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Introduction

In the context of the increasingly active signing of construction contracts between contractors and investors, international contract forms are increasingly widely applied along with the integration of new legal concepts, which are not yet recognised or clearly applied in the Vietnamese legal system. In particular, liquidated damage, estimated damage or predetermined damage compensation is one of the integration concepts, with many controversies and views applied in the Vietnamese legal system.

Liquidated damage and actual damage in accordance with Vietnamese law

In foreign-involved commercial and construction contracts, clauses for delay damages and/or performance liquidated damages are often included. Usually, the aforementioned liquidated damages in the contract are a specific amount that the parties agree in advance to compensate in case a party violates the contract.

Such amount is usually calculated based on an estimate of the loss that may occur as a result of a violation of contract, and is clearly stated in the contract. The purpose of liquidated damages is to ensure the injured party’s entitlement to compensation without the need to prove actual damages, while mitigating and avoid complex disputes related to the calculation of damages.

In comparison, Articles 302 and 303 of the Commercial Law 2005 stipulate that damages caused by violations of obligations are material, actual, direct and identifiable losses suffered by the injured party. The compensation for these actual losses is determined according to the principle of compensation for damage under the Civil Code (Article 585) and is further guided by Clause 1, Article 3 of Resolution No. 02/2022-NQ-HDTP.

Accordingly, the actual damages are determined as the losses that have occurred. The claimant must clearly specify each instance of actual damage that has occurred, the amount being claimed, and provide documents that substantiate their claim.

With the guidance provided by the Council of Judges, it is difficult for the injured party to claim damages if such damages have not occurred or if the claimant finds it challenging to prove the value of the damages that have occurred. As a result, the court may not recognise agreements on liquidated damages as valid remedies for compensating damages resulting the violation of contract.

However, some practical applications still maintain that agreements on liquidated damages are considered valid compensation agreements due to (i) the violation, (ii) the occurrence of damages - despite difficulty in proving the damages, and (iii) the causal link, where the violation is the direct cause of the damages (Article 303 of the Commercial Law). While the damages have indeed occurred, the injured party provides a contractual agreement to claim damages instead of detailed evidence and documentation.

If the payment made by the violating party due to the contract violation is not considered a remedy for compensation, the questions arise: how should it be defined, or where should it be categorized among the applicable remedies for breach of contract? Article 292(7) of Commercial Law recognises the types of commercial remedies to include (i) Specific performance of contract, (ii) Penalty for breaches, (iii) Compensation for damage, (iv) Suspension of performance of contract, (v) Stoppage of performance of the contract, (vii) Termination of contract, and (vii)  Other remedies agreed upon by involved parties which are not contrary to the fundamental principles of Vietnamese law, treaties to which the Socialist Republic of Vietnam is a party and international commercial practices.

In particular, when applying the elimination method, paying an agreed amount before a violation occurs may fall into one of two categories: either the penalty for breach/violation outlined in Clause 2 or the other remedies agreed upon by the parties in Clause 7 of Article 292 of the Commercial Law.

Therefore, the practical application also has differences. Because an agreement of contractual remedy/penalty is unpopular and specific instructions are absent, to ensure the enforceability of the provision, the supposed injured party tends to structure the liquidated damage clause as the penalty clause.

Which remedy to apply?

The classification of compensation for liquidated damages as a sanction for violation, compensation for damages, or an agreement on commercial sanctions between the parties remains controversial. In the practice of dispute resolution, even outside the context of construction contracts, the Court has viewed the provisions on liquidated damages in the contract as a violation penalty. This perspective is illustrated in Decision No. 15/2016/KDTM-GĐT, dated September 7, 2016, from the Supreme People's Court. However, in Judgment No. 660/2022/KDTM-PT, dated November 10, 2022, concerning disputes over construction contracts, the Ho Chi Minh City People's Court examined the legal validity of agreements on liquidated damages.

The court found that while the agreement was inconsistent with the provisions on compensation for damages in Articles 302 and 303 of the Commercial Law, it did not violate the principle of freedom and free will to contract under Article 11 of the Commercial Law. The law must respect the parties' freedom to agree on responsibility for compensation for damages, as stated in Article 360 of the Civil Code.

The Ho Chi Minh City People's Court determined that the parties' liquidated damage agreement constitutes an agreement on compensation for damages, fulfilling the requirements of Article 303 (grounds for liability to pay compensation). The claimant successfully proved that actual losses had occurred under Article 304 (burden of proof of loss), thus validating the liquidated damage agreement.

However, the Court also noted that the agreed amount of liquidated damages would be reconsidered if it was disproportionately large compared to the actual damages suffered by the injured party. Additionally, the judgment reflected the Trial Panel's view that, although the actual damages incurred by the injured party (which were duly proven) exceeded the agreed liquidated damage amount, the Trial Panel would only approve the liquidated amount as agreed by the parties.

Capped limits for each type of remedy

Vietnamese law recognizes limits on penalties for breaches of contract. Accordingly, while the parties may agree on penalties for violations, these must not exceed the maximum limits established by specialized laws.

For construction projects in general, the penalty for breaching contractual obligations, or the total penalties for multiple violations agreed upon by the parties in the contract, shall not exceed 8% of the value of the breached contractual obligations.

However, for construction projects using state capital, the maximum contractual penalty increases to 12% of the value of the breached portion of the contract. In addition to the agreed penalty, the violating party must also compensate the other party for damages, as well as any third party (if applicable), in accordance with Article 146(2) of the 2014 Construction Law.

Is there a limit to the liquidated damage agreement? The answer depends on the chosen application. If it is regarded as an agreement on violation penalties, then the limits outlined above apply. On the contrary, if the liquidated damage agreement is considered a damage compensation agreement, there is no limit. However, the claim for compensation must meet the conditions specified in Articles 302, 303, 304, and 305 of the Commercial Law (inter alias, the obligation to mitigate losses). Therefore, if an agreement is deemed to exceed the actual loss, it may not be recognized or may be decided otherwise.

Recommendations for the drafting of the clause regarding liquidated damages

For the injured party, if choosing to consider the liquidated damage clause as a contractual penalty clause, an additional agreement on compensation for actual damages may be necessary. Conversely, if considering the liquidated damage agreement as a damage compensation agreement, the injured party should pay attention to burden of proof for the loss, fulfilling the obligation to mitigate damages, and anticipating potential losses. This should involve considering the relationships between the contract and other related contracts (such as those with the main contractor, subcontractors, employers, and suppliers) before agreeing on a liquidated amount.

For the violating party, reviewing and recognizing the limits of the liquidated damage agreement will assist in establishing an appropriate compensation limit, as well as in formulating effective negotiation or dispute resolution strategies.