Contractual penalties and what to keep in mind in 2014

November 21, 2013  |  Alica Stegmannová

Penalties are often used by parties to a contract as protection against a breach of obligations. Even though the law does not restrict such parties very much in how they formulate the penalty, the general principles of private law and established case law need to be considered. Otherwise, contractual penalty covenants could be invalid or the penalty could be reduced by the courts. Let’s look closer at why and when this could occur and what the new Civil Code has to say about such penalties.

To stipulate a valid penalty covenant, the parties must clearly define their contractual obligations. Most often these include the obligation to pay a fee, deliver goods on time, duly use leased premises or carry out a certain activity. At first sight, the simplest way is to impose a general penalty for “any failure to fulfill the conditions set forth by the agreement”. This shortcut, however, cannot be recommended as it is unclear whether each minor default is subject to a contractual penalty. Even the Supreme Court has no final opinion in that regard. In some of its judgments, the Supreme Court has ruled such descriptions invalid on account of vagueness, while in others it has allowed them with reference to the contractual will of the parties.

Conditional contractual penalties can also be problematic. The law clearly sets forth that a contractual penalty is a sanction for breaching a contractual obligation (such as if the purchaser fails to pay the purchase price). But often, in an attempt to provide more flexibility to the debtor, the contractual penalty is formulated so that the obligation to pay is conditional on another act or circumstance, typically by the other party’s rescission of the agreement or by the debtor’s failure to remedy its default within an additional deadline. Such covenants are in conflict with the law and are thus invalid.

Sometimes less is more, such as with regard to the amount of the contractual penalty. The law does not restrict it to a specific amount, but the limit in this case should be in line with good morals. In other words, the contractual penalty should not be unreasonable, not even equal to the debt itself. Although each case is assessed individually, based on the case heard by the Supreme Court we can see that the percentage set out in contractual penalties is an imaginary border of 0.5% of the outstanding amount per day of delay. Of course, this rule is not unbreakable, since the courts always consider all the circumstances of the case. Nevertheless, this level is still regarded as indicative in accordance with good morals. In civil-law relationships contractual penalties that are inconsistent with good morals are invalid; the Commercial Code, however, sets forth that the courts have the right (applicable in particular to relationships between entrepreneurs) to reduce the amount.

Selected changes in the new Civil Code

The new Civil Code effective from 1 January 2014 regulates contractual penalties based on the previous civil-law and commercial regulations. One of the most important changes is undoubtedly the removal of the former two-track regulation in the Civil Code and the Commercial Code. The new Civil Code removes contractual penalties from the institution of securing a liability and includes them under debt confirmation, which also includes debt recognition. Contractual penalties are not intended to provide certainty to creditors that their claims will be satisfied (as is the case with security instruments, such as liens where debts are satisfied from substitute performance rendered from the revenues arising from a pledge converted into money), but to force the debtor to repay its debts under a threat of other liabilities (typically a monetary sanction). A contractual penalty is thus intended to confirm a debt.

The new legal regulation is more open to the will of the parties. A crucial change is the omission of a strict requirement that the contractual penalty be in writing. Now it is exclusively up to the parties whether they agree in writing or orally. It is recommended, however, to insist that it be in writing in case proof is required later.

The new legal regulation is rooted in the Commercial Code’s concept, pursuant to which contractual penalties can also be agreed if an obligation is breached through no fault of the parties (e.g., if the seller does not obtain approval from the relevant authority). The new Civil Code expressly admits that the contractual penalty can be in the form of non-monetary performance, which used to be disputable. It is also possible to agree on a certain penalty where the obligation ceases to exist after the fine is paid. In other words, debtors may get rid of the duty to fulfill a binding obligation merely by paying a fine. According to the explanatory report, agreements on a contractual penalty will not be invalid even in cases outside of breaching a contractual duty. From the viewpoint of the new Civil Code such an arrangement will not be considered a contractual penalty but will be a valid (unnamed) covenant.

In conclusion, it is worth mentioning that although the autonomy of the parties is significantly strengthened in the new Civil Code, in some cases the possibility of stipulating a contractual penalty is completely excluded.