Key Takeaways

  • Contract penalties are provisions designed to deter breach by imposing financial or legal consequences if a party fails to perform its obligations.
  • Courts distinguish between enforceable liquidated damages and unenforceable penalties based on proportionality, intent, and legitimate business interests.
  • Drafting enforceable penalty clauses requires clarity, reasonable estimates of loss, and evidence of the non-breaching party’s legitimate interest.
  • Penalties can vary by industry and contract type — including delivery delays, quality failures, or service interruptions — and must be tailored to context.
  • Understanding how courts interpret and enforce penalty provisions can help businesses manage risk and avoid costly litigation.

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.

Drafting Effective Penalty Clauses

To ensure that contract penalties are enforceable, they must be carefully drafted with clear purpose, proportionality, and legitimate intent. Courts will scrutinize whether the clause protects a legitimate business interest rather than acting as a punitive measure. Consider these best practices when drafting penalty provisions:

  • Be specific and measurable: Define precisely what constitutes a breach (e.g., missed deadlines, quality issues, or service interruptions) and the resulting penalty.
  • Link the penalty to actual harm: The amount should reasonably reflect the anticipated loss caused by the breach. Excessive penalties that far exceed potential damages are likely to be struck down.
  • Avoid punitive language: Use neutral terms like “compensation” or “liquidated damages” instead of “penalty” where appropriate.
  • Account for industry standards: In regulated industries such as construction, IT services, or government contracting, ensure that penalty provisions align with common practice and legal expectations.
  • Provide for mitigation: Include clauses that allow for negotiation or reduction of the penalty in cases of partial performance or mitigating circumstances.

Courts are more likely to uphold penalty clauses when they are structured as a reasonable pre-estimate of loss rather than as a punishment.

Liquidated Damages

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.

Common Types of Contract Penalties

Contract penalties are not one-size-fits-all; they are often tailored to the nature of the agreement and the risks involved. Common examples include:

  • Delay penalties: Imposed when a contractor or supplier fails to deliver goods or complete work by a specified date.
  • Performance penalties: Triggered when the product or service delivered fails to meet agreed-upon quality standards or performance metrics.
  • Payment penalties: Applied for late or missed payments under a commercial agreement.
  • Compliance penalties: Used when a party fails to adhere to legal, regulatory, or safety obligations contained in the contract.
  • Termination penalties: Charged if a party ends the contract early without justification.

Each type of penalty clause must still pass the enforceability test: it should be proportionate, justifiable, and designed to protect a legitimate interest rather than punish the breaching party.

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.

Enforcement and Judicial Approach

When disputes arise over contract penalties, courts apply specific tests to determine enforceability. The key considerations include:

  • Legitimate interest: Does the clause aim to protect a valid commercial interest beyond simple compensation for loss?
  • Proportionality: Is the amount stipulated a fair reflection of potential harm, or is it extravagant and unconscionable?
  • Commercial justification: Does the clause serve a valid business purpose, such as incentivizing timely delivery or ensuring compliance with critical terms?
  • Contextual evaluation: Courts examine the circumstances at the time of contracting — not after the breach — to decide if the penalty was reasonable.

It’s important to note that courts in different jurisdictions may apply slightly different tests, but the overarching principle remains the same: penalties intended solely as a deterrent are likely to be unenforceable, while those serving a protective purpose are more likely to stand.

Frequently Asked Questions

  1. Are contract penalties always enforceable?
    No. Courts often strike down penalties deemed punitive or disproportionate to the actual harm caused. They are more likely to enforce clauses that reflect a genuine pre-estimate of loss.
  2. What is the difference between liquidated damages and penalties?
    Liquidated damages are pre-agreed compensation for anticipated losses and are generally enforceable. Penalties are punitive and designed to deter breach, and are often unenforceable.
  3. Can penalties be included in all types of contracts?
    Yes, but they must be carefully tailored to the nature of the contract and the risk involved. Sectors like construction, supply chain, and government contracting commonly use them.
  4. What happens if a penalty clause is unenforceable?
    If a court deems a penalty unenforceable, it will likely disregard the clause and instead award damages based on actual loss.
  5. How can businesses protect themselves when drafting penalty clauses?
    Work with a contract attorney to ensure the clause reflects a legitimate interest, is proportional, and aligns with legal standards. UpCounsel’s marketplace can connect you with experienced lawyers for this purpose.

If you need help with penalties in contracts, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.