Liquidated damages agreement and the adjudicative approach of courts and arbitral tribunals in vietnam

In the context of increasingly complex civil and commercial transactions, the liquidated damages agreement is used by many enterprises as a mechanism to control risks and anticipate financial consequences when contractual breaches occur. However, unlike the legal systems of Common Law countries, where liquidated damages agreements are widely recognized and have default enforceability, Vietnamese law places emphasis on the principles of “actual damages” and “compensation for the purpose of remedying, not for the purpose of punishment.” Therefore, the value of a liquidated damages agreement depends closely on how it is drafted, its scope of application and the evaluative approach of Courts and Arbitral Tribunals. Accordingly, the most important question in adjudication practice is whether Courts and Arbitral Tribunals in Vietnam accept the liquidated damages agreement and if they do, to what extent they accept it.

1.The legal framework governing the adjudicative approach of Courts and Arbitral Tribunals

A liquidated damages agreement is a type of agreement in which the parties consent to apply a fixed or predetermined amount of compensation for cases of contractual breach or resulting damages. The purpose of this agreement is to minimize disputes over proving actual damages and to make the dispute resolution process faster and more efficient. This agreement must be established lawfully and must not be punitive in nature, so as to ensure fairness and alignment with the reasonably anticipated damages.

However, the Civil Code 2015 and the Commercial Law 2005 both provide that liability for damages only arises when there are actual, direct damages and when the causal link between the breach and the damages can be proven. Vietnamese law does not have specific provisions on liquidated damages agreements, therefore all agreements regarding this type of compensation must be interpreted within the general framework of the law on damages and the principle of freedom of contract. This gives rise to somewhat differing adjudicative approaches between Courts and Arbitral Tribunals in practice.

2.The adjudicative approach of the Courts tends to comply with the general framework of the law on damages

Adjudication practice shows that Vietnamese Courts often do not regard liquidated damages agreements as absolutely binding and the degree of acceptance of a damages claim will largely depend on whether actual damages can be proven. Courts often interpret such agreements as advance arrangements intended to assist in determining the potential level of damages in the future, but not excluding the obligation of proof and not allowing the compensation amount to exceed the actual damages.

In many cases, Courts still require the claiming party to provide evidence of actual damages such as incurred costs, lost profits, damages caused by delayed performance or costs of hiring a replacement supplier. If actual damages cannot be proven, Courts often dismiss all or part of the claim, even if the contract contains a liquidated damages amount. This approach arises from the fundamental principles underlying Vietnamese law on compensation, which are that “compensation for damages is not intended to punish” and “the party claiming compensation must prove the damages.”

Even when accepting the legal validity of a liquidated damages agreement, Courts often recognize only part of the claimed amount if they find that the compensation is excessively high, unreasonable or does not reflect the actual extent of damage. In such cases, Courts tend to reduce the compensation amount if it contradicts the nature of the damages, declare a part of the agreement invalid if it is overly punitive or adjust the compensation amount based on the evidence provided by the parties.

3.The adjudicative approach of Arbitral Tribunals tends to comply with the principle of freedom of contract between the parties

Arbitral Tribunals, particularly the Vietnam International Arbitration Center, tend to be more flexible than Courts in recognizing liquidated damages agreements. Arbitral Tribunals place high value on the principle of freedom of contract and regard the contract as “the law of the parties” thus demonstrating a significantly higher degree of respect for liquidated damages agreements compared to Courts. Therefore, instead of requiring full proof of damages as Courts do, Arbitral Tribunals tend to regard the liquidated damages amount as a binding commitment, provided that the agreement is transparently made and is not contrary to legal provisions or to social morality.

However, this flexibility does not mean that Arbitral Tribunals accept liquidated damages agreements unconditionally. Arbitral Tribunals often adopt a balanced approach, treating the liquidated amount as a reasonable basis for establishing damages, but still requiring the non-breaching party to provide at least minimal supporting evidence of actual damages incurred, such as financial losses, delays or other costs paid by the non-breaching party. This evidential requirement is considerably less stringent than that applied by Courts – which require more comprehensive and detailed proof – but still preserves the fundamental principle of damages under Vietnamese law.

In addition, Arbitral Tribunals also assess liquidated damages agreements based on their reasonableness and their proportionality to the risks anticipated by the parties when entering the contract. If the compensation amount is viewed as proportionate to the potential damages and not punitive, Arbitral Tribunals are willing to recognize the entire amount. Conversely, if the agreement shows signs of being punitive rather than reflecting reasonably anticipated damages and departs from the actual damages, Arbitral Tribunals may also reject or partially adjust the amount, similar to the Courts.

4.Practical recommendations when drafting liquidated damages agreements

From a dispute-risk perspective, a liquidated damages agreement is effective only when it is carefully drafted. To increase the likelihood that such an agreement will be accepted by the dispute-resolution authority, the following points should be considered when drafting the contract:

• First, the scope of breaches and the corresponding compensation amounts must be defined clearly and transparently, avoiding situations where a single compensation amount applies to different types of breaches that vary completely in nature and extent of damages.
• Second, the compensation amount should be constructed on the basis of cost factors that can be estimated specifically and reasonably, such as the projected costs that may arise if a breach occurs, the potential lost profits or the costs needed to hire a replacement supplier. Determining the estimated amount based on such practical references will create a solid foundation for proving damages when a dispute arises.
• Third, the agreement should be combined with a mechanism allowing claims for additional compensation for damages exceeding the liquidated amount, thereby ensuring reasonableness and compliance with the principle of full compensation under Vietnamese law.

In conclusion, although liquidated damages agreements are increasingly used in contract practice, their legal value still depends substantially on the perspective of the dispute-resolution authority. Courts tend to adopt a cautious approach and prioritize the principle of actual damages, while Arbitral Tribunals are more flexible but still require minimal proof and assess the reasonableness of the compensation amount. herefore, to optimize the effectiveness of such clauses, parties need to draft rigorously, closely aligned with the nature of damages and prepare sufficient evidence in the event disputes arise.