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13 December 2011
Contractual penalties are of great significance, especially in franchising. This is because losses arising from causes such as a breach of a non-compete provision or a confidentiality obligation relating to know-how are very difficult to quantify.
The Erfurt District Court recently considered a contractual penalty clause and set strict criteria for its validity, in line with previous case law.(1) In order for the clause to be valid, the court required penalties to be limited in cases of multiple breaches of the non-compete provision.
The defendant was head of the plaintiff's organisation. He bought and sold the plaintiff's products in his own name and for his own account. He also introduced new customers to the plaintiff on a consultancy basis, who then bought and sold the plaintiff's products in their own names and on their own account. The contract between the plaintiff and the defendant included a non-compete and enticement provision, and provided a penalty clause whereby the defendant was to pay a penalty of €25,000 for every proven breach thereof.
When the defendant conducted an information seminar for a competitor, the plaintiff terminated the agreement without notice and demanded the contractual penalty of €25,000 from the defendant.
The court found that the contractual penalty clause was invalid on the grounds that it was unreasonably high, and dismissed the claim. First, the court held that the contractual penalty clause did not differentiate between the seriousness of the breach and the degree of fault. Second, the court noted that the provision contained no maximum limit in the event of multiple breaches.
The court found that the contractual penalty clause was a general condition in the meaning of Section 305(1) of the Civil Code. While the agreement of a contractual penalty in general conditions is admissible in principle, the penalty clause – even in business-to-business cases – is subject to the 'reasonableness of content' test.
An admissible drafting of a contractual penalty clause reconcilable with general conditions must address the dual purpose of contractual penalties. A contractual penalty is intended, firstly, as an incentive to the debtor to perform its contractual obligation. In the event of breach of the contractual obligation and a resulting loss, the contractual penalty shall further idemnify the creditor in the amount of contractual penalty, without having to prove the loss.
When assessing the reasonableness of a contractual penalty, the courts must consider the amount in the context of the interests to be protected.
Accordingly, the amount of the contractual penalty must depend on the objective seriousness of the breach and the degree of fault. A contractual penalty clause in a specific amount for every act and every imaginable breach of the competition prohibition constitutes an unreasonable disadvantage within the meaning of Section 307(1) of the code. This was so in the case before the court. The court held that a contractual penalty of €25,000 for every proven breach did not differentiate according to the objective seriousness of the breach or the head of organisation's degree of fault. According to the wording of the clause, a penalty of €25,000 applied even to minor breaches.
In addition, the contractual penalty clause must limit the possible penalty to allow for a reasonable outcome where mutiple breaches have occurred. Otherwise, a contractual penalty could result in "the commission earned by the defendant over a number of years [being] exhausted to a degree destroying his livelihood".
In franchising, contractual penalties play a major role because the loss which is caused, for example, by the breach of the non-compete provision or the confidentiality obligation relating to know-how, are very difficult to quantify. It is therefore extremely important to draft contractual penalty clauses properly.
The validity of contractual penalty clauses in form agreements - for example franchise agreements - is subject to the law on general conditions according to which a contractual penalty clause is valid only if it is reasonable (Section 307 of the code).
A contractual penalty clause is reasonable only if the amount of the contractual penalty reflects the nature, seriousness and duration of the breach of contract.(2) If a fixed amount is intended, a contractual penalty clause is valid only if the amount is still reasonable, even for the most minor breach. Stating such an amount would, on the other hand, be impractical. While a once-off minor breach of the contractual non-compete provision would result in only a minor penalty, a minor penalty would not be commensurate with the interests of the franchisor in the case of a more serious breach against the contractual non-compete provision. For this reason, the Hamburger Brauch – which sets out standard practice for determining contractual penalties – has been adopted. It provides that the amount of the contractual penalty is not stated in the agreement, but rather is fixed by the franchisor at its discretion in the case of breach. The franchisee then has the right to have the amount of the contractual penalty reviewed by the agreed court or the court with statutory jurisdiction.
According to the Erfurt District Court, a contractual penalty clause is valid only if a maximum limit for the event of a number of breaches is stated. The call for a maximum limit on contractual penalty clauses in distribution agreements is surprising. The court relied on rulings which concern contractual penalty clauses in construction agreements.(3) Such rulings usually concern penalties for non-compliance with deadlines calculated as a percentage (eg, 0.5 %) of the contract amount per calendar day of non-compliance with the deadline. In these cases, there is a risk that in the vent of a delay of over three months (100 calendar days), the contractor would lose half of the contract amount. By the strict binding of the contractual penalty to the amount of the contract, the contractor suffers unreasonable disadvantages contrary to the principle of good faith. This situation would be transferable to distribution agreements only if the contractual penalty were expressed in a percentage of turnover for every day of the breach; however, that is not the case.
Thus, there is no need for an upper limit in the case of multiple breaches, as long as the contractual penalty for each breach is reasonable. The franchisor's interest in protecting against gross breaches is the overriding factor. A practical problem also arises: if a maximum limit for the contractual penalty is set in advance, the franchisee can calculate whether it is financially more favourable to it to pay the contractual penalty than to comply with the contractual obligation. Ultimately, contractual penalty clauses as general conditions would be very difficult to formulate. The Erfurt District Court gave no indication of the amount which should be set for such a maximum limit. The Hamburger Brauch, which provides no upper limit, offers no solution either.
It remains to be seen whether the demand for an upper limit on contractual penalty clauses in distribution agreements will be upheld by the Federal Court of Justice. Provided that no ruling to the contrary has been delivered, a contractual penalty clause in a distribution agreement is subject to an increased risk of invalidity.
For further information on this topic please contact Karsten Metzlaff or Karl Rauser at Noerr LLP by telephone (+49 30 20 94 20 00), fax (+49 30 20 94 20 94) or email (firstname.lastname@example.org or email@example.com).
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