Supreme Court rules on contractual penalty reduction

Katarzyna Widłok

Courts are empowered to reduce contractual penalties that they consider too excessive. But such decisions must be supported by a robust argument.

Contractual penalty reduction – criteria

In its judgment of 19 Jan 2024* the Supreme Court (“SC”) considered how courts may reduce contractual penalties. It explained that such a power of reduction is mainly designed to avoid penalties that are too high compared to what is called properly protectable interests of the creditor.

SC also made a point of noting that the list of situations where penalty reduction may be available is open ended. It is not just about the relationship between the penalty amount and the potential loss incurred by or damages due to the creditor. The relevant criteria include also the relationship between the penalty amount and the contract price or the value of the thing contracted for.

In addition, courts should consider such questions as:

• What was the nature of the debtor’s breach of contract? Was it serious and long-lasting or rather small?
• Has the debtor gained anything by breaching the contract?
• Was it the parties’ intention for the penalty to also “punish” the debtor on top of serving as a loss recovery mechanism for the creditor?

How should the court justify its decision to reduce?

SC concluded that the power to reduce contractual penalty is part of judge-made law. Thus, courts have a certain margin for discretion in deciding when a penalty is excessive and do not have to resort solely to strict maths. However, to avoid being accused of arbitrariness, the court should make a case in support of its decision which should refer to the above criteria. The court needs to provide a reasonable explanation that the reduced penalty continues to serve the purposes for which such penalties are designed and is not grossly unfair to the creditor.

Conclusion

Courts may reduce contractual penalties. However, they must provide reasons for their decisions to do so and the reasons should refer to the SC criteria (ratio of penalty to contract value, nature of breach, debtor’s gain etc.).

To summarise, contracting parties will do best to note that courts have a certain leeway in reducing contractual penalties but are also required to do so by reference to specific criteria. These criteria should be reflected in the written argument in support of the judgment. Parties are recommended to use that knowledge when negotiating their contractual penalty clauses or defending excessive penalty claims.

*(case number II CSKP 865/22)