How high can the contractual penalty be?

In the IT world, the rule is that projects start with a non-disclosure agreement - NDA.

You just want to make sure at the beginning that your project, idea or solution is not leaked to the world by the other side. But the very word agreement makes it clear that it is an agreement between two parties.

And unfortunately, there are not only agreement-keeping gentlemen in the world. That's why we need to look for ways to make sure that the other party doesn't breach the agreement.

This is exactly what a contractual penalty can be used for.  Perhaps CZK 500 000.

Is such a penalty appropriate? Is it too much?

What is too large a penalty?

The party has two options. Accept the amount of the contractual penalty and pay it in the event of a breach of the affirmed obligation.

Or start a lawsuit. Because maybe it was a specific case, the party feels wronged, feels there was no breach of duty.

In such a case, the court comes into play. The court may reduce the excessive fine in accordance with Section 2051 of the civil code ↗. It has the so-called moderation right of contractual penalty.

Up till now, the court has assessed what the penalty clause looked like. That is, it has primarily assessed the financial amount that the parties agreed to in the contract. It has been established by case law that a contractual penalty of approximately 0.5% per day of the amount due is still considered OK.

The case of BVV Trade Fairs Brno

An example similar to the above has recently made its way to the Supreme Court. BVV Trade Fairs Brno and the company that was considering organizing the car fair had concluded a preliminary non-disclosure agreement.

In the event of a breach, a contractual penalty of CZK 250,000 has been set.

However, in the course of arranging the details, information that the non-disclosure agreement protected was leaked to the media. The company started to sue Trade Fairs Brno for payment of a contractual penalty.

What was the court's conclusion?

In this context, the Supreme Court issued a landmark decision (31 Cdo 2273/202), according to which it is not so important what the content of the penalty clause looks like (it is up to the parties what they agree and their autonomy of will).

What becomes important is the specific breach of the contractual obligation. In other words, contractual penalty arrangements must be assessed in specific cases.

"The court does not examine the unreasonableness of the contractual penalty arrangement, but the unreasonableness of the specific claim for contractual penalty."

Three steps of assessment

The Supreme Court has divided the assessment of contractual penalties into three questions that must be answered in assessing the amount:

1. What is the purpose of the contractual penalty?
2. What are the specific circumstances of the contractual penalty? It is not only the circumstances in which the contractual penalty was agreed upon that are examined, but also the specific breach that led to the contractual penalty (e.g., the extent of the information disclosed, the culpability of the other party, etc.).
3. If, on the basis of the above issues, the contractual penalty is inadequate, the court may reduce it. It shall take into account the purpose which it is intended for and the value and importance of the obligation which the contractual penalty protects.

What does this mean in practice?

In our view, the contractual penalty is much closer to compensation for damages. It will no longer be a provision that automatically (if the correct amount is observed) gives rise to an obligation to pay. Now, the contracting party will have to prove that a claim for contractual penalty has actually arisen, which is very close in nature to compensation for damages.

In view of this fact, when drafting contracts, such as non-disclosure agreements, it is important to bear in mind that it will not be enough to say, "0.5% is OK." The time is coming when the parties will have to better define the terms of the contractual penalty and its justification. Or look for alternative ways to enforce compliance with a hardened obligation.

Either way, it would be ideal that no agreement has to go to court. Therefore, it is always advisable to set contractual obligations in a balanced way. We have a lot of experience in doing this and would be happy to show you what a balanced contract can look like.

Try our non-disclosure agreement ↗ , for example.