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The performance of obligations may be secured by various forms: penalty, pledge (hypothetic), suretyship, guarantee, earnest money, or any other form resulting from the contract. This article shall discuss the penalty as the most often used kind of security of performance of obligations. A penalty is a sum of money determined by law or contract which the debtor shall be bound to pay to the creditor in the case of failure to perform an obligation, or defective performance thereof. A penalty may be determined as a fine or forfeit. A fine may be established in the form of a concrete sum of money, or expressed in percentage terms on the amount of the secured obligation, and the forfeit stipulated for a delay in performance of an obligation may be established for every day, week, month, etc., that exceeds the time-limit of the performance. Before entering into a contract, where a penalty is determined, parties of the contract should know several things.
Firstly, the penalty, as a kind of security of obligation, is an additional obligation in relation to the principal obligation; consequently, where the transaction from which the obligation has arisen is declared void, any agreement upon the security of performance of such an obligation, by way of penalty, shall be equally void.
Secondly, the clause by which it is agreed upon, a penalty must be made in writing. Agreement on a penalty must be made in writing, even if the contract of the principal obligation is made in another form. However, it does not mean that agreement on a penalty made in another form shall be void. The problem in such case is that parties lose the right to use testimony of witnesses as evidence to prove the agreement.
Where an obligation with a penal clause is established, the creditor may not demand both the real performance of the principal obligation and the penalty, except in cases when the debtor is in delay of the performance of the obligation. It follows from this provision that the creditor must choose what to demand – penalty or real performance of the principal obligation. This provision is imperative and any stipulation of parties contrary to this provision shall be void. Moreover, under the Civil Code, it is not allowed to demand to compensate damages and to pay penalty agreed in the contract. The purpose of the penalty is not to punish the debtor, but to compensate for the creditor’s damages. Therefore, the sum stipulated in the penal clause shall be set-off into damages in the case where compensation of damages is claimed.
It should be pointed out that parties are free to determine the amount of the penalty in the contract; nevertheless they should remember that in certain circumstances, the court shall have a right to reduce it. The amount of penalty stipulated may be reduced by the court when it is manifestly excessive, or if the creditor has already benefited from partial performance of the obligation, though the sum may not be reduced below the damages payable for the failure to perform the obligation, or for defective performance thereof. The court may reduce the penalty on its own initiative, or on the request of another party. However, no reduction of the penalty paid shall be allowed.
And finally, one more important question related to prescription should be mentioned. Prescription is a time period established by law during which a person can defend his violated right by bringing an action. According to the Civil Code of the Republic of Lithuania, an abridged six-month prescription shall apply in respect of claims arising from the exaction of penalties. If the prescription is expired, the request of the debtor to apply the prescription is a basis for the court to reject the claim.