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17 May 2023 The essentials of Swiss contract law: Contractual Penalties (no. 4)

This blog series gives a short and compact overview on the essential elements of Swiss contract law.

Swiss law allows the parties to a contract to agree on contractual penalties. The possibility is provided for in Art. 160 et seqq. of the Swiss Code of Obligations ("CO"). The statutory provisions deal with the relationship between the contractual penalty and the contractual performance (Art. 160 CO), the relationship between the contractual penalty and any actual loss (Art. 161 CO) and the amount of the contractual penalty (Art. 163 CO).

The relation between claiming the penalty and specific performance of the contract

According to Art. 160(1) CO, unless otherwise agreed by the parties, the creditor has to choose between the contractual penalty and compelling performance of the contract. If the contract provides that the penalty and the specific performance cannot be cumulated and the creditor chooses the penalty, he is bound by this decision and can no longer compel performance. The Swiss Federal Supreme Court decided in a case relating to a non-competition clause that the debtor was no longer bound by the non-competition clause because the creditor had opted for the penalty (DFSC 63 II 84).

According to Art. 160(2) CO, the situation is different if the parties agreed on a contractual penalty in the event of a failure to comply with the time or place of performance stipulated in the contract. In these cases, the creditor may claim the penalty in addition to performance provided he has not expressly waived such right or accepted performance without reservation. Therfore, the statutory presumption is, contrary to general contractual agreements on penalty, that a creditor may claim the penalty and specific performance.

The relationship between the penalty and damages

The relationship between the contractually agreed penalty and damages is governed by Art. 161 CO. The provision is of dispositive nature and the parties may agree otherwise.

Art. 161(1) CO states that the penalty is payable even if the creditor has not suffered any loss. In this case, the culpable breach of the contract is sufficient and the penalty is payable even if there was no loss in the sense of the Swiss Code of Obligations. Indeed, one of the purposes of agreeing on a penalty is that the creditor is relieved from establishing an actual loss. For this reason, penalties are often agreed in practice in cases in which it would be difficult for the creditor to establish the existence of a loss under Swiss law (increase of liabilities or decrease of assets).

Furthermore, Art. 161(2) CO foresees that the creditor may, where the loss suffered exceeds the penalty amount, claim further compensation only if he can prove that the debtor was at fault. In this case, the debtor's fault is not presumed contrary to Art. 97 CO. Hence, in order to claim additional damages that exceed the amount of the penalty, the creditor needs to prove that a loss exceeding the penalty occurred and that the debtor was at fault. Even if the creditor can prove all elements for a damages claim (i.e., (i) breach of contract, (ii) financial loss, (iii) causal nexus between the breach of contract and the loss and (iv) fault of the debtor), he can only claim as damages that part of the loss that exceeds the amount of the penalty.

Reduction of a penalty

The parties can agree on a contractual penalty without any restrictions on the amount (Art. 163(1) CO). To counterbalance this freedom of the parties, Art. 163(3) CO provides that the court may, at its discretion, reduce penalties that it considers excessive. In practice, the courts will only exercise this power in case of blatant disproportion. The circumstances of the individual case are decisive.

The Swiss Federal Supreme Court has considered the following criteria when assessing contractual penalties:

  • The severity of the breach of the secured main obligation (DFSC 4A.656/2012; DFSC 4A.107/2011; DFSC 103 II 129).
  • The economic situation of the parties involved (DFSC 4A.656/2012; DFSC 4A.595/2012; DFSC 4A.107/2011). The more strained the financial situation of the debtor, the more likely the contractual penalty will be considered excessive (DFSC 4C.276/2003).
  • The seriousness of the fault of the parties involved (DFSC 4A.656/2012; DFSC 4A.595/2012; DFSC 105 II 200; DFSC 103 II 135).
  • The economic dependence of the debtor on the creditor (DFSC 4A.595/2012; DFSC 4A.107/2011; DFSC 114 II 264; DFSC 51 II 162).

In practice, the court's power to reduce a penalty at its discretion increases the procedural risks of the party that tries to enforce a penalty. Hence, it is advisable to already take the above points into consideration  when negotiating a penalty.

Liquidated damages

In addition to penalties, Swiss law also allows for liquidated damages (for which there is no statutory basis). In the case of a dispute, there are often discussions whether the parties intended to provide for a penalty or for liquidated damages in their contract. Hence, the distinction between the two concepts is important.

Contrary to a penalty, liquidated damages have no penal character but only a compensatory function. The amount of liquidated damages must fall within the scope of the financial loss that may typically be expected in the case of a breach of the contractual obligation concerned. This means that the parties, when entering into the contract, must anticipate the likely financial loss caused by a particular breach of contract and define a corresponding lump sum. Liquidated damages are owed (in contrast to the contractual penalty) only if a financial loss has actually occurred (compensatory function).

In contrast, the contractual penalty has several objectives: On the one hand, the threat of a penalty is intended to exert pressure on the debtor to meet its main obligation to perform properly and in due time. On the other hand, the contractual penalty also has a compensatory function, because the lump sum amount compensates for the loss caused (double function of the contractual penalty).

To determine whether the parties intended to agree on a contractual penalty or liquidated damages, an interpretation of the contract is necessary (see our blog on the interpretation of contracts). In cases of doubt, the tendency is to assume a contractual penalty. In contrast, sufficient indications must exist if liquidated damages are to be assumed.

We have also published a podcast episode on this topic. If you have any questions on contractual penalties, please do not hesitate to contact our team.

Other articles in the series:

Authors: Christian Oetiker, Pascal Burgunder, Selim Keller