Contractual penalty – an instrument accompanying many contracts, well known even to legal laymen. It is also a tool at risk of being misused. A high contractual penalty can be disproportionate and, in extreme cases, even liquidating. For such cases, the Czech Civil Code provides for a moderation of contractual penalties, which allows the court to reduce an unreasonably high contractual penalty taking into account the value and importance of the secured obligation[1].

The court, of course, does not have an unlimited right to change the amount of the penalty at its discretion. The limit is the amount of damage incurred, which must in any case be compensated. In the context of the statutory wording, courts can only take into account explicitly defined criteria – the value and importance of the secured obligation. Other circumstances, such as the personal assets of the debtor or creditor or the overall “perceived” balance of the contract, do not come into play.

The existing concept of the described instrument is fundamentally changed by the decision of the Supreme Court of 11 January 2023, file no. 31 Cdo 2273/2022. The judges of the Grand Chamber of the Civil Division stated that “the Court does not examine the unreasonableness of the contractual penalty provision, but the unreasonableness of the specific claim for contractual penalty.” Thus, in practice, the courts will now not examine the contractual penalty arrangements, but the unreasonableness of a specific claim with regard to the interests of the parties in question.

In order to fulfil the quoted legal phrase and to unify the practice of lower courts, the Supreme Court introduced a three-step test for assessing the legal conformity of a contractual penalty:

1. The court will assess the function (preventive, compensatory or punitive) of the agreed contractual penalty according to its actual content[2].
2. Furthermore, the court must look at the specific circumstances existing not only at the time the contractual penalty was agreed, but also at the time of the breach of the contractual obligation, or even later if there is a connection.
3. After evaluating the issues identified in the previous steps, the court will turn to an overall assessment of the reasonableness of the amount of the agreed contractual penalty.

If the court concludes that the contractual penalty is unreasonably high, it shall reduce it to a reasonable amount, particularly in view of its function in the particular case. In particular, the second step marks a significant departure from previous case law. Until now, the amount and method of negotiation of the contractual penalty has been the main focus of the review, and subsequent circumstances have not played any role. Newly, the courts will also assess the foreseeable impact of a breach of contractual obligations and evaluate each claim in a truly individual and flexible manner. At the same time, this does not mean that the reduction of penalties should be arbitrary with the new case law – it will always stay within the boundaries of the test presented and, with fairly negotiated contractual terms, brings greater certainty of fairness to all parties.

The judgment belongs to the so-called “green collection” of the most important decisions of the Supreme Court and is a step towards more precise assessment of freely concluded contractual arrangements. Courts will no longer need to try to describe the unreasonable arrangement in general terms, but will need to analyse the specific claims of individual debtors and creditors.

[1] article 2051 of Act No. 89/2012 Coll., the Civil Code

[2] The interpretation of the function of the contractual penalty is governed by article 555 of Act No. 89/2012 Coll., the Civil Code

Author: Veronika Odrobinová, Adam Simota