The penalty clause is a contractual clause that obliges the party responsible for the breach to pay a predetermined sum to the other party in exchange for not performing its obligations under the contract. In contrast to the liquidated damages clause, which is a true pre-estimate of losses suffered due to the breach of contract, a penalty clause involves a penalty designed to discourage or punish and not compensate.
American courts tend to avoid enforcing the punitive penalty clause and prefer liquidated damages clause in cases where the sum is a reasonable estimate of losses anticipated. The explanation is given by Cornell Law School's Legal Information Institute. In England and Wales, however, the case of Cavendish Square Holding BV v Makdessi [2015] UKSC 67 redefined the criterion as the protection of legitimate commercial interest of the party.
The teams working with Dock 365 can save jurisdiction-tested language of the clauses into the clause library.
It is very important for the contracting parties to be accountable and comply with each other when the stakes involved in a contract are high and breach may result in major losses. In many instances, failure of construction, supply, or services agreement may create various problems for the party. In such instances, having an effective penalty clause will act as motivation for the parties to fulfill their contractual obligations. Read further for more on penalty clause and its drafting.
A penalty clause refers to a contractual clause in a business contract which states a fixed amount of money that is to be paid by the party failing to perform a certain contractual obligation. The main aim of this clause is to act as an incentive not to breach the contract since the financial liability will be known in advance to both parties.
It is essential to differentiate between a penalty clause and a liquidated damages clause. In accordance with the Legal Information Institute of Cornell Law School, a liquidated damages clause refers to a sum which is reasonable pre-estimate of the amount that a party may lose due to a breach of the contract. The main purpose of such a clause is not punishment but a substitute for proving damage at court. On the contrary, a penalty clause imposes a certain amount of money that is unreasonable with respect to any expected loss and serves as punishment.
This issue is critical since US and UK courts have different criteria for determining the nature of the damages clause.
Though there are significant enforcement risks associated with penalties in American courts, the reasons why businesses include damages provisions in their commercial dealings are numerous:
First, a negotiated sum of damages serves as a strong signal that non-performance comes at a high price. This kind of message is often worth more in terms of the deterrence provided than the actual financial compensation one would get after the enforcement of a contract in court. It makes the other party interested in performing his contractual obligations.
Secondly, when the cost of breach of an agreement is impossible to determine beforehand, such provisions in a contract can save one from further expenses incurred in determining what the sum of compensation should be. WorldCC (World Commerce & Contracting), a professional international organization of contract management professionals, states that many commercial cross-border contracts contain such provisions to avoid disputes after breach of contract.
The challenge for legal teams working on such issues is making sure that the specified sum can be justified as a legitimate pre-estimate of damage and not a penalty.
Enforceability depends heavily on jurisdiction. The same clause may be upheld in one country and voided in another.
United States: American common law recognizes a damage clause as legitimate only when the negotiated figure is a reasonable estimate of the damage caused by the breach of the contract and proof of that amount will be difficult at the time of making the contract. If the court deems the negotiated figure as an exaggerated one and a punishment, then the clause will automatically be struck out. According to Cornell University Law School's Legal Information Institute, "Reasonable pre-estimate" test is recognized by all US courts for all forms of commercial contracts. In case the contract entails the sale of goods, then § 2-718 of the Uniform Commercial Code applies.
United Kingdom: It is also worth mentioning that the ruling by the UK Supreme Court in the case of Cavendish Square Holding BV v Makdessi [2015] UKSC 67 brought about considerable progress in the English law in this context. The case established that the clause is still effective even though it is not merely compensatory in nature provided there is a valid business purpose to enforce the clause.
Civil law jurisdictions: France and Germany have laws that allow for penalty clauses to a greater extent, although the courts have statutory power to mitigate any excessive amount. Any business organization that operates internationally should be able to address this difference when dealing with damages clauses.
A penalty clause is a clause within a contract specifying the consequence, mostly monetary, for a party failing to honor their agreed obligations within the agreement. While meant as a form of deterrence against breaches, these types of clauses also ensure that interests of the non-breaching party are protected. However, whether these clauses can be enforced depends on applicable laws since many courts do not allow clauses which seem more punitive than compensatory.
Penalty clauses prove to be helpful in agreements where breaches may cause considerable financial or operational loss to the other party involved, such as delay in construction, supply chains interruption, among others. Penalty clauses ensure that breaches within these kinds of agreements are dealt with appropriately through clearly outlining the consequences to be faced upon breach.
As enforcement of penalty and liquidated damages clauses depends on how well they are written and relevant laws, the commercial and legal teams need to be very cautious while incorporating these clauses in an agreement. Below are the top four things to consider.
Penalty clauses should be prepared meticulously so that they do not become unenforceable due to certain characteristics in their construction. Such penalty provisions should clearly describe what is meant by the provision, emphasizing the need to compensate for the losses that may arise, but in an estimated way that does not involve any punishment to the party who breaches the contract. A business should offer a reasonable estimate of the damages that can arise with figures that can back up its estimate to prevent the provision from being voided in court.
Poor drafting is probably the most frequently encountered problem with damages clauses. The clause will stand the best chance of being enforced if it states: (1) the precise trigger – which obligation, on breach of which, the clause will be triggered; (2) the amount payable or the method for its calculation; and (3) whether this clause serves as an exclusive remedy of the injured party or works together with some other remedies available under the contract, including but not limited to termination and specific performance.
At the time of drafting, there must be a real effort to justify the figure by estimating the likely extent of losses that may occur in case of the described breach. According to the Legal Information Institute of Cornell University, courts consider the situation at the time of contracting rather than at the time of the breach when considering the reasonableness of the stipulated sum. Having this reasoning recorded either in a contract preamble or in a separate negotiation memo is beneficial for evidentiary purposes.
The size of the penalty stipulated in the penalty clause should be able to act as a deterrent to breach without being too harsh considering the actual damages incurred. Too harsh penalties could deter parties from forming business agreements, or make them dispute enforceability. The use of the right penalty clauses can enable organizations to build good relations and reputation with their contractual partners.
A penalty clause that looks fair to both parties at the time of negotiating will definitely be enforceable more easily compared to one which seems harsh and punitive only to the other party. In the US and UK courts, the question will be whether the stipulated penalty was made in good faith to share risks or to prevent breach by whatever means to the breaching party.
According to WorldCC, negotiators should benchmark the stipulated damages in terms of the actual cost associated with such a breach scenario, like the cost of getting a new supplier on an emergency basis or revenue foregone during an agreed downtime period for services. If a breach scenario results in uncertain financial implications, then a higher stipulated amount will be justified by a court of law.
Mutual clauses, whereby both the parties have equal liability for similar breaches, will always get better reception by courts as compared to one-sided clauses.
Whether or not a penalty clause is enforceable is a rather complex matter in the United States, since such clauses are generally regarded as undesirable from the courts' perspective. According to American contract law, there is a distinction between a penalty clause – a contract provision which requires the payment of excessive/punitive damages if a breach occurs – and liquidated damages clause, the goal of which is the fair compensation of actual or anticipated losses due to the breach of the agreement. The main problem is that penalty clauses are usually unenforceable since they are considered punitive in nature, in contrast to the basic tenet of contract law that seeks to provide for compensation, but not punishment, of the breaching party. The following are some requirements for an enforceable liquidated damages clause.
Companies working in multiple countries need to know that what is an enforceable clause in one legal jurisdiction can be invalid in another. After Cavendish, the English Law allows for a valid clause that protects a genuine commercial interest, regardless of the amount being above pure compensatory damages. According to the US Law, the same clause can be declared unenforceable, being deemed punitive in nature due to the excessive amount.
Civil law jurisdictions, such as those of most members of the EU, allow for penalty clauses, with the option for courts to mitigate their amount if they are grossly exaggerated. The French Code Civil (Article 1231-5) and the German BGB (§ 343) both provide for provisions where courts can mitigate the amount of penalty clauses.
The choice of jurisdiction for international contracts will determine the applicable standard regarding enforceability. Legal departments need to store clause texts, approved for use in different jurisdictions, in a contract management tool like Dock 365, enabling access to clause libraries by business unit, contract type or region.
The wording of penalty clauses should take into consideration the circumstances and risks associated with the contract. It must be considered what kind of obligations need to be met, how real is the danger of violation, and what consequences this violation may lead to. What is more, very strict or punitive clauses may discourage the other party from negotiations. The proper balancing of the clauses' enforceability and mutual acceptability is vital. An open discussion of the purposes and justifiability of such a clause may help build mutual trust and conduct more effective negotiations.
Suggesting the penalty style of the clause shows that you see non-compliance as a significant danger, and it influences the attitude of counterparties to negotiations. The latter will try to persuade you to reduce the amount of penalty, exclude some triggers or limit the exclusivity of the clause, and their reaction will show their confidence in compliance.
In negotiating a damages clause, one needs to take a position where the provision is looked at from the perspective of allocating risk instead of punishment. In instances where there is disagreement over the stated amount of damages, one may find out if there could be an opportunity to lower the number to what can be considered a fair liquidated damages amount. Mutual damages provisions – whereby both parties have equal exposure to the other party for their breaches – are usually easier to negotiate and enforce.
According to WorldCC, business negotiations are shifting from punitive measures towards collaborative approaches to risk management. Negotiating damages clauses from this angle will lead to more legal and relationship-friendly arrangements.
Clause penalties provide great benefits in contracts to protect against breaches. They serve the purpose to protect the interest of the party by specifying the consequences of non-performance when they are crafted properly. Businesses have to be careful enough to ensure that the penalty clauses comply with the law and are proportionate to mitigate any potential issues. It is crucial to find a way to balance between fairness and enforcement to maintain good relationships while minimizing risks related to the contractual breach.
A manual approach to managing penalty and liquidated damages clauses in the contract portfolio means multiplying risks: it becomes more probable to include outdated wording, inconsistent terms, and to overlook specific jurisdiction requirements when more and more contracts are signed.
Dock 365 is a contract and vendor management system that is natively based on Microsoft SharePoint and Microsoft 365. It offers a clause library to enable legal departments to store pre-approved and tested for jurisdictional requirements penalty and liquidated damages wording so that the contract template would always include only up-to-date and enforceable wording. The system offers an automated way to check for deviations from the pre-approved wording in the process of drafting the contract. Additionally, milestone notifications remind teams about performance deadlines.
For organizations managing contracts across multiple jurisdictions, Dock 365 supports organization by business unit, region, and contract category, making it straightforward to maintain distinct approved clause sets for different governing law scenarios. Because Dock 365 is built on Microsoft 365, all contract data remains within your own tenant - data never leaves your environment and is retained in full even if you move off the platform in the future.
Dock 365 enables businesses to draft, review, and manage contracts with greater accuracy and efficiency. With features like automated compliance checks, templates, and clause libraries, they ensure that penalty clauses align with legal and industry standards. Additionally, contract management software allows businesses to monitor obligations, deadlines, and potential risks in real time, reducing the likelihood of breaches. Notifications and alerts help parties stay on track with their commitments, while advanced reporting tools provide insights into contract performance. By streamlining the drafting process and improving oversight, contract management software not only enhances the enforceability of penalty clauses but also fosters better contract governance, ultimately saving time and mitigating risks for businesses.
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