Maciej Szewczyk

Renunciation of a contract and the requirement to pay a contractual penalty

The effectiveness of provisions for payment of a contractual penalty for renunciation of an agreement is determined by the mutual intent of the parties as reflected in the content of the agreement.

A reservation in a contract of a duty to pay a contractual penalty in the event of non-performance or improper performance of an obligation by one of the parties (the debtor) is a convenient instrument that is often used in practice in Poland. It significantly strengthens the position of the party entitled to demand the penalty (the creditor) by eliminating the need to prove the amount of the loss, or even that any loss occurred at all (resolution of 7-judge panel of the Supreme Court of Poland of 6 November 2003, Case No. III CZP 61/03).

In bilateral agreements, the parties often include provisions under which one of them has the right to demand payment of a contractual penalty in connection with the party’s exercise of the right to renounce the agreement as a result of non-performance or improper performance by the other party. Provisions of this type may be found in particular in certain transaction agreements, i.e. involving rights to shares in companies, a set of corporate assets, or a company’s enterprise.

The effectiveness of such provisions can be problematic, however, particularly in a case where the party entitled to renounce the agreement (and demand payment of a contractual penalty) is the party required to provide non-monetary consideration and renunciation of the agreement occurs in connection with non-performance (or improper performance) of a monetary obligation by the other party.

As the Supreme Court of Poland has indicated, the effectiveness of the reservation of a contractual penalty in the event of renunciation of the contract cannot be evaluated in isolation from the nature of the non-performance or improper performance of the obligation (judgment of 7 February 2007, Case No. III CSK 288/06).

Under Civil Code Art. 483, reservation of a contractual penalty should serve to provide redress for loss arising out of non-performance or improper performance of a non-monetary obligation.

Therefore, if on the basis of the agreement (or on the basis of Civil Code Art. 491) a party has a right to renounce the agreement as a result of non-performance by the other party of an obligation to pay money (e.g. the purchase price), there are no grounds to demand that the other party pay a contractual penalty (Case No. III CSK 288/06). Such a provision in a contract should generally be regarded as ineffective in light of the wording of Civil Code Art. 483 (e.g. Supreme Court resolution of 18 July 2012, Case No. III CZP 39/12, but the Supreme Court took a differing view in the judgment of 13 June 2008, Case No. I CSK 13/08).

Example: X does not perform the obligation to pay for goods supplied by Y. Y renounces the agreement (due to lack of payment, i.e. non-performance of a monetary obligation) and demands that X pay a contractual penalty.

Another situation would be where the agreement provides for a contractual penalty not so much for non-performance or improper performance of the agreement by one of the parties (giving the other party the right to undo the contractual relationship by exercising its right to renounce the agreement), but rather for non-performance or improper performance of the party’s obligations connected with renunciation of the agreement by the other party.

In the case of renunciation of a bilateral agreement by one of the parties, Civil Code Art. 494 imposes on the parties the duty to restore to one another the consideration provided under the contract. Thus, in connection with such mutual settlements, there may be non-performance or improper performance of obligations connected, for example, with returning the consideration received from the other party. Reservation of a contractual penalty in the event of such non-performance or improper performance of obligations which arise as a consequence of renunciation of the contract is clearly permissible (Supreme Court judgment of 20 October 2006, Case No. IV CSK 154/06).

Example: X does not perform the obligation of paying for goods supplied by Y. Y renounces the contract (due to lack of payment, i.e. non-performance of a monetary obligation) and demands that X return the goods supplied. When X fails to perform this obligation, Y demands that X pay a contractual penalty.

The distinction between these situations is essential from the point of view of determining the effectiveness of a provision calling for payment of a contractual penalty by one of the parties when the contract is renounced by the other party.

Sometimes the imprecise wording of the contractual provisions in this respect makes it difficult to assess the effectiveness of the provisions. Then it may be necessary to look beyond the face of the contract to seek out the true intention of the parties when they concluded the imprecise provision.

Parties to a contract often provide that there is a duty to pay a contractual penalty “in the event of renunciation of the contract.” This wording may be treated as an agreement by the parties that an event of non-performance or improper performance entitling one of the parties to renounce the contract also constitutes grounds to seek payment of a contractual penalty from the other party (Supreme Court judgment of 7 February 2007, Case No. III CSK 288/06). As a rule, the intent of the parties is to introduce an additional sanction (alongside the possibility of undoing the contract by renouncing it) with respect to the party required to provide monetary consideration. But, as discussed above, under the predominant view in the case law and the legal literature, this is not permissible under Civil Code Art. 483.

Therefore, if it is not entirely clear from the wording of the contract that such provision is intended by the parties to be a special sanction for non-performance of the mutual obligations which under Civil Code Art. 491 are connected with renunciation of the contract, then, based on commercial practice, it should be assumed that the contractual provision does not refer to that situation.

Based on case law from the Supreme Court of Poland (e.g. Case No. IV CSK 154/06), it appears correct to assume that a demand for payment of a contractual penalty in such circumstances would be found to be unjustified.

Maciej Szewczyk, Mergers & Acquisitions Practice, Wardyński & Partners