Contractual penalty: what to look out for when negotiating it?

Quick overview

A contractual penalty is a pre-agreed penalty for breach of a contractual obligation. It is triggered by the breach of the obligation itself, usually without the need to prove damage or fault. However, you must specify in the contract exactly what the penalty is for, when it is payable and whether the creditor can claim damages in addition to the penalty. If the penalty is unreasonably high, the court may reduce it on the debtor’s application.

When negotiating a contractual penalty, look out for the following:

• whether the obligation whose breach is being penalised is clearly described,
• whether the amount of the penalty corresponds to the significance of the obligation secured,
• whether the contract expressly preserves the right to compensation,
• when the contractual penalty is payable,
• whether you do not exceed the legal limit for the lease together with the security deposit.

Not sure if the penalty in your contract is valid and enforceable? Send us your contract for review. An attorney will review the wording of the penalty, its amount, its relationship to damages, and the risk that a court will reduce or invalidate it.

What does liquidated damages mean?

A liquidated damages is a possible (but not mandatory) part of a contract in which one of the parties to the contract agrees to perform a certain amount (usually paying a certain amount) in the event of a breach of a contractual obligation (for example, to deliver some goods within a given period of time).

What is relevant for the application of liquidated damages is the breach of the contractual obligation itself and not whether the other party has suffered any damage as a result. Even if the damage is less than the amount of the contractual penalty, or even none at all, the contractual penalty must still be paid (for example, if the deadline for delivery of the goods is not met, the debtor will be forced to pay the contractual penalty even if this fact does not restrict the other party’s business or other activities).

The debtor will also normally (unless otherwise agreed) have to pay the liquidated damages regardless of its fault. Thus, for example, if the van with the goods did not arrive because it was hit by a stranger or because a tree fell on it and destroyed the cargo.

If the amount is set correctly, securing a contract with a contractual penalty can be much more beneficial and easier than claiming damages.

Unlike liquidated damages, which refer to actual damages, liquidated damages do not require proof of the amount of damages. Thus, in practice, there may be situations where the parties to a contract are faced with the question of whether the liquidated damages are subject to VAT, similar to the VAT on damages.

Liquidated damages and compensation

In this context, it is important to point out that by agreeing a contractual penalty , the creditor loses the right to compensation for damages arising from the breach of the obligation to which the contractual penalty relates. The contractual penalty thus plays the role of a ‘ lump sum’ compensation under the Civil Code.

If you have, for example, agreed in your contract that the manufacturer is obliged to pay a contractual penalty of CZK 100,000 in the event of a machine failure, you cannot claim damages of CZK 200,000 even if you prove it to the last penny. A person ignorant of this fact can easily be fooled into thinking that the contractual penalty (even if agreed at a very low level) is a nice “insurance” of the contract and a kind of possible extra bonus, but in reality he may lose a much larger sum.

In our experience: we often encounter contracts in which the contractual penalty is agreed as an apparently convenient insurance, but there is no sentence that the creditor can claim damages in excess of the penalty. In one typical case, the entrepreneur then resolves that the actual damages significantly exceeded the agreed penalty, but the contract has made it unnecessarily difficult for him to make a further claim.

On the other hand, however, the law does not prevent the parties from agreeing that the contractual penalty does not affect the creditor’s right to claim compensation for damages arising from the breach of the contractual obligation to which the monetary or non-monetary penalty relates. Such a procedure is certainly more pragmatic and can be recommended.

Unless the parties’ contractual agreement on liquidated damages provides otherwise, the payment of liquidated damages does not relieve the debtor of the obligation to fulfil the original obligation.

In practice, this means only one thing: it is not enough to write the amount of the liquidated damages into the contract. If you want to be able to recover more actual damages, this must be explicitly stated in the contract. We will be happy to check that your contract contains this protection and that the wording does not deprive you of money unnecessarily.

Amount and negotiation of liquidated damages

As we mentioned above, the most common form is an obligation to pay a lump sum (e.g. a lump sum of money). However, it can also be a specific amount (percentage or fixed) for each day of delay in complying with the obligation. A contract usually provides for several obligations, the breach of which is not always of the same severity. In such a case, it is proposed to negotiate an upper limit for the contractual penalty and to scale the specific amount depending on the criteria set.

In addition, the contractual penalty does not have to take the form of a monetary amount only: it can also be the performance of work, the transfer of some things, etc. E.g. if I don’t deliver 100 tonnes of coal by a certain date, I will deliver one tonne more for every week a day late.

The definition of the obligation to which the penalty is attached is very important. It is possible to specify only certain obligations under the contract, the performance of which is secured by the penalty, or the penalty can be linked to the breach of ‘any’ obligation under the contract.

The Supreme Court was previously reluctant to adopt such a formulation, but in a later decision it also accepted this option. In any event, for the legal certainty of both parties , it is better to formulate the breach of obligations very precisely – either by reference to the provision of the contract in which they are found, or by reiterating the obligation.

A client of ours wanted to adopt a model contract from the internet in which liquidated damages were linked generally to “breach of contract”. The problem was that the contract contained dozens of obligations of varying severity, ranging from a formal information obligation to a major payment obligation. We therefore recommended that penalties should be broken down according to specific obligations and that lower amounts should be set for less serious breaches. The result was a contract that was clearer, more balanced and more defensible in the event of a dispute.

Reasonableness of the contractual penalty

The reasonableness of liquidated damages is also a big issue. The amount of liquidated damages is not limited in advance by law. A contractual penalty of 0.50% per day of the amount owed for each day of delay is sometimes referred to as a disputed limit. This has already been assessed as excessive by some courts.

Others, however, have allowed even 1% of the amount due per day. Obviously, the situation would be assessed on a case-by-case basis and the reasonableness or unreasonableness of the contractual penalty cannot be prejudged. The reasons and circumstances which led to the negotiation of the amount of the contractual penalty under consideration are always relevant.

From our practice: The most common mistake is not only an excessively high contractual penalty, but mainly a penalty set without any relation to the significance of the breached obligation. The court will perceive a fine differently for a one-day delay with a minor administrative task and differently for a breach of a non-compete or confidentiality agreement that may cause substantial damage to the other party.

If the court finds the contractual penalty to be excessive, it may decide to reduce it to a “reasonable” amount if necessary. However, this is only ever done on the debtor’s application, which is to the advantage of the creditor, who can thus achieve the reasonableness of the contractual penalty.

If the amount of the penalty payment is manifestly unfair, it would be a null and void agreement under the Civil Code.

A liquidated damages clause may be included in the terms and conditions of business if two entrepreneurs refer to it. However, if the contract with the entrepreneur is concluded by a consumer, it can only be agreed in the contract itself, not by reference to the terms and conditions. In such a case, the negotiation would be regarded as absolutely null and void.

Make sure that the contractual penalty is related to the context of the whole contract and forms a whole with it. Searching for models on the internet is not usually helpful in this respect. A contractual penalty does not have a pattern that fits every situation. On the other hand, for the layman, it is advisable to consult a lawyer, as an incorrectly negotiated contractual penalty can lead to its invalidity.

Importantly, you can also negotiate a contractual penalty orally. The conventional idea that a written contract is required no longer applies. However, you must of course take into account the conclusiveness of such an agreement. This can be based on an e-mail conversation or the testimony of a trustworthy witness.

The tax implications of contractual penalties must also be taken into account when dealing with them. In some cases, the question may be whether a contractual penalty or damages are subject to VAT. According to recent case law, it depends on the specific nature of the transaction – if a contractual penalty replaces the price of the transaction, it may in certain cases be seen as a transaction for consideration subject to VAT.

It is important to bear in mind that while a contractual penalty is primarily punitive in nature and is generally not subject to VAT, the situation may be more complex with regard to compensation for damages. Indeed, in practice, we encounter cases where the tax authorities examine whether it is compensation for lost income or actual compensation for damages that would not be subject to VAT.

Maturity, default interest and limitation of contractual penalties

The law does not explicitly state when a contractual penalty is due. Therefore, it is worthwhile to expressly stipulate its due date in the contract. This can be done by a specific time limit (the day of default or, for example, seven days after default) or by linking the due date to a written notice from the creditor. The limitation period for contractual penaltiesruns independently of the original contract and is three years from the date on which the contractual penalty is due.

However, if the debtor fails to pay the contractual penalty even after it has become due, default interest shall be added to it. This situation is distinguished from the negotiation of conventional contractual default interest, which may be negotiated in addition to the contractual penalty, as the two are not mutually exclusive.

Contractual penalty in the lease agreement

Previously, the law did not allow the negotiation of a contractual penalty in a lease agreement. However, the amendment effective from July 2020 has removed this obstacle. As the tenant is generally in a weaker position in this contractual relationship, he is protected by the law in this respect, so that the contractual penalty together with security cannot exceed three times the monthly rent. At the same time, the Civil Code states that unreasonable obligations cannot be imposed on the tenant and therefore an unreasonable penalty cannot be demanded.

Securing the lease by a combination of security and liquidated damages can also bring positive benefits for the tenant. Although visually the amount remains the same (i.e. a maximum of three times the rent), the penalty will not be payable before the commencement of the tenancy but only in the event of a breach of duty. In effect, therefore, the upfront amount may be significantly reduced, which may make housing slightly more affordable again. However, the landlord is left with the same level of security. The downside, however, can of course be the subsequent enforcement of the penalty, which may not be straightforward.

Contractual penalty and withdrawal from the contract

As we have mentioned several times, the contractual penalty should be related to the breach of the obligation, so it cannot be used to sanction the withdrawal from the contract, since in such a case it is the exercise of a right, not a breach. The court may consider such an arrangement as severance pay instead of a contractual penalty, which is governed by different rules. According to previous case-law, “where a contractual penalty is essentially a penalty for the exercise of the right to withdraw from the contract, an agreement on the obligation to pay a contractual penalty on withdrawal must be regarded as absolutely void.”

Contractual penalty and compensation for damages under the Civil Code

The relationship between liquidated damages and damages is one of the most common issues in contracting. According to the Civil Code (CCC), a contractual penalty may constitute ‘ liquidated damages’, i.e. a predetermined amount to be paid by the debtor in the event of a breach of a contractual obligation.

This means that the creditor does not have to prove the actual amount of damage – the mere existence of a breach of duty gives rise to a claim for a contractual penalty. Such an arrangement facilitates the recovery of the claim and increases the creditor’s security.

However, unless the parties expressly stipulate otherwise, the right to damages is extinguished by the contractual penalty. Thus: the creditor can no longer claim both contractual penalty and damages for the same event. In practice, therefore, the formulation that ‘the contractual penalty does not affect the right to damages’ is often used to ensure that both claims can be asserted.

Do you address liquidated damages in the contract or is the counterparty already seeking liquidated damages from you? Send us the documents. We will assess whether the claim is justified, what the risks are and what course of action makes the most sense for you.

Summary

A contractual penalty is a contractual instrument that motivates the debtor to perform and provides security to the creditor. Unlike damages, it does not require proof of injury and is payable regardless of fault. However, unless otherwise agreed, liquidated damages replace the right to compensation, which may be disadvantageous for the creditor. The amount of the penalty is not limited by law, but the court may reduce it on the debtor’s application if it is excessive. The contractual penalty may be agreed orally, its due date should be specified in the contract and, if not paid on time, it is subject to default interest. In lease agreements, the maximum amount is limited to three times the monthly rent. When negotiating it, it is important to ensure legal precision and consider its tax implications, including possible VAT liability.