Contractual penalty linked to withdrawal from contract

Recently, two fundamental decisions of the Supreme Court of the Czech Republic have been issued, which fundamentally change the approach of the Supreme Court to the hitherto relatively formal conception of the issue of contractual penalties agreed upon withdrawal from the contract.

This shift in case law could be very briefly characterized by the fact that there is no direct deviation from the current approach (i.e. the impossibility of negotiating a contractual penalty in connection with exercising one’s right), but in the spirit of the provisions of Act. No. 89/2012 Coll., the Civil Code (hereinafter referred to as “Civil Code”) the Supreme Court interprets the individual provisions of such agreed contractual penalties in a manner that preserves validity, if it is at least somewhat possible. In this article, we will very briefly approach the specific decisions where a clear shift in the approach of the Supreme Court of the Czech Republic can be seen.

  • Previous case law and legal practice

First, we will look briefly at previous legal practice in this area, which was based on for a long-term unequivocal and established case law of the Supreme Court of the Czech Republic.

The case law and legal practice were thus fundamentally based on the premise that withdrawal from the contract cannot be validly sanctioned by a contractual penalty. This long-established conclusion was based primarily on the legal regulation of the institute of a contractual penalty (which was in principle not different even from the previous Civil Code), which allows its negotiation only in the event of a breach of contractual obligation. As withdrawal from contract represents exercise of one’s legal right, not a breach of obligation, it was not possible to validly negotiate a contractual penalty linked with withdrawal, even if the withdrawal was made due to a previous breach of contract.

Case law and legal practice therefore relatively formally required that any contractual penalty must be linked to the breach of contract, which may subsequently be a reason for withdrawal from the contract.

The abovementioned can then be demonstrated in an older ruling of the Supreme Court of the Czech Republic from 31st of March 1998, file no. 3 Cdon 1398/96 or the ruling of the Supreme Court of the Czech Republic from 27th of April 2006, file no. 33 Odo 469/2006.

According to this case law, it was therefore the case that “an agreement, the purpose of which is to negotiate a contractual penalty for the case of exercising the right of withdrawal and not for the case of breach of contractual obligation, is contrary to the provisions of § 544 of the Civil Code and is therefore (…) absolutely invalid according to Section 39 of the Civil Code.”

Older specialized publications (for example ŠKÁROVÁ, M. in ŠVESTKA, J., SPÁČIL, J., ŠKÁROVÁ, M., HULMÁK, M. a kol. Občanský zákoník I, II, 2. vydání, Praha: C.H.Beck 2009, s. 1606.) also expressed similar beliefs when saying: “A contractual penalty cannot be considered, for example, an obligation to pay a certain amount in the event of withdrawal, because withdrawal does not represent a breach of duty but the exercise of a right either under law or when established contractually.”

  • Deviation from the formal approach for the first time

A very new approach, which can be characterized as a departure from the previous formal approach, was taken by the Supreme Court of the Czech Republic in the ruling file no. 23 Cdo 1192/2019, from 30th of October 2019. It is even explicitly expressed by the Supreme Court of the Czech Republic that this ruling indeed represents a departure from previous practice at the end of the legal sentence of the ruling, where it states:

“It is therefore not possible to maintain the existing conclusions on the absolute invalidity of such legal action.”

Now, let’s get closer view at what legal action the Supreme Court of the Czech Republic had in mind. In this case, the Supreme Court of the Czech Republic addressed the issue of when the contractual penalty was agreed upon withdrawal from the contract (i.e. for exercising the right, not breach of duty), however in the case where breach of contract was the reason for such withdrawal. According to the text of the contract, the contractual penalty applied to both cases at the same time, i.e. both to withdrawal and to the breach of a contractual obligation. Thus, the court was dealing with a situation where the right to pay a contractual penalty is linked both to the breach of duty by the debtor and to the withdrawal from the contract by the creditor.

The court of first instance, as well as the court of appeal, concluded with reference to previous case law and legal practice that this is an invalidly agreed upon contractual penalty and at the same time it leads to absolute invalidity. In this respect, the Supreme Court of the Czech Republic concludes that in this particular case it is no longer possible to rely on previous conclusions of case law and legal practice on the absolute invalidity of such juridical acts and states:

“The agreement of the parties, which links the right to a contractual penalty to a legal fact other than a breach of a legal obligation, which is represented by the withdrawal from the contract by the creditor for breach of duty by the debtor, is not prohibited and is therefore admissible. At the same time, such an arrangement does not deviate from the limits of the definition of the contractual penalty, as follows from Section 2048 of the Civil Code, so it is not an inominate arrangement. The possibility of such an arrangement is not precluded even by the legal regulation of withdrawal from the contract.”

The Supreme Court of the Czech Republic thus clearly deviates from the earlier formal approach, and without changing the basic rule of inadmissibility of negotiating a contractual penalty for exercising the law, bridges the apparent contradiction by interpreting juridical acts, which in principle allows to maintain the validity of a contractual penalty for withdrawal in situations where the withdrawal was preceded by a breach of a contractual obligation which was the reason for the withdrawal and which is also subject to the contractual penalty.

  • Deviation from the formal approach for the second time

This shift, which reflects the new approach of the Supreme Court to this issue, can be demonstrated in another recent ruling as well, namely the ruling from 18th of March 2020, file no. 23 Cdo 2070/2018.

In this case, the Supreme Court of the Czech Republic dealt with a situation where the contracting parties agreed on a “sanction” in the amount of CZK 60,000, which the contracting party is obliged to pay to the other contracting party in the event of withdrawal from the contract.

As in the first case, the lower courts ruled in accordance with the above-mentioned practice and considered this arrangement as an agreement on a contractual penalty, which, however, is absolutely invalid in the light of previous case law.

Even in this case, the Supreme Court of the Czech Republic decided to deviate from the previous practice, although in this case it no longer does so explicitly, but only implicitly. In essence, however, it is an expression of an identical, more benevolent approach to the issue in favor of the real will of the parties and the validity of the arrangements, where possible.

In this case too, the Supreme Court of the Czech Republic did not dispute the opinion that a contractual penalty can be negotiated only in the event of a breach of duty, but noted that the “sanction” arrangement does not necessarily have to be considered a contractual penalty.

The Supreme Court of the Czech Republic pointed to the fact that even according to previous case law it is permissible for the parties to agree on severance pay or another lump sum compensation, which will be due if one of the parties decides to withdraw from the contract.

As seen by the Supreme Court, the term “sanction” does not preclude the assessment of this arrangement as the above-mentioned admissible compensation and, conversely, with regard to the intentions and purposes of the parties and the need for interpretation in favor of validity of the contractual arrangement where possible, concluded the parties, without any doubt, did not want to enter into an invalid arrangement and the agreed amount must therefore be considered as contractual compensation, not as a contractual penalty, and therefore represents a valid arrangement.

  • Conclusion

There is a certain shift in the perception of the issue of contractual penalties agreed upon the withdrawal from the contract. It’s represented by the departure from the current rather strictly formal approach to a more benevolent approach, where the Supreme Court uses interpretative aids in favor of validity of contractual penalty (or sanction or compensation) upon withdrawal from the contract, if it is otherwise possible in the given case.

Undoubtedly, however, the contractual penalty arrangement would continue to be invalid in the event of withdrawal from the contract without a reason, i.e. where the withdrawal is not linked to a breach of duty. In that regard, it is therefore still the case that a contractual penalty can be negotiated only in the event of a breach of an obligation.

When preparing contracts, the parties should pay particular attention to the choice of appropriate institutes for securing and corroboration of debts and, in particular, to correct expression. It is therefore advisable to consult an expert, who will choose the appropriate securing and corroboration institutes and who will avoid the risks arising of invalidity of fundamental arrangements. And if not, an expert is at least insured for such case.

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