Pitfalls when negotiating a contractual penalty

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A contractual penalty, i.e. the obligation of the contracting party to pay the other contracting party a certain amount in the event that the first party fails to meet its contractual obligations, is an absolutely normal part of a wide range of concluded contracts. The purpose of this institute is to motivate the contracting parties to properly fulfill their contractual obligations and to enable the party that has performed properly and on time to satisfy itself at least partially from the contractual penalty in the event that the other contracting party does not do so.

However, in order for the contractual penalty to actually fulfil its intended purpose even in the event of litigation, it must not be considered disproportionate by the court or even contrary to good morals.

The case law of the Supreme Court based on the old legislation of the Commercial Code was applied in relation to the proportionality of the contractual penalty until very recently. The main point of this case-law was the possibility for the court to take into account only facts that existed at the time of negotiating the contractual penalty. No other circumstances that took place after it had been agreed could have influenced the assessment of whether or not the penalty was disproportionate. It follows from the above that if the provision on the contractual penalty appeared to be appropriate at the time when the contractual penalty was agreed, it was never possible to moderate (i.e. reduce), regardless of the circumstances that came after it had been agreed.

However, in January 2023, a ground-breaking decision of the Supreme Court was made, as a result of which the above conclusions can no longer be applied to contractual penalties negotiated after 2014.

When assessing the proportionality of a contractual penalty, courts must still take into account circumstances that already existed when the contractual penalty was agreed, such as the value or significance of the obligation secured by the contractual penalty for the party who was not properly and timely fulfilled, and in what proportion to it was the amount of the contractual penalty. However, it will also be necessary to take into account the circumstances that existed in the event of the breach of the obligation secured by the contractual penalty and even circumstances that occurred after the breach of the secured obligation. Based on the above, the courts will then decide whether, or in what amount, to moderate the contractual penalty.

The fundamental difference is therefore that the court will no longer examine only the adequacy of the contractual penalty arrangement itself, but the specific claim of the creditor based on the contractual penalty. In other words, if the court concludes that the claim from the contractual penalty asserted in a particular case is disproportionate, it will reduce it proportionately, regardless of whether the contractual penalty arrangement itself was reasonable or not.

It is also worth mentioning that the relationship between the moderation of the contractual penalty and the conflict of the contractual penalty with good morals was also resolved differently. Therefore, if the court finds that the contractual penalty is contrary to good morals, it will no longer be possible to moderate it, instead the provision on the contractual penalty will be considered invalid and the creditor will therefore not be entitled to its payment at all.