A penalty clause is a provision in a contract that requires one party be penalized if they have breached the contract.

What Is a Penalty Clause?

In contracts, there are a variety of clauses that can be used. In order to encourage the fulfillment of the contract, many people request that the contract include a penalty clause, which mandates the breaching party pay or suffer a penalty. However, penalty clauses are almost always unenforceable.

It's also important to understand that penalty clauses are different from liquidated damages clauses. Liquidated damages are meant to compensate the injured party for their losses and should not be used to penalize the person who has broken the contract. Penalty clauses can also be included in judgments. For example, a court may require a penalty if someone has not made support payments within the required time period.

Unenforceable Penalty Clauses

In 2015, the rules related to unenforceable penalty clauses were updated by the Supreme Court. The Court instituted a new two-factor test to determine if a penalty clause can be enforced. For a clause to be enforceable, there should be an actual interest served by creating the penalty. The amount penalized should not be excessive. If you plan to include a penalty clause in a contract, you should make sure the clause complies with these factors.

The best way to identify a penalty clause in a contract is to determine whether the clause is focused on preventing a breach of contract or if its purpose is estimating a potential loss. If the latter is true, then it is a liquidated damages clause and not a penalty clause. This is important because enforcing a penalty clause is often impossible, but provisions meant to account for anticipated losses can be enforced if the estimate is reasonable.

To make sure that the penalty clause in your contract can be enforced, there are several factors that you need to keep in mind:

  1. Does providing damages to a party after a contract breach create a secondary obligation? If so, try to clarify the language of the clause so breaching the contract is part of the primary obligation.
  2. Is there a legitimate reason for the innocent party to try and guarantee the primary obligation is fulfilled?
  3. Does the clause include a reasonable estimate of the losses that would result from breach of contract? If you do have a reasonable estimate, you only need to prove legitimate interest for the clause to be valid.
  4. Make sure that the penalty could not be considered excessive, unconscionable, or extravagant, all of which would make the clause invalid.

The negotiating power of the two parties involved in a contract can help the courts decide if a penalty clause can be enforced. For example, if the two parties are on equal footing, then courts will usually defer to their judgment, meaning the clause probably will be enforceable. When you're interested in using a penalty clause, you need to consider the type of agreement that you will be using:

  • Acquisition agreements should consider using restrictive covenants that are connected to the primary obligations instead of penalty clauses.
  • Construction contracts should never use a penalty clause. A liquidated damages clause will be more effective.
  • In shareholder agreements and Articles of Association, primary obligations cannot be created. However, secondary obligations can be created for the purpose of damages.

What's Wrong with Penalty Clauses?

The biggest disadvantage of penalty clauses is they are very rarely enforceable. For example, the ruling in the Dunlop court case stated penalties could not be used to prevent breaches of contract. If your goal in including a penalty cause is making sure contractual performance occurs, the clause will not be enforced.

Another drawback to penalty clauses is it can be hard to calculate an amount which would not be considered excessive to the court. For the penalty to be approved, you would need to show it was genuinely estimated. If there is no basis for the amount of the penalty other than your opinion, the court will decline to impose your penalty. Unfortunately, this is true even if the nature of the breach would prevent you from calculating a genuine estimate.

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