Proper formulation of contractual penalties in commercial contracts

The legal nature and functions of a contractual penalty

A contractual penalty may be stipulated solely in the event of non-performance or improper performance of a non-monetary obligation. Attaching a penalty to a monetary obligation – e.g. for late payment of an invoice – is legally impermissible and renders such a provision void; in such cases, interest for late payment remains the appropriate remedy.

A fundamental feature of this institution is its accessory nature in relation to the principal obligation and the independence of the claim for a penalty from the obligation to prove damage. This issue was resolved by a resolution of a panel of seven judges of the Supreme Court dated 6 November 2003 (ref. III CZP 61/03), which stated that a creditor may claim payment of a contractual penalty regardless of whether they have suffered damage and to what extent. Demonstrating the mere fact of non-performance or improper performance of the obligation is therefore a sufficient condition for the effective pursuit of a claim – which constitutes a significant procedural facilitation for the creditor.

Despite the significance of the above-mentioned Supreme Court resolution, the case law of the common courts is not entirely uniform on this matter. It happens that courts – despite the unambiguous position expressed by the extended panel – still require the creditor to demonstrate the amount of damage suffered.

A contractual penalty serves simultaneously a compensatory, preventive and punitive function. The multifunctionality of this institution justifies its widespread use in commercial contracts as an effective tool for disciplining the debtor and motivating them to perform their obligations diligently.

Formal requirements for the correct formulation of a contractual clause

For a contractual provision concerning contractual penalties to be effective, it must meet the following requirements:

• The contractual provision must clearly specify which conduct on the part of the debtor – or their failure to act – triggers the obligation to pay the penalty. It is unacceptable to use vague phrases such as ‘any breach of contract’ or ‘failure to comply with good practice’.
• The amount of the penalty must be calculable at the time of concluding the contract using simple arithmetic operations – as a fixed sum, a percentage of the remuneration, or a daily rate. Reference to future, uncertain events breaches this requirement and may render the clause ineffective.
• Pursuant to Article 484(1) of the Civil Code, a contractual penalty is, as a rule, exclusive in nature: the creditor may not claim damages exceeding its amount, unless the parties have expressly provided in the contract for the possibility of claiming supplementary damages. Omitting this aspect at the negotiation stage may significantly limit the scope of the creditor’s protection in the event of damage exceeding the amount of the penalty.

Moderation of the contractual penalty

Article 484(2) of the Civil Code grants the court the power to reduce the contractual penalty in two cases: where the obligation has been performed to a significant extent, or where the stipulated penalty is grossly excessive.

The assessment of grossly excessive penalties takes into account a wide range of circumstances: the ratio of the penalty to the actual or hypothetical loss, the ratio of the penalty to the value of the contract, the gravity of the breached obligation, the duration of the breach, and the punitive nature that the parties intended to attach to the sanction. None of these criteria is absolutely decisive – the court assesses the totality of the circumstances of each case on a case-by-case basis.

Importantly, the possibility of moderating a contractual penalty is not excluded in relations between businesses, i.e. within the scope of their commercial activities. Whilst the fact that both parties are professionals may be taken into account as one of the factors in assessing the justification for reducing the penalty, it does not preclude the very institution of moderation.

Summary

The effective reservation and enforcement of contractual penalties in commercial contracts is based on several fundamental principles. The penalty may only cover non-monetary obligations, and its amount must be determinable at the time the contract is concluded. The creditor is not obliged to prove damage, but the precision of the clause’s wording – including the identification of a specific obligation and a quantifiable amount – determines in practice the effectiveness of the provision.

The courts have broad powers to moderate grossly excessive penalties, which should encourage the parties to set the level of sanctions at a level proportionate to the value of the contract and the actual risk of breach. Excessive penalties, though seemingly advantageous to the creditor, expose them to judicial intervention and the unpredictability of the outcome of the dispute. Reliable documentation of breaches, timely demands for payment from the debtor, and an awareness of the limitations regarding the accumulation of penalties and their limitation periods are essential elements for the effective protection of the creditor’s interests in commercial transactions.

Author

Aleksandra Chomicka

Radca prawny, Senior Associate

She gained experience in providing day-to-day legal services to individuals and entrepreneurs at a number of law firms in Warsaw specializing in corporate law and family law. At the firm, she provides services to entrepreneurs and individual clients in the field of contract and business law. As part of her professional practice, among other things, she analyzes, reviews and creates civil law contracts, prepares legal opinions in the field of civil and business law, and drafts and prepares corporate documents,…

View profile →