Penalty – as security of obligations under supply agreement

January 27, 2015

Unlike state procurement supply agreements which in most cases require to provide a bank guarantee as a security of obligations, in simple supply agreements the obligations performance very oft are secured by penalty only.

Pursuant to article 293, Civil Code of the Republic of Kazakhstan (Civil Code) Penalty means a monetary amount, prescribed by laws or agreement, and payable by a debtor to a creditor in case of default or improper performance of obligations, in particular in case of untimely performance.

So the lawmakers distinguish two types of penalty:

  • lawful penalty , i.e. the one stipulated by laws, and thereby payable regardless of relevant clause in an agreement;
  • contractual penalty, i.e. the one prescribed in and stipulated by a contract.

As the amount of lawful penalty is so small (see article 353 Civil Code), that its security purpose can be called in question, we recommend stipulate a Penalty Clause and include therein an amount and calculation scheme in the agreement. In this regard and in order to make coincide the interests of the parties, we advise during drafting a supply agreement to note the following:

An agreement should provide that a penalty may be demanded only if it is demanded in a written form by a non-breaching party;

A penalty amount must be prescribed as an exact amount in monetary means and not as goods one;

In cases, when a penalty is expressed in percentage, the penalty should be designated as certain percentage of default or breached obligation amount, but not as percentage contract price.

And the most critical issue about penalty, the relevant clause in an agreement should contain the maximum limit of penalty, e.g. 10% of the sum of default and/or breached obligation. When no maximum limit is not fixed in the agreement, a penalty starts to accrue from the day of obligation default and continue up to performance of default obligation.

We hope our advice is helpful for you, though if you suffer from breach of the agreement by a counterparty, please keep in mind that your demands to pay penalty do not oblige you to prove losses. In case a lawsuit is brought into court against you, you may demand to reduce the penalty amount by virtue of article 297 Civil Code.

Gaukhar Abdigaliyeva