Meaning

A penalty clause in a contract obligates the defaulting party to provide some form of compensation to the innocent party in the event of a breach of contract.

The Conventional Penalties Act of 1962 states that penalty provisions are legally binding but that the court has the authority to lower the compensation. In order to assess whether or not the penalty is excessive compared to the damages inflicted, the court must compare the punishment with the real loss or harm caused. You must therefore ensure that the penalty specified in the clause is reasonable. Additionally, you are only permitted to seek one of the two remedies—a penalty or damages—for the same offence.

You must be careful when drafting such phrases and incorporating them into your contracts because a complete body of law has been created to regulate penalty clauses. Because other sections in a contract that deals with breach, damages, liability limitation, and termination are all important and connected, you should avoid looking at penalty clauses individually.

Enforceability

When deciding whether a penalty clause is lawful, the court applies a test to determine if it is a secondary obligation that causes harm to the party who violates the clause that is out of proportion to the innocent party’s legitimate interest in seeing the primary obligation enforced. 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?

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.