Contractual penalties are a common contractual mechanism with which to sanction the breach by one of the parties of their contractual obligation. However, the parties’ will in negotiating and enforcing a contractual penalty cannot be left entirely unchecked, and the Civil Code thus provides a number of corrective mechanisms, among them the so-called moderation of a contractual penalty.
Contractual penalties are a fairly common contractual mechanism with which to sanction the breach by one of the parties of their contractual obligation. Generally speaking, it is left at the discretion of the contractual parties which of their mutual obligations they wish to secure with a contractual penalty, what procedure they wish to stipulate for its enforcement, or how they wish to determine the amount of the penalty (be it in the form of a specific amount or in the form of a formula for calculating the penalty). However, the parties’ will in negotiating and enforcing a contractual penalty cannot be left entirely unchecked, and the Civil Code thus provides a number of corrective mechanisms, among them the so-called moderation of a contractual penalty.
Penalty moderation – i.e., the option enshrined in the law to ask a court to lower an excessive contractual penalty – is governed by Sec. 2051 of the Czech Civil Code, according to which “the court may upon obligor’s request lower a disproportionally high contractual penalty, taking into account the value and significance of the obligation covered by the penalty, down to the amount of the damage which was caused by the breach of the relevant obligation up until the court ruling. In the event that a subsequent claim for damages arises, the injured party may bring such claim up to the amount of the contractual penalty”.
This legal mechanism has its origin in provisions that were in force before today’s Civil Code came into existence. Under previous law, contracts were governed either by the (“old”) Civil Code or by the Commercial Code; the moderation mechanism concerned strictly the latter case. By contrast, if a contract governed by the (old) Civil Code provided for an excessive contractual penalty, this caused the contractual understanding in question to be null and void. Simply but, there existed only two options: all or nothing.
Given that the underlying concept is identical, the (until then) settled case-law in commercial-law matters was destined to be more or less perpetuated when the new Civil Code was adopted.
According to that case-law, the principal aspect to be considered by the court when assessing the proportionality of a contractual penalty were the reasons which led to the parties’ agreement on the penalty in the given amount, and the accompanying circumstances of their agreement. While the value and significance of the secured obligation also played some role, they would only be considered as a part of the court’s determining of the new, lower amount of the penalty (i.e., after the court principally found the penalty to be disproportionate). The personal, financial, and social circumstances of the obligor were of no relevance for the moderation of the agreed contractual penalty. The decisive circumstances were always those which were present at the time at which the parties agreed on the penalty, and never any subsequent circumstances.
However, in recent times, the Supreme Court has deviated to a substantial degree from this settled case-law, instead conceiving of new rules as to how the judicial moderation of contractual penalties is supposed to play out going forward.
Above all, courts are expected to no longer examine the (dis-)proportionality of the contractual penalty clause (as a part of the contract between the parties), but to always assess whether or not the specific claim brought by the obligee in a specific individual case is disproportionate. Instead of assessing a general contractual construct which came into existence when the contract was negotiated, the focus will henceforth be on a concrete claim in a concrete amount for the concrete violation of a contractual obligation.
Also, in the future, the assessment of whether a contractual penalty is disproportionate shall take into account the way in which the contractual obligation was breached, and the circumstances of such breach, and the extent to which the obligee’s interests were affected. Courts are expected to review not only the circumstances which were known at the time at which the parties entered into the arrangement regarding the contractual penalty, but also the circumstances which were present at the time at which one of them violated its contractual obligation, and the circumstances which occurred subsequently (provided that they are clearly in causal relation to the breach of contract, and could have been foreseen at the time).
The new review process is supposed to follow a series of three steps.
In a first step, the court, following the rules of interpretation set out in the law, shall determine what purpose the contractual penalty is supposed to fulfill. In particular, it shall differentiate between compensatory and punitive aspects – i.e., contractual penalties that are meant to provide lump-sum compensation to the injured party (so as to avoid the cumbersome need to provide evidence to quantify the damage suffered), on the one hand, and contractual penalties that sanction the obligor for their breach of contract, on the other.
In the next step, the court shall look into all concrete aspects of the case at hand, always with a view to the thus determined function of the contractual penalty. As has been mentioned above, these aspects range from the circumstances known at the time at which the parties agreed on the contractual penalty, to the circumstances which were present at the time when the breach of the contractual obligation occurred, to circumstances which arose in the wake of such breach (where pertinent and relevant). Based on all these circumstances, the court is to answer the question whether or not the amount of the contractual penalty is appropriate, given the obligee’s infringed interests which the contractual penalty was supposed to protect.
If the court concludes in the step described above that the contractual penalty is not disproportional, or if the court finds itself unable, based on the evidence taken, to bring light into the scope of consequences of the breach of contract in order to be able to arrive at the legal conclusion of a disproportionate claim for penalties, then it must not curtail the obligee’s claim for the penalty. In the opposite case, the court shall proceed in this third and last step to bring down the contractual penalty to a proportionate amount, taking into account the role and purpose of the penalty as well as the value and significance of the obligation whose fulfilment it was supposed to ensure.
Conclusion
The above-described three-step test, and the fundamental and comprehensive shift in expectations from the moderating court is certainly in one sense revolutionary: A principle which was formed over many years is being abandoned and replaced by a completely different concept. Little wonder that the change has already attracted vocal proponents and detractors alike. In practical terms, one may expect claims for contractual penalties to be subjected to a more careful review and analysis by the court than previously. On the one hand, this will facilitate decisions that are tailored better to the circumstances of each individual case; on the other hand, such decisions pose much more stringent demands on the parties’ proposals of evidence to be taken and on the evidentiary procedure to be followed by the court, and mean more pressure on the participants and on the judge who is supposed to decide the case.