On immorality of contractual penalties

Tomas Nielsen, CFO World

The contractual penalty is one of the most popular instruments used to secure the performance of duties in contractual documents. Nonetheless, to have the contractual penalty correctly defined may not be simple at all. In their decisions, courts put pressure on the penalty arrangements to be clear and definite; it must be absolutely clear to what type of breach the contractual penalty applies to and how the amount of the contractual penalty is calculated. At the same time, applying the rules of interpreting the intention of the parties as defined by law, the courts look for logical content in the parties’ agreements. As such, not all contractual penalty arrangements being unclear at first glance are in fact declared void by the court (and vice versa!).

Some views suggest that courts may find the contractual penalties to be immoral and as such make them void. Given the importance of contractual penalties, these are rather delicate views (low contractual penalties may not function well). The contractual penalty, of course, shall not apply without restriction, that is, fundamentally to violate the principle of justice. At the same time, views saying that the contractual penalties are subject to an objective limit that cannot be exceeded cannot be accepted either, although these are complemented by the interpretation of some court decisions (cf, for instance, Czech Supreme Court's decision Ref. No. Odo 438/2005 stating that the contractual penalty of 1% of the outstanding rent is contrary to accepted principles of morality, whereas the contractual penalty of 0.05% is not). The distorted (or, if you like, improperly simplified) nature of this interpretation, I believe, is demonstrated by the very wording of the said judgment itself according to which not only the amount of the contractual penalty is to be considered in an individual case but also its function and/or its arrangement terms and conditions. Contractual penalties providing only for the compensation of damage incurred (compensatory function) shall be approached by the courts differently. Often referred to as lump-sum damages, this type of contractual penalties facilitates the recovery of damage: if the duty in question is breached, the exact amount of damage needs not to be demonstrated; the contractual penalty is quantified instead.

A completely different approach should be adopted by the courts in respect of penalties protecting the party in question against the breach of duties (especially if the party's activities may be fundamentally affected by such a breach), or penalising the other party for breaching these duties (in law referred to as deterrent and retributive functions); the last two functions being quite often omitted by lawyers in their practice. In connection herewith, it is worth mentioning the quite interesting relationship of the contractual penalty to damages - where the contractual penalty is arranged for and the duty subject to the said contractual penalty is breached, the aggrieved party is not entitled to damages. The parties, however, may agree in their contractual documents otherwise (based on the contractual penalty function).

Impacts of disproportionate contractual penalties are also quite interesting. Whereas it cannot be excluded in civil law that these contractual penalties could be really made void by the court for being contrary to accepted principles of morality, in commercial law, I believe, this should not happen; the Czech Commercial Code provides for a specific right of the court to reduce a disproportionately high contractual penalty (discretionary power to reduce the amount). If the contractual penalty is found disproportionate by the court, it can (and should) be reduced by the court to the level of the damage incurred. This is also suggested by the Czech Supreme Court case law: the fact of finding contractual penalty disproportionate does not justify the application of Section 265 of the Czech Commercial Code according to which exercise of a right which contradicts the principles of fair business conduct is not granted legal protection but may result in exercising the discretionary power to reduce the amount. Starting on 1 January 2014, the discretionary power to reduce the amount, however, shall apply also to civil law cases, especially in connection with new Section 2051 of the Czech Civil Code (introducing other novelties as well).

In relation to the proportionality of contractual penalties, the question of limiting the amount of contractual penalties set on daily, monthly or similar basis (that is not defined by means of a fixed amount) is also quite important as even if the daily rate is agreed to be relatively low, the amount accrued in cases where the debtor (obligor) is in long delay may be quite high (and may exceed the value of the duty itself). Again, an answer to this question can be found in the case law. In one of its decisions, the Czech Supreme Court has stated the following: "In other words, a disproportionate contractual penalty may not be judged from its total amount but rather whether it results from long-time delay and the related increase by otherwise proportionate 'daily rate' ". This is a fundamental and at the same time quite logical conclusion based on the fact that if the amount of the contractual penalty not arranged as proportionate depends only on whether and when the debtor fulfils his duty the total amount accrued cannot be considered disproportionate (as otherwise it would mean for the debtors that with some patience they can reach a state where they no more need to care about fulfilling their duties).

(Published in CFO World magazine)