Tiếng ViệtIn business practice, contract breaches are inevitable — but losing the right to claim penalties or damages due to poorly drafted clauses is entirely preventable. Penalty and damages clauses are essential legal mechanisms in commercial contracts, protecting a company’s interests and deterring counterparties from violations.
However, many businesses have failed in enforcing their claims simply because the penalty or damages clauses were declared invalid by the court, lacked evidentiary support, or did not comply with legal requirements. This highlights a crucial point: drafting penalty and damages clauses accurately and in compliance with the law from the outset serves as the most effective legal safeguard for any enterprise.
In this article, LexConsult & Partners will clarify the legal nature of each contractual remedy, identify common drafting errors, and provide practical guidance on how to craft penalty and damages clauses that are both legally enforceable and strategically advantageous, significantly enhancing a company’s chances of success in potential disputes.
1. Distinguishing Between Penalty and Damages Clauses in Commercial Contracts
Pursuant to Articles 300 and 302 of the Law on Commerce 2005:
Article 300 – Penalty for Breach
A penalty for breach refers to a situation where the non-breaching party requires the breaching party to pay a monetary penalty for breach of contract, provided that such a clause has been agreed upon in the contract, except in cases of exemption from liability as prescribed in Article 294 of this Law.
Accordingly, if the contract contains a specific agreement on the penalty amount, the aggrieved party has the right to demand payment of that amount without having to prove actual loss. This is a legal mechanism designed to secure contractual performance.
Article 302 – Compensation for Damage
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Compensation for damage means that the breaching party must compensate for the losses caused by its contractual breach to the non-breaching party.
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The amount of compensation includes the actual and direct losses suffered by the non-breaching party as a result of the breach, as well as the direct profits that the non-breaching party would have earned had the breach not occurred.
Under Article 302, compensation for damage imposes liability on the breaching party to make good the actual losses suffered by the non-breaching party. To successfully claim compensation, a company must prove the following three elements:
– The occurrence of a contractual breach;
– Actual and quantifiable damages;
– A causal link between the breach and the resulting damage.
Therefore, penalty and damages clauses are not mutually exclusive. A company may claim both simultaneously, provided that the contract expressly and lawfully stipulates such terms. Combining both remedies not only strengthens deterrence but also ensures full protection of financial interests in case of dispute.
2. Maximum Penalty for Breach in Commercial Contracts
Under Article 301 of the Law on Commerce 2005:
Article 301 – Maximum Penalty
The penalty for breach of contractual obligations, or the total penalty for multiple breaches as agreed by the parties in the contract, shall not exceed 8% of the value of the contractual obligation(s) breached, except as otherwise provided in Article 266 of this Law.
This cap applies exclusively to contracts governed by the Law on Commerce, i.e., those involving at least one trader or relating to commercial activities. If the penalty amount exceeds the 8% threshold, the court will declare the excess portion invalid and only recognize the penalty within the lawful limit — which can significantly affect the company’s recoverable rights in case of dispute.
3. Common Mistakes Businesses Make When Drafting Penalty and Damages Clauses
– Failure to specify penalty rates or calculation methods: A common error that renders the clause vague and unenforceable. For instance, vague wording such as “penalty as prescribed” or “penalty for breach of contract” without specifying the percentage or fixed amount will make it impossible for the court to determine the basis for enforcement.
– Combining penalties and damages into a single amount: Many businesses mistakenly merge both remedies into one undifferentiated payment, blurring their distinct legal nature. This can lead to the clause being declared void for lack of clarity and transparency. Under the law, a penalty clause serves a deterrent function and does not require proof of loss, whereas damages require evidence of actual loss.
– Unclear scope of application: Some contracts simply state that “breach shall be penalized” without identifying which specific obligations trigger the penalty — such as delays in performance, product quality, confidentiality, or payment obligations. Such ambiguity can cause the clause to be deemed too general and unenforceable.
– Lack of supporting evidence mechanisms: Many contracts omit procedural safeguards, such as written notices, acknowledgment records, or documented communication (emails, delivery notes, etc.). Without supporting evidence, even a favorable clause may fail in court. This is especially critical for high-value or complex transactions.
– Absence of a statement of voluntariness and legality: A penalty or damages clause may be rendered invalid if it does not affirm that it was “mutually agreed upon by the parties, in compliance with the law.” The absence of such a declaration weakens the enforceability of the clause if challenged in arbitration or court proceedings.
4. How to Draft Legally Compliant and Enforceable Penalty and Damages Clauses
To increase the likelihood of prevailing in a dispute, a company should:
– Clearly specify the penalty rate as a percentage or fixed amount (not exceeding 8%);
– Identify the specific breach of obligation that triggers penalties or damages;
– Record the right to claim both penalty and damages concurrently;
– Support the claim with documentary evidence such as invoices, subcontracts, or email correspondence;
– Include the statement: “These penalty and damages clauses are voluntarily agreed upon by both parties and do not contravene applicable laws.”
5. Sample Penalty and Damages Clause for Businesses
“In the event that Party B fails to deliver goods in accordance with the agreed schedule, Party A shall have the right to impose a contractual penalty equal to 5% of the value of the breached obligation. In addition, Party B shall compensate Party A for all actual losses incurred as a result of such breach, including but not limited to: warehousing costs, losses due to delay, and replacement costs incurred from engaging third parties.”
Note: This sample clause is for reference only. For optimal legal effect, the clause should be tailored to the specific characteristics of each contract.
6. Frequently Asked Questions on Penalty and Damages Clauses
When can a penalty clause be declared invalid by the court?
→ A penalty clause may be rendered invalid if it exceeds the statutory limit (8%), lacks clear mutual agreement, or violates principles of voluntariness and transparency under the Civil Code and Commercial Law.
What elements are required for a damages clause to be enforceable?
→ A valid damages clause must clearly establish:
(i) the breach of obligation,
(ii) actual and quantifiable loss,
(iii) a causal link between the breach and the loss, and
(iv) supporting evidence such as invoices, receipts, and correspondence.
Can penalty and damages clauses be included in an appendix to the contract?
→ Yes. However, the appendix must explicitly state that it forms an integral part of the main contract to avoid being deemed “independent and void.”
Do penalty and damages clauses need to be notarized?
→ Not necessarily. They only need to be clear, complete, and voluntarily agreed upon by both parties to have binding legal effect.
Should businesses use standard templates from the internet?
→ No. Standard templates are often generic and fail to reflect the specific nature of each transaction. Businesses should always consult a lawyer to tailor the clauses and ensure legal enforceability.
If the contract is in English, should the penalty and damages clauses be bilingual?
→ Yes, especially for cross-border contracts. It is advisable to specify the governing language to prevent misinterpretation and disputes over terminology.
In international commercial disputes, which law governs penalty and damages clauses?
→ The applicable law is the one chosen by the parties in the contract. If no governing law is specified, conflict-of-law principles will apply — typically the law of the place where the obligation is performed or where the contract has the closest connection.
Should the damages clause specify each type of recoverable loss?
→ Yes. Detailing specific losses (e.g., loss of revenue, incidental expenses, reputational damage) strengthens evidentiary value and increases the likelihood of judicial acceptance.
In commercial contracts, penalty and damages clauses are not merely mechanisms to enforce performance — they are critical legal tools for protecting a company’s financial and reputational interests. A well-drafted clause that clearly defines the penalty amount, scope of application, enforcement conditions, and proof of loss provides a decisive advantage in negotiation and litigation.
Conversely, a vague or unlawful clause may be rendered void or unenforceable, leaving the company without effective remedies. Therefore, investing in precise, legally sound drafting of penalty and damages clauses is not just risk prevention — it is a core strategy for effective contract management.
If your business needs to review existing contracts or draft high-value commercial agreements, contact LexConsult & Partners for professional assistance in preparing legally compliant, enforceable, and strategically advantageous penalty and damages clauses.
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