Finding appropriate balance in establishing contractual penalties in IT contracts

By Piotr Kowalski, Kancelaria Pałucki, Trusiński, Prawo i Podatki, Sp. J

The presence of various, and frequently excessive, contractual penalties in IT contracts (e.g. with the objective of implementing and then maintaining a specific computer system) is a regular phenomenon in the current market situation. A sensible ordering party will not agree to enter into a contract in which contractual penalties – as an effective mechanism protecting its interests and aimed at preventing specific behaviours of an unreliable contractor – are not provided for. On the other hand, the multiplicity and amount of contractual penalties in some contracts may indicate that the object of the contract is merely the initiation of imposing such penalties, which unfortunately distorts the idea of this institution.

IT contracts, unlike other contracts in business transactions, provide leeway as far as establishing various contractual penalties is concerned. For instance: in service level agreements (SLA) there are frequent penalties referring to the severity of a defect (e.g. critical – preventing the functioning of the system, and non-critical – defined as the remaining cases), and response time and the channels through which they were reported (e-mail, telephone, etc.). Thus, it is possible to obtain a few different penalties for the same incident. It is worth underlining that sometimes a software defect is caused by the failure of the ordering party and not of the contractor, e.g. the existing system has not been upgraded to a version enabling the implementation of a specific module. It must be kept in mind that in this type of agreement, the parties usually submit the status of an entrepreneur (persons running a business activity), and Polish legislature requires such entities to take special precautions since they are “professionals.” This repeatedly causes problems in providing effective explanations that a specific defect or delay arose from circumstances beyond a given party’s reasonable control.

Therefore, where does this “appropriate balance” lie in establishing contractual penalties?

Firstly, the parties ought to exercise common sense at the time of negotiating the contents of the agreement. It is important to remember not to double contractual penalties, assign the contractor with deadlines or periods that are possible to meet, and the amount and method for charging contractual penalties must refer to the agreement value and its importance to the interests of the ordering party. The agreement ought also to provide for the cooperation principles of the parties and reporting the problems or risks noticed at every stage: starting with the analysis, through implementation, collection, and maintenance of its object – this will prevent a situation in which the ordering party is not adequately prepared to commence or continue a process. For this purpose, the parties ought also to appoint teams to handle a given contract (with powers to modify its scope), as well as the personnel authorised to report the risks noticed to the other party.

In the event of circumstances justifying a penalty, the agreement should provide for a mechanism enabling the contractor to submit explanations, simply speaking: provide it with a chance to defend its position. In response to such explanations (a written application) the Ordering Party should be entitled to withdraw from charging penalties. As far as larger contracts are concerned, the parties should consider the introduction of an impartial and professional entity, which, against specific remuneration and within a set time, would assess the source and causes for a given defect – without the need to take the case to court (which due to the participation of court experts may generate high costs and which may be exceptionally time consuming).

Finally, if a given case cannot be settled amicably, the contractor must bear in mind that it is entitled to apply to the court to moderate the contractual penalty. Nevertheless, in such a case it should be able to demonstrate that one of the following circumstances occurred: its obligation has largely been fulfilled, or a respective contractual penalty is grossly excessive (the assessment of “gross excessiveness” is carried out by the Court).

However, it does not change the fact that most risks related to the imposing of contractual penalties may be neutralised by the parties, which may provide for flexible and comprehensive contractual provisions.u