You think you have made clear arrangements about the exclusivity of your supplier’s services. The supplier has agreed to service your company only. You have even agreed unequivocal penalty clauses under which the supplier pays a penalty for every breach and another one for every day the breach continues. Unfortunately, the supplier breaches the exclusivity clause, forcing you to claim the full amount of penalties due. And then the supplier refuses to pay them because he finds them unreasonable. Now what?
The Supreme Court decision of 16 February 2018 ECLI:NL:HR:2018:207 confirms the standard for reducing penalties.
Dutch law on contractual penalties
Under Dutch law parties may include penalty clauses in their contracts and agree upon an amount for the penalty that suits them best.
Penalty clauses can have two different functions: as an incentive to ensure compliance by the obligee or as liquidated damages (e.g. in a situation where it may be difficult to sufficiently substantiate the amount of damages incurred as a consequence of a breach). A combination of these two functions is also possible, depending on the way in which the penalty clause was drafted.
Under Clause 6:94 of the Dutch Civil Code (“DCC”), the court may reduce the contractually agreed penalty at the request of the obligor if it is fair to do so. However, the court may not award the obligee less than the damages due by law for failure in the performance. This underlines the importance of being clear about the function of a penalty clause when drafting. A penalty that was intended as an incentive only may be more susceptible to reduction than a penalty intended to recover (liquidated) damages.
This statutory authority of the court cannot be excluded by the parties in their contract.
Standard for reduction
Though the wording of Clause 6:94 DCC suggests otherwise, this Clause does not entitle the court to reduce the amount of penalties simply because it perceives the amount as being unfair.
In its decision of 27 April 2007 ECLI:NL:HR:2007:AZ6638 (Intrahof vs. Bart Smit), the Supreme Court ruled that the court should exercise its authority to reduce a penalty amount cautiously. A penalty may be reduced where there is an imbalance between the amount of the penalty and the damages incurred by the breach, in the given circumstances, that is excessive and therefore unacceptable. The court should take into account not only the amount of damages but also the nature of the agreement, the content and purpose of the penalty clause and the circumstances under which the penalty clause was invoked.
The Supreme Court has repeated this standard in various other cases over the past few years.
PROTEC and Easystaff
In its decision of 16 February 2018 ECLI:NL:HR:2018:207, the Supreme Court again had to decide about a matter in which the District Court and the Court of Appeal had reduced the amount of penalties.
Employment agency Protec had agreed with Easystaff Payroll Services that Easystaff would not provide back office services to third parties that involved staff who had been assigned by Protec first. If Easystaff breached this agreement, it would pay a penalty of EUR 20,000 for each breach and EUR 5,000 for every day the breach continued. Protec found out that several persons that had been working for Protec first, contrary to the exclusivity clause the parties agreed, had been working for third parties as well, while these third parties were being serviced by Easystaff. Protec claimed penalties and Easystaff disputed the amount being claimed.
The District Court found – taking into account the circumstances of the case, including the amount of damages incurred by Protec as a consequence of the breach by Easystaff – that a penalty of EUR 5,000 for the breach and EUR 100 for every day the breach continued was appropriate. The Court of Appeal approved the approach taken by the District Court, but decided to uphold the reduced penalty of EUR 5,000 per event and to increase the penalty for each day the breach continued from EUR 100 to EUR 150.
Compared to the amounts of penalties that the parties had originally agreed, this involved a substantial reduction, raising questions such as how these reduced amounts were established.
In his conclusion of 24 November 2017 ECLI:NL:PHR:2017:1327 the Advocate General notes that the Court of Appeal had applied the correct standard. The Court of Appeal had correctly identified the circumstances that were relevant to the amount of the reduction, but failed to explain in what proportion each of these circumstances had contributed to its judgment. According to the Advocate General, this obscured how the Court of Appeal had concluded that the agreed penalty should be reduced to this precise amount and why a smaller reduction would have been unacceptable.
The Supreme Court established that the Court of Appeal had applied the correct standard and had explained its decision by referring to the circumstances that (i) Protec drafted the agreement, decided on the amounts of the penalties, and the parties did not negotiate the amount of the penalties, (ii) Protec did not substantiate how the amounts of the penalties were established, (iii) the penalties incurred were excessively high compared to the damages Protect had actually suffered, (iv) only a limited number of occasional breaches occurred at the very beginning of the term of the contract and (v) the penalty clause was intended to Protec against competition and the breaches that occurred did not result in a loss of customers.
The Supreme Court – which cannot investigate the facts – considered this to be a sufficient explanation.
For parties negotiating a penalty clause, it is important to realise that the court may be in a position to intervene and reduce the amount of penalties. As courts may feel tempted to ask themselves what they consider a reasonable amount for a penalty in a particular situation, it is important to remind the court of the applicable standard: penalties should not be unacceptable. This could well be a higher amount than what may intuitively be perceived as reasonable.
One viewpoint that may be important in establishing the amount of the reduction, is the manner in which the amount that the parties included in the penalty clause was established in the first place.
If you are the party stipulating a penalty it is worthwhile considering, documenting and possibly sharing with your contracting party your reasons for proposing that particular amount. Should a dispute arise about whether penalties should be reduced, then you are likely able to substantiate much better and thus more convincingly why the amount of penalties is not unacceptable indeed.