Enforcement of award at risk if punitive damages disproportionate (Federal Grid Company JSC v FNK Engineering LLC)
Arbitration analysis: In April 2013, the Supreme Commercial (Arbitrazh) Court of Russia ruled that any punitive damages claimed for breach of contract must be proportionate to the value of the contract (or part thereof) or else an application for enforcement of an arbitral award ordering the payment of such punitive damages will be rejected. Mikhail Samoylov, Senior Associate at KIAP Attorneys at Law, discusses the court’s ruling and considers whether the Russian courts may take a similar approach to the enforcement of international arbitration awards.
Federal Grid Company JSC and FNK Engineering LLC entered into a contract to develop a project in relation to high-voltage transmission lines. The contract was dated 22 October 2010 and had a final completion date of 30 September 2013 (the ‘Contract’).
The Russian Civil Code classifies contracts of construction and development as either divisible or indivisible. Divisible contracts divide the entire performance of the contract into stages, with each stage controlled and paid for independently. The Contract, in this case, was divisible and completion was determined in accordance with a series of milestones.
The parties agreed that if FNK Engineering LLC delayed performance against any of the milestones it would be liable to pay, as punitive damages, 0.1% of the total value of the contract, per day until full performance of the relevant milestone was achieved. Under Russian law, punitive damages are an enforceable legal remedy that parties are free to include in contracts.
The Contract also provided that any disputes arising out of it should be resolved by the Arbitration Court of the Russian Union of Industrialists and Entrepreneurs.
In breach of the Contract, completion of the first project milestone by FNK Engineering LLC was delayed by 59 days. As the result of this breach, Federal Grid Company JSC referred the dispute to arbitration. Federal Grid Company JSC sought to recover of RUB 2.7 million (approximately £54,000) of punitive damages for the delay. The total value of the Contract was approximately RUB 47 million (approximately £94,000) and the total value of the first stage of the project was just over RUB 2.4 million (approximately £48,000).
The tribunal’s award and attempted enforcement
The arbitral tribunal rendered an award in favour of Federal Grid Company JSC, including an award of punitive damages. However, FNK Engineering LLC failed to satisfy the arbitral award and Federal Grid Company JSC applied to the Arbitrazh Court of Moscow for a writ of execution for the enforcement of the arbitral award.
Both the Arbitrazh Court of Moscow and the Federal Arbitrazh Court of Moscow Region rejected the application for enforcement of the arbitral award.
On 24 April 2013, the Supreme Commercial (Arbitrazh) Court of Russia upheld the decisions of the lower courts.
In rejecting the application for enforcement, all courts referred to s 239(3)(2)of the Commercial Procedure Code of the Russian Federation:
‘The commercial court refuses to issue a writ of execution for the enforcement of an arbitration tribunal award, if it establishes that: the arbitration tribunal award violates the fundamental principles of Russian law.’
Key points from the judgment of the Supreme Commercial (Arbitrazh) Court
All of the courts that considered the application for enforcement agreed that any punitive damages claimed for breach of contract must be proportionate to the value of the contract (or relevant stage thereof). It was also agreed that punitive damages are a tool for the protection of the interests and rights of a creditor, rather than a tool for his unjust enrichment.
When determining whether the level of punitive damages claimed for breach of contract is proportionate, the courts must consider:
- the ratio between the accrued punitive damages and the size of the main contractual obligation
- the proportionality of the punitive damages to the value of the breach of the contract, and
- the duration of the accrual period of the punitive damages
An award of disproportionate punitive damages is seen as a violation of a fundamental principle of Russian law. Russian litigation practice suggests that punitive damages of 10 to 25 per cent of the total value of the relevant contract (or contractual milestone) may be reasonable. In the instant case, the total amount of punitive damages claimed in relation to the delayed achievement of the first milestone was RUB 2.7 million (approximately £54,000) and the total contractual value of the first milestone was just over RUB 2.4 million (approximately £48,000), ie the amount of punitive damages claimed for delayed achievement of the first milestone exceeded the contractual value of that stage. Accordingly, the courts considered that this amount of punitive damages was disproportionate and dismissed the application for enforcement of the arbitral award.
Points for practitioners
In the context of Russian law, the court’s approach is not new. It is clear law that if the total value of the punitive damages is higher than the total value of contract (or a part of contract), then both the Russian state courts and the arbitral tribunal have the discretionary power to reduce the amount of punitive damages that can be recovered (Civil Code of Russia, s 333). Further, if a state court rejects a motion for the reduction of the value of an award of punitive damages, then a higher court may render a new decision reducing the value of the punitive damages.
In the present case, the arbitral tribunal rejected the motion of FNK Engineering LLC to reduce the amount of punitive damages. If an arbitral tribunal rejects a motion for the reduction of the value of punitive damages, as it did in the instant case, then the state court, following the decision of the Supreme Commercial (Arbitrazh) Court of Russia in this case, may reject the application for enforcement of the arbitral award in its entirety, rather than reconsider the terms of the award itself. This is, essentially, a denial of protection for the original contractual right, which is surely erroneous.
Despite the fact that this controversial decision concerns only domestic arbitration and says nothing of international arbitration, there is a possibility that the same approach could apply in the context of the recognition and enforcement of international arbitral awards.