What Are Penalties in Contracts?
Penalties in a contract are specified terms that cause a penalty to be paid by a party if that party doesn't keep the terms laid out in the contract.3 min read
2. Liquidated Damages
3. Breach of Contract
Penalties in a contract are specified terms that cause a penalty to be paid by a party if that party doesn't keep the terms laid out in the contract. The Supreme Court recently examined the common law rule on penalty clauses in consumer and commercial agreements. The Supreme Court has differentiated between:
- Secondary obligations, which require a penalty if they improve a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party.
- Conditional primary obligations, which fall outside the penalty regime.
Previously, the penalty test assumed a total distinction between what was and was not an authentic pre-estimate of loss. Anything that did not fall into the first category was considered a penalty and treated as such. Later, the courts tried a more lenient approach by examining whether the provision was extravagant and unconscionable, containing important characteristic of deterring breach, but without any business justification. Both of these methods have been overridden by the Supreme Court's most recent definition.
Primary, Secondary, and Conditional Obligations
Provisions that try to provide an alternative to court-awarded damages for the breath of a primary obligation are considered secondary obligations. For example, "You are required to comply with Clause A. If you breach Clause A, you will compensate us with a specified sum." In this case, the requirement to pay is a secondary obligation related to the consequences of breaching the primary obligation, which is to comply with Clause A.
Conditional primary obligations do not require a party to perform an act, but state that if a party in the agreement does not perform or other circumstances exist, it will have to pay (or will not receive) a particular sum. These conditional primary obligations fall outside of the realm of penalty doctrine. For example, "I will pay you a particular amount of money, but only if you do not breach Clause A."
It's necessary to phrase such provisions correctly, as conditional primary obligations are not included within the terms of penalty law, but the content remains important. You are not allowed to disregard the penalty principle by making contractual provisions conditional. Within the court, each party's intentions will be examined and challenged should it appear there is any provision that is a hidden punishment for breach of contract.
As of the Supreme Court's most recent decision, a provision might be considered a primary obligation if the innocent party has a legitimate interest to protect. This could mean an interest in performance or a suitable alternative to performance. For example, it could be an interest in payment or other legitimate reasons for desiring that an obligation be performed. Consider defining in detail a party's legitimate interest in enforcing a provision beyond financial compensation.
It might seem misleading that courts will frequently refuse to enforce provisions of contracts deemed to be penalties. It might even seem that the lack of enforceability in penalty clauses means that contracts do not contain much incentive to uphold the terms.
However, the law does recognize contract provisions that require payment of "liquidated damages," and these are indeed enforceable by the courts. Liquidated damages are considered actual damages (compensatory damages). Money may be awarded to compensate for actual losses, the amount of which is determined by proven harm, loss, or injury. Actual damages differ from punitive damages, the latter of which may be imposed when a defendant has acted particularly maliciously.
Breach of Contract
A breach of contract can occur in a variety of ways, including minor, partial, or material. When a minimal amount of something is missing, such as a small payment, or one out of 100 items promised for delivery, a breach is considered partial. When a larger amount of something is missing, such as multiple payments, or 95 out of 100 items promised for delivery, the breach is considered material. It can make a significant difference in damages whether a partial or material breach has occurred.
If a party has breached its end of the contract, the court may award the plaintiff in many different ways. For example, the breached party may receive expectancy damages, which equate to what they would have received from the unbreached contract. Sometimes, the court will consider additional factors such as lost profits for a business that was not able to establish itself. In this case, the court would probably award the breached party the capital spent to start the company.
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