The field of Estonian law of obligations is sufficiently wide and extensive. There are many different types of contracts, the rights arising from them, and the main and accessory obligations. The main obligations are inextricably linked to a particular type of contract. For example, in a contract of sale, the seller’s main obligation is to deliver a certain thing to the buyer and the buyer’s main obligation is to accept the thing.[1] In a contract for services, the contractor undertakes to achieve a certain result and the customer undertakes to pay an agreed fee for this.[2] The basic obligations derive directly from the legal rules governing a particular type of contract. When a contract is concluded, the parties may agree on the manner, time, etc., in which the main obligations are to be performed, or they may negotiate that certain main obligations do not arise at all (unless the law expressly prohibits this). However, if the contract is concluded in the form prescribed by law, all the obligations prescribed by law are binding on the parties.
However, accessory obligations are not linked to a specific type of contract. An accessory obligation exists only if the parties have agreed to it at the time of the conclusion of the contract. The most common accessory obligation is definetely the contractual penalty. A contractual penalty is an obligation which is prescribed in the contract and under which the party which fails to perform the contract undertakes to pay an amount of money determined by the contract to the injured party.[3] A contractual penalty clause is often found in contract for services, authorisation agreement, lease contract and loan or credit agreements. For example, if a building ordered is not completed on time – the rightful party can claim penalty from the builders; if an IT system breaks down and the bank suffers damages – the bank can claim penalty from the company responsible for the functioning of the IT system; if a lessee breaks a dining table in a rented apartment – the lessor can claim penalty from the lessee; if a recipient of the loan fails to repay the credit on time – the lender can claim penalty from the recipient of the loan.
The Law of Obligations Act, which provides for the institution of a contractual penalty, allows for two alternative ways of agreeing on a contractual penalty. First, the parties may agree that the contractual penalty may be claimed together with the performance of the main obligation breached. In such a case, the contractual penalty will play the role of a coercive measure – i.e. the obligated party will have to perform its obligation properly (i.e. at the right time, in the right place, in the right way). If the obligated party fails to perform the obligation properly, the creditor may claim performance of the obligation (e.g. reworking of the work) plus a contractual penalty. In such a case, the obligated party must bring the work into conformity with the terms of the contract at his own expense and, in addition, pay the contractual penalty. Since all parties in a contractual relationship seek to maximise their revenues and minimise their costs, in theory a penalty agreement will ensure that the obligated party performs its obligations promptly but also properly.
Alternatively, the parties may negotiate that a contractual penalty may only be claimed in lieu of the proper performance of the main obligation breached. In such a case, the agreement on penalty starts to play a substitutive role. In other words, the obligated party must perform the main obligation, but in case of non-performance must pay the contractual penalty. However, in such a case, the rightful party loses the right to require performance of the obligation breached so that the result is in conformity with the terms of the contract. A comparison of the two alternatives described above may lead to the perception that the first alternative is always preferable to the second. The rightful party may claim performance of the obligation at the expense of the obligated party and also a contractual penalty. However, as always, each situation is unique and it is therefore necessary to assess the appropriateness of applying alternative 1 or 2 depending on the objectives of the rightful party.
For example, a company that needs object A to be built by a certain date is a rightful party. If, for whatever reason, object A is not completed by that specified time, the rightful party needs object B to be built. In order to build object A, the rughtful party engages a construction company, which agrees to build object A by the agreed time and in accordance with all the terms of the contract and the building regulations. In a construction contract, the usual practice is to agree a penalty clause (if the construction is not completed by the agreed time, the rightful party will continue to demand completion construction and, in addition, the payment of the penalty). In the present case, the rightful party could also include in the contract that if object A is not completed within the agreed time, the construction company must pay the penalty and complete the construction or only pay the penalty. However, this is not in the interest of the rightful party – if object A is not completed by the specified time, the rightful party no longer needs it and object B must be built insted. An agreement on a normal (monetary) penalty does not allow the rightful party to achieve the above objectives. The amount of the penalty must be high enough to cover the construction of object B, but it is difficult to foresee its cost. In addition, if object A is not built, the rightful party has to go through the process of signing the construction contract from the beginning – looking for a new construction company, signing a new construction contract, etc. It is precisely in such a situation that the fact that a contractual penalty may also consist in the commission of a certain act may help.[4] In such a case, the rightful party may agree with the construction company that the construction company must complete object A within a specified time and, if it is not completed, the construction company must instead construct object B as a contractual penalty.
However, a breach of a main obligation does not always give a right to claim a contractual penalty. In the event of a breach of a main obligation by the obligated party due to force majeure, the entitled party will not be able to claim penalty. In the Estonian legal system, force majeure are circumstances which are beyond the control of the obligor and which, at the time the contract was entered into or the noncontractual obligation arose, the obligor could not reasonably have been expected to take into account, avoid or overcome the impediment or the consequences thereof which the obligor could not reasonably have been expected to overcome.[5] However, the definition of force majeure in practice is realy narrow – as a rule, only war, a technogenic or natural disaster and a sudden economic downturn are considered to be force majeure. For example, an increase in the price of building materials does not qualify as a force majeure because the situation in the construction sector is generally relatively unstable and companies accept the risks if they decide to deal with it. However, the parties may, by mutual agreement, modify the above principle and give the rightful party the right to claim penalty even if the breach of a main obligation is excusable.[6]
The Estonian legal system does not provide for the amount of the contractual penalty or the conditions for its determination. In other words, the parties may agree on the amount of the contractual penalty that they themselves consider appropriate in a particular situation. The amount of the penalty may be set in the contract as a fixed or variable amount. In the first case, the parties agree on the exact amount that the rightful party may claim from the obligated party in the event of a breach of a main obligation. The variable amount of the penalty will be set out in the contract as a percentage of either the value of the obligation(s) breached or the value of the whole contract. The amount of the penalty does not change on its own during the entire term of the contract and may only be increased or decreased by further agreement of the parties. However, it should be borne in mind that a financial contractual penalty is generally subject to penalty for late payment. In other words, if a contractual penalty is legitimately claimed from the obligated party but is not paid, the rightful party may also claim penalty for late payment on the contractual penalty. In the contract, however, the parties may agree whether and to what extent penalty for late payment will apply to the contractual penalty. In other words, the parties may set the amount of penalty for late payment which suits them, or they may limit themselves to the statutory amount.[7] However, the legislator has ensured effective protection of the rights of the obligated party against unreasonably high contractual penalties. In particular, the obligated party may request a reduction in the amount of the contractual penalty if it considers the contractual penalty to be unreasonable. The Estonian legal order does not provide for criteria of reasonableness of the amount of the contractual penalty, but it can be said that the amount of the contractual penalty exceeding the cost of the main obligation breached is unreasonably high.
One of the most important prerequisites for a claim for penalty is that the right to claim penalty must be exercised within a reasonable time after the discovery of the breach of a main obligation.[8] That is to say, the rightful party must inform the obligated party that it intends to penalty. Notification of the intention gives the obligated party the opportunity to remedy the breach of a fundamental obligation (redo the work, repair the damage, etc.). Once the intention has been notified, the rightful party may proceed to determine the exact amount of the contractual penalty. „Reasonable time“ is an undefined legal concept, i.e. a term which must be redefined each time in the light of the circumstances of the particular situation. In other words, 7 days may be a reasonable time in one case and 6 months may be a reasonable time in another. An unreasonably long period for the claim or notification of intention to claim contractual penalty would be contrary to the principle of good faith, as it would allow one party to influence the decisions of the other party and to manipulate the claim for a contractual penalty as a means of exerting economic pressure.[9] The Supreme Court had held that a reasonable period could be 3 months from the discovery of the breach of a main obligation until the claim for a contractual penalty, but had stressed that in certain cases 3 months could also be an unreasonably long period.[10] However, it can be stated with certainty that the notification of intention to claim penalty must be made as soon as possible after the discovery of the breach of a main obligation.
In conclusion, a contractual penalty is a fairly simple, but also very useful, accessory obligation that can be used with almost any type of contract. A penalty clause provides an opportunity to exert legitimate pressure on the other party of the contract, which is more likely to guarantee proper performance of the main obligations. At the same time, the institution of penalty is also very flexible – the parties can choose whether, in the event of a breach of a main obligation, they will claim the performance of a certain act, or whether they will claim the refraining from performing a certain act, or whether they will claim the penalty, which may be a fixed or variable amount. Despite all this, however, there are a number of serious pitfalls associated with contractual penalty, on which the success of the application of a contractual penalty directly depends.
[1] VÕS § 208 lg 1
[2] VÕS § 635 lg 1
[3] VÕS § 158 lg 1
[4] VÕS § 158 lg 2
[5] VÕS § 103 lg 2
[6] VÕS § 160
[7] VÕS § 113 lg 1 and VÕS § 94 lg 1
[8] VÕS § 159 lg 2
[9] VÕS. Kommenteeritud väljaanne. § 159. p 4.2.
[10] RKTKo 3-2-1-28-08, p 13