.