Moderation of contractual penalties in the Czech Republic: Statutory regulation, existing and new interpretations

In a ground-breaking decision of 11 January 2023, the Supreme Court of Czech Republic fundamentally changed the concept of moderation of contractual penalties. In its decision in case No. 31 Cdo 2273/2022, it deviated from its long-term practice. In the future, the courts will have to consider circumstances that could not be considered before when assessing the unreasonableness of a contractual penalty.

For the ninth year in a row, the rule allowing the modification of contractual penalties is contained in Section 2051 of the Civil Code, according to which: "An unreasonably high contractual penalty may be reduced by the court, on the debtor's motion, taking into account the value and importance of the secured obligation, up to the amount of the damage incurred up to the time of the decision by the breach of the obligation to which the contractual penalty relates."

According to the existing court practice (which adopted the case law conclusions adopted under the Commercial Code regime, repealed as of 1 January 2014), the basis for moderation was the unreasonableness of the contractual provision on contractual penalty. As a matter of principle, the inadequacy of the specific contractual penalty claim arising from the contractual arrangement in the individual case was not assessed. At first sight, this difference may appear to be a legal technicality, but these different approaches have fundamental practical consequences.

The existing concept of moderation meant that only those circumstances that existed at the time the contractual penalty was agreed could be considered in assessing the (un)reasonableness of the contractual penalty. It was not possible to consider later circumstances – typically relating to the specific breach of the obligation the contractual penalty was linked to.

In practice, for example, it was not possible to ask the court to reduce the penalty by referring to the reasons or circumstances of the delay or the reasons for the duration of the delay. Nor could it be argued that the breach of the obligation did not actually affect the interests of the creditor, which the contractual penalty was intended to protect. Also, it was not possible to argue that the total amount of the penalty was disproportionate as far as it was the result of a prolonged delay and the associated increase in daily rates. All those circumstances occur only after the contractual penalty has been agreed.

New interpretation

The Supreme Court has now concluded, based on a legal analysis and a comparison of the current legislation with the previous one, that a rethink of the current approach is necessary.

According to the Supreme Court, the subject of moderation should not be a contractual arrangement in general, but the claim for contractual penalty itself.

Considering the specific interests of the parties, the contractual penalty paid to the creditor in a particular case should not be disproportionate. The reasonableness of the penalty should be assessed in the light of the manner and circumstances in which the breach of the contractual obligation secured by the penalty occurred and the extent to which it affected the interests of the creditor which should have been protected by the penalty.

The Supreme Court stated that this modified interpretation more closely respects the autonomy of the parties' will and allows the court to assess the fairness of the contractual penalty claim by considering the specific effects of the breach of the contractual obligation. So, although this change in settled case-law undermines legal certainty to some extent, the Supreme Court considers that legitimate reasons justifying the change prevailed.

The court's procedure for moderating (or assessing the reasonableness of) a contractual penalty should now include the following steps:

• The court must first clarify what function the contractual penalty was intended to perform. Diverse types of contractual penalties pursue different interests of the parties. A contractual penalty may have a preventive (coercive), a lump-sum (lump-sum compensation) and/or a punitive function.
• Then, the court examines the specific circumstances, considering the established function of the contractual penalty. In doing so, it must take into account all the circumstances of the particular case, considering not only the circumstances already known at the time the contractual penalty was agreed, but also the circumstances at the time of the breach of the contractual obligation, and circumstances that arose later, if they originated in the breach of the contractual obligation and were foreseeable at the time of the breach. Based on those circumstances, the court will decide whether the amount of the contractual penalty is reasonable in relation to the creditor's interests which were impaired as a result of the breach of the contractual obligation and should have been protected by the contractual penalty.
• If the court concludes in the preceding step that the contractual penalty is not unreasonable, or if it fails to clarify the extent of the consequences of the breach of the contractual obligation in the creditor's sphere based on the evidence taken, to be able to draw a legal conclusion that the contractual penalty claim is unreasonable, it cannot reduce the creditor's claim for contractual penalty. Otherwise, the court will, in the third step, reduce the contractual penalty to a reasonable amount, considering the functions it is intended to perform, and the value and importance of the obligation secured.

Moderation will still be possible only in cases where the court considers the contractual penalty unreasonable. But it will now also be able to consider the circumstances of the specific claim. It’s worth noting here that the burden of proof as to the unreasonableness of the contractual penalty (ie the obligation to allege and prove that it was unreasonable and why) is on the debtor. If the debtor fails to prove the unreasonableness, the court will not proceed to moderation.

Conclusion and possible implications of the change

This new concept of the moderation of contractual penalties undoubtedly brings a fundamental change from the existing judicial practice. It will no longer be the case that a contractual penalty provision once moderated by a court is applicable to all future claims arising from it. The court will now be able to moderate each individual contractual penalty claim separately. So, at least in this respect, legal certainty may be weakened.

In addition, borrowers' options for defending against contractual penalties are significantly expanded. In a moderation application, they’ll be able to argue specific reasons why the contractual penalty is unreasonably high. There’s also likely to be scope for the moderation of high penalties for long delays, where it will now be possible to defend the reasons that led to the delay. The full implications of this conceptual change are not easy to predict at this moment. But it’s still the case that moderation is regarded as a rather exceptional instrument, where the conclusion on the unreasonableness of a contractual penalty is left purely to the discretion of the court. We don’t expect a completely diametric change in the approach to the moderation of contractual penalties. But it remains to be seen in the years to come what direction the case law will take following this change.