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Reproduced with permission of the authors and MEALEY'S International Arbitration Report, Vol. 21, No. 6 (June 2006) 1-5

Commentary

Penalty and Liquidated Damages Clauses in CISG Contracts Revisited

Dr. Florian Mohs [*] and Dr. Bruno Zeller [**]

[Introduction]
1.  Express Penalty and Liquidated Damages Clause Forms Part of the Contract
2.  The Question of Validity
3.  Effects of a Valid Penalty and Liquidated Damages Clause in Cases Where
     the Actual Loss Exceeds the Lump Sum
4.  Conclusion

[INTRODUCTION]

This article is another reply to the case note of Marcus S. Jacobs and Yanming Huang on a recent CIETAC award.[1] The CIETAC award concerned a contract for the international sale of commodities between a European seller and a Chinese buyer. The contract was governed by the CISG and included a "penalty" clause according to which the seller was to pay a fixed amount of damages in the event of failure to deliver. The seller so failed and the buyer claimed damages under Articles 75 "and/or" 76 CISG.

The authors of the initial case note did not display many facts but, under their view, the legal question was whether the parties, by including a penalty clause in their contract, impliedly opted out of the damages regime of the CISG by virtue of Article 6 of the Convention with the consequence that any increase of the agreed sum was to be determined according to Article 114 of the Chinese Contract Law [2] Law at the discretion of the arbitrators. This reply will again attempt to give an answer to this question.

1. EXPRESS PENALTY AND LIQUIDATED DAMAGES CLAUSE FORMS PART OF THE CONTRACT

The starting point for any analysis is the penalty and liquidated damages clause in the contract itself. There is nothing unusual in the fact that the parties to any sales contract are free to include an express provision for penalty and liquidated damages in the event of a breach of contract.[3] This is nothing more and no less than freedom of contract and party autonomy.

These principles are found in most legal systems and reinforced by the second -- substantive -- limb of Article 6 CISG which states that the parties may derogate from or vary the effect of any of the provisions of the Convention.

The question of whether the parties impliedly opted out of the Convention's damages regime to the effect that any domestic law applies is in itself misconceived. The reason for this is that the second -- substantive -- limb of Article 6 CISG only applies to the relationship [page 1] between (express and implied) contract terms and the default rules of the Convention but does not allow for any recourse to domestic law. The clause in the contract at hand can, admittedly, derogate from the damages regime of the CISG in full or vary specific damages provisions of the CISG. It cannot, however, render any domestic law applicable. In other words, the approach of Marcus S. Jacobs and Yanming Huang to this case unduly mixes the choice of law level (first limb) with the substantive law level (second limb) of Article 6 CISG by discussing the issue of an implicit opting-out.

In conclusion, by agreeing on a penalty and liquidated damages clause the parties modified the damages regime of the CISG. In exactly what way this modification comes into play is a question of contract interpretation and will be addressed below.

2. THE QUESTION OF VALIDITY

If the parties have included a penalty and liquidated damages clause in their contract the question of public policy arises whether such a clause is valid. That is the only question not addressed by the CISG but left to the applicable domestic law pursuant to Article 4(a) CISG which states that the Convention is not concerned with the validity of any of the provisions of the contract.[4]

Different jurisdictions hold polar views on the issue of the validity of penalty and liquidated damages clauses. In common law jurisdictions the distinction between penalty clauses, which are invalid, and liquidated damages clauses, which are valid, is of great practical importance.[5]

In civil law jurisdictions both liquidated damages clauses and penalty clauses are valid but the court or the arbitral tribunal may reduce the amount of money to be paid.[6] Despite technicalities in the details, the core rule according to which both the common law systems and the civil law systems distinguish between penalty clauses on the one hand and liquidated damages clauses on the other hand displays a common understanding: penalties are meant to deter a breach of contract whereas liquidated damages clauses pre-estimate future loss. Due to the fact that this distinction has proven difficult to be drawn in practice, modern systems, for example the Dutch law of obligations [7] or the UNIDROIT Principles of International Commercial Contracts,[8] treat penalty and liquidated damages clauses uniformly as being valid with the possibility of reduction.

In the present case, the penalty and liquidated damages clause was valid according to Article 114(1) of the Chinese Contract Law.[9]

In conclusion, penalty and liquidated damages clauses are enforceable under the Convention, unless, by virtue of Article 4(a) CISG, the applicable domestic law considers them invalid or provides for a reduction.[10]

3. EFFECTS OF A VALID PENALTY AND LIQUIDATED DAMAGES CLAUSE IN CASES WHERE THE ACTUAL LOSS EXCEEDS THE LUMP SUM

Given a valid penalty and liquidated damages clause difficult questions arise concerning the modification of the standard damages regime of the CISG. Before addressing these questions, the precise scope and function of the particular contract clause needs to be determined. This is a question of contract interpretation to which Articles 8 and 9 CISG apply.[11] Due to the fact that we do not know many facts of the actual case we assume different fact patterns to illustrate the interaction between the contract term and the default rules of the CISG.

In the present case, the actual loss suffered by the aggrieved party seems to have exceeded the lump sum since the buyer claimed damages under Articles 75 "and/or" 76 CISG. Both provisions allow for specific methods of calculating damages. According to Article 75 CISG the aggrieved party may claim damages for their cover transaction. According to 76 CISG the aggrieved party may claim the difference between the contract price and the market price if they did not undertake a cover transaction. In general, both provisions require that the aggrieved party avoided the contract for fundamental breach of contract; facts which we cannot infer from the original case note.

However, it needs to be noted that Article 74 might form a basis for claiming such damages even without the necessity of contract avoidance.[12] Assumingly, the buyer in the present case would have recovered a higher sum under one of these provisions than under the penalty and liquidated damages clause which, in effect, constituted a limitation clause.[13] [page 2]

The question of whether or not the aggrieved party may claim for damages in addition to a contractual penalty and liquidated damages clause is to be answered by interpreting the clause. The crucial point is whether or not the clause was meant to be exclusive.[14] For example, if the parties agreed that a penalty clause applies "without prejudice to any other remedy available" it is apparent that the aggrieved party may cumulatively claim for damages. They can claim the penalty amount without having the need to prove the actual loss but can claim further loss if the burden of proof can be discharged. The situation is different if the party can claim the original penalty clause as a penalty clause. Full compensation for losses can still be claimed, as the penalty clause is only payment for the breach of the contract but not compensation for the actual loss.[15]

On the other side of the spectrum, if the parties agreed that the fixed sum be paid "in full and final settlement," they effectively derogated all other available remedies. Another factor to be considered is the event for which the penalty and liquidated damages clause applies.[16] If the clause only applies in the event of delay the aggrieved party might well have a damages claim for their performance interest, for example loss of profit.[17] Usually, the aggrieved party will have a claim for the recovery of any money paid to the party in breach on avoidance of the contract in addition to any penalty and liquidated damages.[18]

In conclusion, the questions concerning claims to the actual loss exceeding a contractual penalty and liquidated damages provision is not a question connected to the validity of such clauses and thus not outside the scope of the CISG. Rather, it is a question as to the extent of damages which is a matter governed by the Convention and it can be resolved by virtue of Article 7(2) CISG in applying the principles of the Convention, here the principle of full compensation as embodied in Article 74 first sentence CISG.[19] There is thus no need to look at Chinese law for any discretionary increase in the amount of damages by the court or the arbitral tribunal.

4. CONCLUSION

It is to be hoped that in this article the authors effectively rebutted the view of Marcus S. Jacobs and Yanming Huang that the parties to a CISG contract, by including a penalty clause in their contract, impliedly opted out of the damages regime of the CISG to the effect that domestic law applies giving discretionary power to the court or the arbitral tribunal to increase the agreed sum. By contrast, this is a question of damages which is governed by the CISG. The Convention has rules to be applied to the question whether the aggrieved party can claim damages in excess of a penalty and liquidated damages clause. Domestic law becomes decisive only with respect to the validity of such clauses. [page 3]


ENDNOTES

* [Editor's Note: Dr. Florian Mohs is a postdoctoral researcher at the University of Basel and a visiting scholar at the Law School of the University of Melbourne, Australia. He worked as an associate to Professor Ingeborg Schwenzer coordinating the publication of the 2nd edition of the Commentary on the UN Convention on the International Sale of Goods (Oxford University Press, 2005). Dr. Mohs holds law degrees from the University of Basel, Switzerland (iur.) and the Victoria University of Wellington, New Zealand (LL.M.).

** Dr. Bruno Zeller is a Senior Lecturer at the School of Law at Victoria University, Melbourne, Australia and an Adjunct Professor at Murchoch University Perth. He is also an Arbitrator and Member of the Australian Institute of Commercial Arbitration. He has published extensively on matters pertaining to the Convention on Contracts for the International Sales of Goods [CISG]. Comments can be sent, and questions could be asked by e-mail at bruno. zeller@vu.edu.a au. Copyright 2005 by the authors. Replies to the authors' commentary are welcome.]

1. The saga developed as follows: Marcus S. Jacobs and Yanming Huang "An Arbitrator's Power And Duties Under Art 114 Of Chinese Contract Law In Awarding Damages In China In Respect Of A Dispute Under A Contract Governed By CISG" 20(5) Mealey's Intl. Arb. Rep. 20 (2005); Bruno Zeller "The CISG And The Opting Out Clause Pursuant To Article 6 -- A Corrective Reply" 20(8) Mealey's Intl. Arb. Rep. 51 (2005); Marcus S. Jacobs and Yanming Huang "A Rebuttal Of Dr Bruno Zeller's Commentary: The CISG And the Opting Out Clause Pursuant To Article 6 A Corrective Reply" 20(10) Mealey's Intl. Arb. Rep. 17 (2005).

2. Article 114(2) first sentence of the Chinese Contract Law, in an English translation, provides:

"If the stipulated penalty for breach of contract is lower than the loss caused by the breach, the party concerned may apply to a people's court or an arbitration institution for an increase."

3. E. Allan Farnsworth "Damages and Specific Relief " 27 Am. J. Comp. L. 247, 248 (1979) on the Draft Convention; Peter Schlechtriem in Peter Schlechtriem and Ingeborg Schwenzer (eds) Commentary on the UN Convention on the International Sale of Goods (CISG) (2nd ed, Oxford University Press, Oxford, 2005) Art 4 para 23, Art 6 para 12.

4. See Epsilon BVBA v Interneon Valkenswaard BV (Rechtbank van Koophandel, Hasselt, 21 January 1997, English abstract at <http://www.unilex.info/case.cfm?pid=1&do=case&id=262&step=Abstract>) holding that a penalty clause was invalid under the applicable Belgian law.

5. England: Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] EWHC 281 (TCC); Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79. USA: Sec. 2-718(1) UCC (note, however, that it has been suggested to delete the second sentence of Sec. 2-718(1) UCC which, currently, stipulates that "[a] term fixing unreasonably large liquidated damages is void as a penalty" because it is perceived as unnecessary and capable of causing confusion. See Sec. 2-718 UCC and comment 1.b) of the 2002 Draft).

6. See the comparative notes to Article 9:509 of the European Principles of Contract Law.

7. Article 6:91 Burgerlijk Wetboek (BW).

8. Article 7.4.13 of the UNIDROIT Principles addresses both types of clauses under the heading "agreed payment for non-performance" and states:

"(1) Where the contract provides that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party is entitled to that sum irrespective of its actual harm.

(2) However, notwithstanding any agreement to the contrary the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the harm resulting from the non-performance and to the other circumstances."

This provision was relied on as international practice in accordance with Article 9(2) CISG in the award of 5 June 1997 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce and Industry (at <http://cisgw3.law.pace.edu/cases/970605r1.html>).

9. Article 114(1) of the Chinese Contract Law, in an English translation, provides:

"The parties may stipulate that in case of a breach of contract by either party a certain amount of penalty shall be paid to the other party according to the seriousness of the breach, and may also stipulate the method for calculating the sum of compensation for losses caused by the breach of contract."

Chinese law applied as the proper law of the contract.

10. Case law and scholarly writing up to now suggest that any possible reduction of penalty and liquidated damages clauses to a reasonable extent is to be determined by the applicable domestic law because this question is attached to and interwoven with the question of validity. See Diepeveen-Dirkson BV v Nieuwenhoven Vichandel GmbH (Gerechtshof Arnhem, 22 August 1995, English abstract at <http://www.unilex.info/case.cfm?pid=1&do=case&id=156&step=Abstract>); CIETAC award of 6 February 1997 (at <http://cisgw3.law.pace.edu/cases/970206c1.html>); award of 10 January 1998 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce and Industry (at <http://cisgw3.law.pace.edu/cases/980110r1.html>); Peter Schlechtriem ibid (fn 3) Art 4 para 23, Art 7 para 35; Martin Schmidt-Kessel in Peter Schlechtriem and Ingeborg Schwenzer (eds) Commentary on the UN Convention on the International Sale of Goods (CISG) (2nd ed, Oxford University Press, Oxford, 2005) Art 8 para 30; Hans Stoll and Georg Gruber in Peter Schlechtriem and Ingeborg Schwenzer (eds) Commentary on the UN Convention on the International Sale of Goods (CISG) (2nd ed, Oxford University Press, Oxford, 2005) Art 74 para 49.

11. Martin Schmidt-Kessel ibid (fn 10) Art 8 para 44 referring to a decision of the Regional Court of Munich dated 8 February 1995, CISG-online 143 (for an English translation see <http://cisgw3.law.pace.edu/cases/950208g1.html>) as an example for the application of Article 8 CISG to the question of whether the parties agreed on a pre-payment obligation only or, in addition, on a penalty clause. Contrast Klaus Peter Berger "Vertragsstrafen und Schadenspauschalierungen im Internationalen Wirtschaftsvertragsrecht" RIW 1999, 401, 402.

12. With respect to these delicate damages issues see only Peter Schlechtriem "Damages, avoidance of the contract and performance interest under the CISG" at <http://www.cisg-online.ch/cisg/publications.html>.

13. On limitation clauses see generally Hans Stoll and Georg Gruber ibid (fn 10) Art 74 para 50.

14. ICC award 7585 of 1992 (at <http://cisgw3.law.pace.edu/cases/927585i1.html>) enforcing a penalty clause which stated that "[i]f the agreement is terminated by fault or request of the purchaser -- including force majeure -- the buyer is entitled to a compensation fee of 30% of the price" in addition to damages for the preservation of the undelivered machinery, the legal and arbitration costs and loss of profit; Hans Stoll and Georg Gruber ibid (fn 10) Art 74 para 49.

15. See specifically UNCITRAL digest, A/CN.9/SER.C/DIGEST/CISG/74, point 6.

16. See the decision of 23 November 1994 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce (<http://www.unilex.info/case.cfm?pid=1&do=case&id=250&step=Abstract>) implying that a clause providing for a penalty in the event of delay did not bar the buyer's claim for damages based on the non-conformity of the goods. In the end, however, the damages claim for non-conformity was denied on other grounds (insufficient proof). See also the award of 27 July 1999 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce and Industry (at <http://cisgw3.law.pace.edu/cases/990727r1.html>) where the tribunal held that in a claim for the recovery of penalties to be paid to a third party (final purchaser) the buyer could not recover for both delay and non-delivery.

17. See the decisions of 19 February 2004 (at <http://cisgw3.law.pace.edu/cases/040219r1.html>), 19 March 2004 (at <http://cisgw3.law.pace.edu/cases/040319r1.html>) and 20 April 2004 (at <http://cisgw3.law.pace.edu/cases/040420r1.html>) of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce, all granting the seller, although under Russian law, a penalty for delay in addition to their claim for payment of the purchase price; for a case where liquidated damages for delay were granted in addition to the purchase price see the award of 22 January 1996 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce and Industry (at <http://cisgw3.law.pace.edu/cases/960122r1.html>). The same result was reached under the CISG in the ICC award 8247 of 1996 (at <http://www.unilex.info/case.cfm?pid=1&do=case&id=458&step=FullText>). But see the decision of 23 November 1994 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce (at <http://www.unilex.info/case.cfm?pid=1&do=case&id=250&step=Abstract>) striking out the buyer's claim for damages for non-delivery because of a clause providing for a penalty in the event of delay.

18. ICC award 9978 of 1999, CISG-online 708 (<http://www.cisg-online.ch/cisg/urteile/708.htm>) holding that a clause providing for a penalty of 2% of the contract value in the event of non-delivery barred only the buyer's claim as to damages under Articles 45(1)(b), 74 but not as to the purchase price under 81(2); award of 16 April 2003 of the Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce and Industry (at <http://cisgw3.law.pace.edu/cases/030416r1.html>).

19. Contrast ICC award 7197 of 1992 (at <http://www.unilex.info/case.cfm?pid=1&do=case&id=37&step=Abstract>) applying Austrian law pursuant to Article 7(2) CISG as to the aggrieved party's right to recover damages notwithstanding the limits of a penalty clause; award of 18 February 2002 of Tribunal of International Commercial Arbitration at the Russian Federation Chamber of Commerce and Industry (at <http://cisgw3.law.pace.edu/cases/020218r1.html>) not allowing a claim for further losses pursuant to Russian law.


Pace Law School Institute of International Commercial Law - Last updated July 14, 2006
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