The Grand Chamber of the Civil and Commercial Chamber of the Supreme Court recently issued a groundbreaking decision (Case No. 31 Cdo 2273/2022), which revolutionizes the method of "moderation" (reduction) of contractual penalties by the court. In this moderation, the court assesses whether the amount of the contractual penalty is proportionate to the "value" of the obligation secured by the contractual penalty and whether it is appropriate to reduce the contractual penalty claim if it is manifestly disproportionate to the damage caused.

The previous case-law did not consider, in modifying the contractual penalty, facts which occurred after the contractual penalty was agreed, but only the purpose, reason, and meaning which the parties attributed to the penalty at the time of its agreement (i.e. when the contract containing the contractual penalty was agreed). This prevented the interests of the parties from being weighed against the situation in which the obligation secured by the penalty was breached, and thus an assessment of whether the amount of the penalty was fair in relation to the creditor's interests actually affected, i.e. the circumstances.

Consequently, the Supreme Court has now departed from its earlier concept and sees it as essential to consider also the circumstances in which the parties were at the time of the breach of the contractual obligation itself and afterwards, and not when the contractual penalty was agreed. Thus, it is now essential for the modification of the contractual penalty to examine the reasonableness of the specific claim for payment of the contractual penalty in relation to the obligation breached (and not only the reasonableness of the contractual penalty arrangement itself).

For the above, the Supreme Court prescribed a three-step "moderation test" in its decision.

1. In the first step, the court is to determine what function the contractual penalty was intended to perform, according to the basic rules of interpretation of the Civil Code.

2. In the light of the established function of the contractual penalty, it is then to consider all the circumstances of the particular case, both those known at the time the contractual penalty was agreed and those that arose later, provided that they had their origin in the breach of the contractual obligation itself and were foreseeable at the time of the breach.

3. On the basis of these circumstances, the court then assesses whether the amount of the contractual penalty is proportionate to the creditor's interests which have been impaired. If it does not find that it is unreasonable, it may not reduce the creditor's entitlement to liquidated damages. Otherwise, the court shall, 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.

In practice, the conclusions of the Supreme Court will certainly be reflected in the nature of the contractual penalty arrangement. It will now no longer be sufficient to consider the reasonableness of the arrangement itself, but it will be necessary for any particular claim to be proportionate to the creditor's interests at stake.

Thus, it may be advisable to specify in the contractual clause the function of the liquidated damages and the interests which the liquidated damages protect. Even so, it follows from the present decision that it will only be possible to assess the reasonableness of the contractual penalty after the specific claim has arisen, when all the relevant circumstances of the case are known.

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