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

A contractual penalty provides the creditor with the assurance that the debtor will be more motivated to fulfil the obligations imposed by the contract. It is easy to negotiate and apply. Nevertheless, it may not always be advantageous to the creditor. Some of its specifics, such as the relationship to damages, limits on the amount of damages, or the statute of limitations, may also raise questions. This is what we have focused on in our article.

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Chapters of the article

What is a contractual penalty?

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) if it breaches one of its contractual obligations (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.

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Contractual penalty and damages

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 fulfils the role of ‘ lump-sum compensation’ under the Civil Code. For example, if you have agreed in your contract that in the event of a machine failure the manufacturer is obliged to pay a contractual penalty of CZK 100,000, you cannot claim damages of CZK 200,000, even if you have proved it to the last penny.A person who is not familiar with this fact can easily be fooled into thinking that a contractual penalty (even if agreed in a very low amount) is a nice “insurance” of the contract and a kind of possible extra bonus, but in reality he or she may lose a much larger sum.

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 penalty, whether monetary or non-monetary, relates. Such a procedure is certainly more pragmatic and can be recommended.
Unless the parties’ contractual agreement on liquidated damages provides otherwise, payment of liquidated damages does not relieve the debtor of the obligation to fulfil the original obligation.

Amount and negotiation of liquidated damages

As 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 performance. 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 graduate 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.

The amount of the contractual penalty is not limited in advance by law. A contractual penalty of 0.50% per day of the amount due 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 such a penalty cannot be predicted in advance. The reasons and circumstances which led to the negotiation of the amount of the contractual penalty under consideration are always relevant.

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 at the debtor’s request, which is to the creditor’s advantage.

If the amount is manifestly unfair, it would be a nullity under the Civil Code.

A contractual penalty clause may be included in the terms and conditions 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 agreement 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. On the other hand, for the layman, it is advisable to consult a lawyer, as an incorrectly negotiated contractual penalty may 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.

Tip: A contractual penalty is charged for breach of the relevant contract. It is not a payment for the supply of goods or services and is therefore not subject to value added tax (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.

Starší manželský pár je znepokojen ze zvýšení nájemného

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 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 contractual 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.

Tip: We have summarised more tips and advice on how to draw up a tenancy agreement and what it should contain in our article.

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 aseverance payment 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 from the contract must be regarded as absolutely null and void.”

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Author of the article

JUDr. Ondřej Preuss, Ph.D.

Ondřej is the attorney who came up with the idea of providing legal services online. He's been earning his living through legal services for more than 10 years. He especially likes to help clients who may have given up hope in solving their legal issues at work, for example with real estate transfers or copyright licenses.

Education
  • Law, Ph.D, Pf UK in Prague
  • Law, L’université Nancy-II, Nancy
  • Law, Master’s degree (Mgr.), Pf UK in Prague
  • International Territorial Studies (Bc.), FSV UK in Prague

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