Damage, Penalty, Indemnity – Recent Legal Developments

In March 2015 and July 2016, amendments to the Civil Code of the Russian Federation (“Amendments”) were enacted which substantially improved the legal basis for compensation for damages and contractual penalties and permitted the establishment of an obligation to compensate for losses irrespective of a breach of a contract (indemnity). In its order No. 7 of 24 March 2016 (“Order”), the Plenum of the Supreme Court of the Russian Federation explained its view on the interpretation of the Amendments of March 2015.

We expect that the Amendments and the Order will lead to the following improvements:

• Claims for damages will become easier to assert,
• The limitation of liability will be clear,
• Criteria for the reduction of penalties will be defined,
• Contractual means of protecting creditors against loss and damages will be put in place.

Compensation for damages

General

The aim of the obligation to compensate for damages is now clearly defined: As a result of the compensation, the claimant must be put in the position in which it would have been if the obligation had been duly performed. This means that the injuring party is obliged to provide for full restitution of the claimant’s position in the case of due performance of the relevant obligation.

Facilitation of proof

In future, in legal proceedings it will be easier to prove damages suffered and the existence of a causal connection between the breach of an obligation and the damage suffered. A court may no longer refuse the claimant’s claims for compensation for damages merely because the amount cannot be determined. Instead, the court must determine the amount (including lost profit) based on all circumstances and the principles of justice and adequacy. In particular, this means:

• The claimant must only provide evidence which establishes to a reasonable extent the plausibility of the amount of the damage and the existence of a causal connection between the non-performance or defective performance and the damage;
• If the damage which the claimant claims is a customary consequence of the breach of the obligation, the existence of the causal connection will be assumed.

Termination of agreement

The Amendments contain improved rules on compensation for damages in the event of termination of an agreement. These rules apply in particular if the purchaser of goods terminates a sale and purchase agreement due to a seller’s breach of that sale and purchase agreement. Under these rules, the claimant may claim compensation in particular for the difference between

• The price of goods, works and services under the  terminated agreement and
• The price of goods, works and services under a new agreement into which the claimant enters, replacing the terminated agreement.

If the claimant has not signed a new agreement and a current price for analogous items exists, the difference to such a current price may be claimed. Previously, the rules existed only for supply agreements between individual entrepreneurs and commercial entities; they are now extended to all sale and purchase, services and contractor agreements. The new provisions of the Civil Code and the Order stress that the claimant must act in good faith.

Conducting negotiations in bad faith

A person who has conducted negotiations unfaithfully is obliged to compensate the other party for damages suffered. The Order contains substantial clarifications in this regard.

It is assumed that the parties of negotiations are acting in good faith, even if a party terminates negotiations. Therefore, the claimant bears the burden of proving that the defendant did not act in good faith.

As a result of the compensation, the claimant must be put in the position in which it would be if it had not started the negotiations (section 20 of the Order, referring in particular to Art. 434.1 (3) CC). Therefore, it may claim in particular:

• Cost of the preparations for entering into the agreement;
• Losses caused in connection with the loss of opportunity to enter into an agreement with a third party.

If the claimant entered into an agreement based on incomplete or incorrect information, it may claim the recognition of the agreement as invalid by the court and compensation for damages caused by the invalidity if the injuring party:

• Has caused the claimant to make a substantial error, or
• Has deceived the claimant.

Protecting the claimant in the event of a force majeure

Under the Amendments in their interpretation by the Order, the claimant enjoys better protection if the debtor refuses performance by referring to force majeure circumstances. The following rules apply:

Circumstances which depend on the will or action of the debtor, e.g. lack of financial means, breach of contract by its contractual partners or unlawful actions by its representatives do not constitute force majeure.

Force majeure does not terminate the obligation of the debtor if performance is still possible after the force majeure has ended. However, the claimant is entitled to terminate the relevant agreement if, due to the delay caused by force majeure, it has lost its interest in its performance.

The debtor is not liable for damage caused by the delay, but is obliged to take reasonable action in order to reduce the damage caused to the claimant by force majeure; in particular, to notify the claimant of the occurrence of the force majeure, and, in the event of non-compliance, reimburse the claimant for damage suffered.

Interest on delayed payments

The Amendments provide for a non-mandatory interest rate for delayed payments in the amount of the refinancing rate of the Central Bank of the Russian Federation (currently 10%) in the relevant period of time. However, if the amount of interest provided by an agreement is obviously unreasonable in relation to the consequences of the payment delay, a court may reduce the amount of interest, but not below the rate established by law.

If the claimant has suffered losses exceeding the amount of interest, it may claim such excess losses from the debtor. Unless otherwise provided by an agreement, interest on delayed payments may not be claimed if the agreement provides for a penalty for the payment delay. Interest on delayed payments does not affect contractual interest (e.g. on loans or deferred payments).

Limitation of liability

As it will become easier to assert claims for damages under the Order, it will be more important for investors to limit their liability. Russian law is probably more tolerant than many other jurisdictions in this regard:

In general, the parties to an agreement have the right to limit the liability of the injuring party. However, in the cases below, an agreement on limitation of liability is not permitted and is therefore invalid:

• Breach of a legal prohibition (e.g. agreement on accession or other agreement with a consumer if the scope of liability for the relevant type of activity or for the breach is determined by law and the agreement is entered into prior to the circumstances which caused the liability);
• Contradiction of the essence of the laws on the relevant type of activity (e.g. clause in an agreement on security services or transportation limiting the liability of the professional provider of the services;
• Previously agreed exclusion or limitation of liability for an intentional breach of obligation.

 

Under Russian law an agreement which, in general, excludes or limits liability and does not exempt intentional breach from the limitation is valid. However, in legal proceedings the injuring party bears the burden of proof that the damage was not caused intentionally. It may provide evidence that it applied a minimum of diligence in performing the obligation.

Penalties

General

A penalty (“неустойка”) may be specified by agreement for the non-performance or defective performance, in particular the delay, of an obligation. The penalty may take the form of a fixed sum (“штраф”) or of periodical payments (“пени”).To be valid, the agreement on the penalty must be entered into in writing, irrespective of the form of the main agreement. The claimant may not claim a penalty if the injuring party is not at fault regarding the non-performance or defective performance of the relevant obligation.

In general, the claimant may claim compensation for damages which exceeds the amount of the penalty. However, the following may be specified in the penalty agreement:

• Only a penalty, but no compensation for damage may be claimed (“исключительная неустойка”);
• Compensation for damage may be claimed in full in addition to the penalty (“штрафная неустойка”);
• At the choice of the claimant, either a penalty or compensation for damage may be claimed (“альтернативная неустойка”).

Reduction of penalties by the court

The Amendments and the Order have provided for clarifications and limitations of the right of a court to reduce contractual penalties:

A reduction may be granted only in exceptional cases if it is obviously unreasonable and may lead to an unjustified profit for the claimant. If the debtor is a commercial organisation or an individual entrepreneur, the penalty may be reduced only if the debtor has applied for a reduction.

The debtor bears the burden of proof for the unreasonableness of the penalty amount. In assessing the reasonableness of a penalty, the court must consider that:

• Nobody should benefit from unlawful behaviour;
• The unlawful use of third parties’ financial means should not be more profitable to the debtor than lawful use.

As justification for the penalty amount, the following average rates may be invoked:

• For businesses: Average rates for short-term loans granted by banks for supplementing working capital; or
• For private individuals: Average rates for short-term loans granted by banks.

As an example of unreasonableness, the Order mentions the case in which the possible amount of damage is substantially lower than the penalty amount. The Order expressly states that any of the following circumstances by itself is not sufficient reason for reducing the penalty:

• Difficult financial situation of the debtor;
• Existence of debt with other creditors;
• Seizure of money or other property of the debtor;
• Lack of financing from the budget;
• Non-performance of obligations by contractual partners;
• Voluntary performance of obligation on the day of review by court;
• The debtor’s performance of socially significant functions;
• The debtor’s obligation to pay interest.

With regard to the claimant’s objections to a reduction in a penalty, the Order mentions:

• No evidence is required for the fact that damage has occurred;
• The claimant may provide evidence of the consequences of the breach for a reasonable and careful claimant acting reasonably and carefully in analogous circumstances, e.g. a change in average market indicators (interest rate on loans or market prices of certain goods).

Claimant’s fault

The proportion of liability and therefore the amount of a penalty may be reduced if:

• The non-performance or defective performance of the obligation was caused by both the injuring party and the claimant;
• The claimant intentionally or carelessly contributed to increasing the penalty amount; or
• The claimant acted in bad faith.
• However, the failure of the claimant to make the main claim over a long period of time after the relevant obligation has become due may not, in itself, be considered a contribution to increasing the penalty amount.

Indemnity

Subject

An indemnity is an agreement in which one party has an obligation to compensate the other party for certain losses arising upon occurrence of certain circumstances and which are somehow connected with the performance, amendment or termination of an obligation or its subject, but not necessarily with breaches of the agreement. Indemnity, unlike compensation, arises independently from:

• Occurrence of a breach of the agreement;
• Causality between the injuring party’s behaviour and the damage.

An indemnity agreement may be entered into only between persons conducting commercial activities or in shareholders’ agreements or in agreements for the sale and purchase of shares.

Compensation for losses

The indemnity agreement must provide for the amount of the losses to be compensated or rules for determining the amount. The indemnity agreement may provide that all losses caused by the circumstances in question or any part thereof must be compensated – this is sufficient to determine the loss amount.

The claimant may claim compensation for losses if it proves:

• Losses which the claimant already suffered or will unavoidably suffer in future; and
• Causality between the occurrence of circumstances and the losses suffered.

If the claimant has caused the occurrence of the circumstances in bad faith, the circumstances are deemed not to have occurred.

Further aspects

The indemnity agreement must be clear and unambiguous.  The conclusion and validity of the indemnity agreement will be considered separately from the conclusion and validity of the agreement in connection with which the indemnity agreement is signed.

If the losses were caused by a third party, the compensation claims of the claimant against such a third party pass to the debtor that has satisfied the indemnity claims of the claimant. The amount of the compensation claims against such a third party may not exceed the amount of the compensation claims under the general rules of the law.