Penalties – Not The Football Kind

Now to some people in Romania penalties only relate to rugby or football.  But to a lawyer, they have a more significant role in contract law.

We have noted in the past the confusion regarding penalties not only in the minds of investors from the United Kingdom and the United States of America but also the minds of their lawyers as well. They need to understand the question and use of penalties in Romania rather than the role of liquidated damages which they are used to.

What is the difference between penalties and liquidated damages? What is the reason for penalties in a contract and where do liquidated damages fit in, in the Romanian legal landscape?

In all contracts, there has to be inserted provision to enforce the obligation of the parties and enable one of the parties who is not in breach to enforce the obligations of the other party. This can be by way of obtaining from the court an order requiring the party in breach to observe the terms of the contract and/or in addition for the party not in breach to recover the monetary losses that he has suffered. The obligation to pay monetary compensation will in many cases focus the minds of the parties during the negotiations and afterwards it will focus the mind of the party in breach.

The two legal systems most prevalent in the world, the Civil law (Code system) and the Common law system approach the problem of penalties and liquidated damages from two different positions.

As we have discussed before in Romanian law which is a Code Law System it requires in many cases certainty. Certainty of action, delivery and completion, and also an assessment of damages for a breach of any provision of the contract. The use of penalties under the Civil law system enables the parties to clearly ascertain their position with respect to a monetary indemnity if the other party is in breach of contract.

A penalty is what it says it is. It is a penalty for breaching the term of the contract and is an ascertained sum of money which has to be paid for the breach. There is no requirement to prove loss or damage only that there is a breach of the contract. The payment has to be made and the amount is already pre-determined. The intention is to focus the minds of the parties at all times on what it will cost them if there is a breach of contract as well as enabling the amount of any compensation to be paid to be clearly ascertained. There is, therefore, certainty under the terms of the contract. The amount of the penalties is fixed by the parties and may relate to actual or foreseen losses, or may just be a figure agreed upon by the parties to “focus the mind”.

For investors from the United Kingdom or the USA, the use of the definition or term penalties have a significant meaning, especially under contract law. On a breach of contract under the common law, damages are usually assessed on the basis of the loss actually suffered by the party, not in breach of contract. These liquidated damages have to be proved to the court by the claimant and are actual losses suffered rather than an estimate of what losses the plaintiff could have suffered or in some cases an agreed amount for a breach.

Under the common law, penalties are in the main illegal and unenforceable. This means that any clause in a contract written under a common law system which requires the payments of penalties is unenforceable. In any transaction in Romania, this should be explained so that the parties understand their respective positions. There is nothing in the common law system that prevents damages being assessed at an agreed rate; it is the requirement for them to be paid as penalties which creates the difficulties.

In any negotiation in Romania, it is important that the Romanian lawyers explain the position and the parties understand the differences in the two legal systems and the impact it will have on them. This reflects also on the choice of law of any contract. Foreign investors need to understand their possible liabilities and risks as well as exposure. In the past, as an international law firm in Romania, we have had to explain to foreign investors in Romania from the United Kingdom and the United States of America, that they have to pay the penalties even though the other party has not suffered any loss. This is not how they see the position in many cases. The insertion of a penalty clause is normal in a Code law based contract and the amount of penalties does not change depending on the type of breach.

In any contract negotiations, the parties must understand the difference between penalties and liquidated damages and this may influence the choice of law of the contract as mentioned above. Provided the foreign investor understand their liabilities and risks involved then the choice of law may become less of an issue. It is important though that both parties understand the risks that they are assuming. It is for this reason that any foreign investor from a non-Code country needs to be fully appraised of the issues that can arrive out of penalties and properly advised. A risk understood now will in our view limit the possibility of litigation in the future.

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