Pitfalls when negotiating a contractual penalty

12. 7. 2023

The Supreme Court issued a groundbreaking decision in January 2023, departing from its established decision-making practice on the assessment of the reasonableness of contractual penalties and adopting a completely new approach. Read our article to find out how the court’s decision will affect agreement on and the enforcement of contractual penalties.

 

A contractual penalty is the obligation of a contracting party to pay a certain amount to the other contracting party if the former fails to perform its contractual obligations and is a standard part of a wide range of contracts. The purpose of the penalty is to motivate the contractual parties to properly perform their contractual obligations and to enable the party that has performed its duties to be at least partially compensated in the event that the other party fails to fulfill its obligations.

However, for a contractual penalty to actually apply in litigation, the court must not consider it to be excessive or contrary to good morals.

The case law of the Supreme Court concerning the reasonableness of contractual penalties originates from the old Commercial Code but is still applied even in recent times. The central point of the case law was the possibility of the court to take into account only the facts that existed at the time the contractual penalty was agreed upon. No other circumstances arising after the contract was agreed could have any bearing on the assessment of whether or not a contractual penalty was unreasonable. Thus, if the liquidated damages provision appeared proportionate at the time the contractual penalty was agreed, it is not possible to modify (i.e., reduce) it, irrespective of the circumstances that arose after the agreement.

However, in January 2023, the Supreme Court made a landmark decision that nullified the above-mentioned conclusions for contractual penalties agreed after 2014.

When assessing the reasonableness of a contractual penalty, courts must still take into account the circumstances that already existed when the contractual penalty was agreed, such as the value of the obligation the contractual penalty secured for the party to which such obligation was not timely performed and the proportionality of the contractual penalty in relation to the obligation. However, as a result of the Supreme Court’s decision it is now also necessary to take into account the circumstances that existed at the time of the breach of the obligation and even the circumstances that occurred after the breach of the secured obligation. On this new basis, the courts will decide whether or not, and to what extent, to moderate the contractual penalty.

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