Contractual Penalties in Commercial Relationships – Common Mistakes

For a contractual penalty to fulfil its function and also hold up in court proceedings, sufficient attention must be paid to how it is agreed. In practice, we often encounter shortcomings that may lead to its invalidity and thus also to its unenforceability. In this article, we therefore focus on the most common mistakes that occur when agreeing contractual penalties.

The most common mistakes when agreeing a contractual penalty

1. Vagueness or unclear wording

A contractual penalty must be agreed clearly, definitely and comprehensibly. If it is not clear from the agreement for which specific breach of obligation it is to apply and in what amount, such an arrangement is invalid. In practice, we often encounter the problem that the contracting parties use overly general or vague wording, for example “a contractual penalty is agreed for any breach of obligations” or “for a gross breach of obligations”, without specifying precisely which obligations are meant or what is considered a “gross” breach (Judgment of the Supreme Court of the Czech Republic, Case No. 2 Odon 90/1997). Since a contractual penalty can only be agreed for the case of a breach of obligation, an arrangement under which a contracting party is obliged to pay a contractual penalty if it exercises its right to withdraw from the contract is invalid. Withdrawal from a contract is not a breach of obligation but the exercise of a statutory or contractual right, and therefore cannot be sanctioned by a contractual penalty (Judgment of the Supreme Court of the Slovak Republic, Case No. 2 Cdo 141/2000). Another frequent shortcoming in the wording of a contractual penalty is the absence of a clear determination of the amount of the contractual penalty or of the method by which the amount is to be calculated. Such ambiguities may lead the court to consider the contractual penalty arrangement invalid, and the penalty thus loses both its preventive and its sanctioning significance.

2. Disproportionate amount

Although the law does not expressly set an upper limit for a contractual penalty, the courts may reduce a disproportionately high contractual penalty under Section 301 of the Commercial Code. If the amount of the penalty is manifestly disproportionate to the significance of the secured obligation, the creditor risks its moderation (i.e. reduction, down to the amount of the damage caused, up to the time of the court decision, by the breach of the contractual obligation to which the contractual penalty relates) or even a conflict with the principles of fair business dealing under Section 265 of the Commercial Code. If the contractual penalty involved a vexatious exercise of a right contrary to the principles of fair business dealing, such a contractual penalty cannot be awarded (e.g. Resolution of the Regional Court in Bratislava, Case No. 2 CoKR 71/2013). A typical example is a situation in which the contract stipulates a contractual penalty for breach of some ancillary (marginal) obligation whose significance is negligible compared to the main obligation, and moreover in a disproportionate amount – in such a case, it is appropriate to invoke a conflict with the principles of fair business dealing.

3. Absence of written form

Under the law, a contractual penalty must be agreed in writing. If the parties rely only on an oral agreement or on having mentioned the contractual penalty in their order without clearly incorporating it into the text of the contract, such an agreement is not valid.

It should be added, however, that according to the conclusions of the Supreme Court of the Slovak Republic, Case No. 2Obdo/37/2022, the requirement of the written form of an agreement on a contractual penalty is met in commercial relationships also where the agreement on the contractual penalty is contained in the general terms and conditions of one of the contracting parties and the other party declares in a contract concluded in writing that it is familiar with the content of those terms and conditions. It follows from this legal opinion that the provision on the contractual penalty does not have to be directly part of the contract itself. Its inclusion in the general terms and conditions is also valid if the other contracting party declares in the written contract that it is familiar with their content. So, if you sign a contract that contains a reference to your contractual partner’s general terms and conditions, make sure you also know their content.

4. Regulating the relationship between the contractual penalty and damages

When formulating a contractual penalty, it is very important to also resolve its relationship to compensation for damage. Otherwise, the creditor may, by inappropriately setting the contractual penalty, exclude its own claim for compensation for damage, which may in fact be considerably higher.

Under Section 545(2) of the Civil Code, the creditor is not entitled to claim compensation for damage caused by a breach of the obligation to which the contractual penalty relates, unless the parties’ agreement on the contractual penalty provides otherwise. The creditor is entitled to claim compensation for damage exceeding the contractual penalty only if this has been agreed between the parties. This is because a contractual penalty is considered to be lump-sum compensation for damage which “absorbs” the claim for damages.

As this is a non-mandatory (default) legal rule, the contracting parties may regulate the relationship between the contractual penalty and compensation for damage contractually, in various ways. In particular as:

A) A cumulative contractual penalty

With a cumulative contractual penalty, the creditor is entitled to both the contractual penalty and compensation for damage. Here, too, we distinguish two variants:

• Offsettable contractual penalty – the creditor is entitled to compensation for damage only to the extent that it exceeds the amount of the contractual penalty.
• Non-offsettable contractual penalty – the creditor is entitled to both the contractual penalty and full compensation for damage, without limitation.

B) An alternative contractual penalty

With an alternative contractual penalty, the parties agree that the creditor has the right to choose whether to claim the contractual penalty or compensation for damage. This model is particularly suitable in situations where it is expected that the damage may significantly exceed the agreed amount of the contractual penalty.

Contractual penalties in CMR relationships

Our law firm specialises in international road freight transport law, and we very often deal with questions of contractual penalties – both in situations where our client is enforcing them and, conversely, where a contractual penalty is being claimed against our client.

All the above rules apply to CMR relationships, and further specific features apply as well.

Contractual penalties and the blocking rule

If the place of loading and the place of delivery are located in two different contracting states of the CMR Convention, the CMR Convention applies to the carriage on a mandatory basis. In Article 17, it establishes the carrier’s liability for:

• total or partial loss of the goods,
• damage to the goods,
• delay in delivery.

The carrier’s liability is regulated comprehensively and mandatorily in the CMR Convention (Articles 17 to 29). This means that the contracting parties cannot contractually extend or tighten it. Legal literature and case law agree that any stipulations extending the carrier’s liability beyond Article 17 of the CMR Convention are invalid. This also applies to stipulations on a contractual penalty for late delivery, total or partial loss of the goods or damage to them.

This is prevented by the so-called blocking rule under Article 41(1) of the CMR Convention, according to which any stipulation which would directly or indirectly derogate from the provisions of the Convention shall, subject to the provisions of Article 40, be null and void. The nullity of such a stipulation shall not involve the nullity of the other provisions of the contract.

So, if you come across a provision on a contractual penalty for damage to the goods, loss of the goods or delay in a contract of carriage governed by the CMR Convention, it will most likely be an invalid stipulation.

Conclusion

A contractual penalty is an effective legal instrument that can significantly facilitate the assertion of claims in the event of a breach of contract. However, it is important to avoid common shortcomings when agreeing it. If you are not sure how to set up the contractual provisions correctly, our law firm will be happy to help you prepare them so that they are valid, effective and enforceable in practice.