Updated October 6,2020:

A penalty clause in a contract is a provision that obligates the defaulting party to provide some form of compensation to the innocent party in the event of a breach of contract. Getting compensation for a contract breach can sometimes be a difficult process that requires an arduous and costly legal battle. In order to minimize the hassle and cost, you can include a penalty provision in your contract. However, you need to know that a penalty clause can be unenforceable if it does not meet certain requirements. Therefore, you should exercise caution when you are drafting one.

What Is a Penalty Clause?

A penalty clause states that one contracting party is required to give something, usually money, to the other party if he or she breaches the contract. With such a provision in place, the breaching party is more likely to pay the penalty to the other party instead of settling the matter in court. As such, a penalty clause also serves the purpose of dissuading the party from breaching the contract for fear of the consequences.

According to the Conventional Penalties Act of 1962, penalty clauses are enforceable by law, but the court has the power to reduce the compensation. In fact, the court is required to compare the penalty with the actual loss or detriment suffered and determine whether or not the penalty is disproportionate to the damages sustained. Therefore, you have to make sure that the penalty stated in the clause is not outrageous. In addition, you are only allowed to claim either a penalty or damages for the same act, but not both.

A whole body of law has been developed to govern penalty clauses, so you need to be careful when you are creating such clauses and including them in your contracts. You should avoid viewing penalty clauses separately because other clauses in a contract that pertain to breach, damages, liability limitation, and termination are all relevant and intertwined.

Enforceability of a Penalty Clause

When determining the validity of a penalty clause, the court conducts a test to find out if the clause is a secondary obligation that inflicts a detriment on the breaching party that is out of proportion to the innocent party's legitimate interest in the enforcement of the main obligation. The test is conducted by asking the following questions:

  • Has the main obligation been breached and triggered a secondary obligation? If so:
    • Does the secondary obligation serve to protect any legitimate business obligation?
    • Is the second obligation unconscionable, extravagant, or exorbitant?

How to Draft an Enforceable Penalty Clause?

There are a number of things you need to do to avoid unenforceable penalties, including:

  • Consider whether compensation or damages to be paid to the innocent party for a contract breach are a result of a secondary obligation.
  • If there are damages resulting from a secondary obligation:
    • Make sure there is a legitimate interest that is proportionate to the enforcement of the main obligation by the innocent party.
    • Consider whether the penalty clause has an actual pre-estimation of loss. If it does, it will be considered valid without the need to show anything else.
    • Avoid making the penalty extravagant or unconscionable.
  • Other considerations
    • The bargaining power and sophistication of the contracting parties may have an impact on the court's willingness to declare a penalty clause unenforceable.
    • In a situation where properly advised parties with similar bargaining power are negotiating a contract, the court will initially have a strong presumption that they are in the best position to determine what makes a legitimate provision in the contract.

Penalty Clause for Different Types of Contract

The way to draft or use a penalty clause may differ depending on the type of contract you are creating. Below are a few examples:

  • Construction contract: Make sure you use a liquidated damages clause instead of a penalty clause.
  • Acquisition agreement: Consider whether restrictive covenants, such as non-complete clauses, can be linked to the main obligation of the agreement.
  • Articles of association or shareholders' agreement: Such agreements may not create main obligations, but they may create secondary obligations that impose damages. In this case, you should take legitimate interest and proportionality into consideration.

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