What is a penalty clause in a contract?

Lots of businesses turn to penalty clauses in a bid to reduce contract risk. But does it work? 

This post explores what penalty clauses are, how they work, and whether or not they’re enforceable. Let’s get started. 

What is a penalty clause?

A penalty clause is a clause within a contract that seeks to make the counterparty responsible for paying a large sum of money if they breach the contract. However, this sum of money is usually not proportionate to the loss that will be suffered due to the breach. Instead, the sum is inflated, making it excessive in many instances.

In fact, penalty clauses are different from other clauses that discuss awarding damages since they propose a sum of money that is so large that it ‘punishes’ the breaching party, rather than just compensating for the losses they have caused. 

This is why they are controversial and usually unenforceable. But more on that later.  

What is the purpose of a penalty clause?

If penalty clauses aren’t designed to compensate for anticipated losses, then why do parties use them? 

Well, one reason why businesses try to include a penalty clause within their contract is to encourage performance. If the penalty a party receives for breaching a contract is high enough, it’s likely that they’ll do everything in their power to avoid that penalty and perform their contractual obligations. That’s the idea, at least.

Some businesses also try to include a penalty clause within their contract to simply increase the amount they’ll receive if the contract is breached. In situations where there’s an imbalance of bargaining power, or where the contract is being negotiated by someone without legal expertise, things like this just fall through the net. 

But what happens if penalty clauses do fall through the net during contract negotiations? Are they enforceable? Well, it’s complicated. Stick with us. 

Is a penalty clause in a contract enforceable?

The general rule within the UK is that penalty clauses are not enforceable. However, there are some exceptions to this rule.

For a clause to be enforceable, it must meet the criteria discussed by the Supreme Court in the case of Cavendish Square Holdings BV v Makdessi. Let’s discuss this criteria together now. 

1. The clause is a secondary obligation

According to the Supreme Court, the court will only consider whether a penalty clause is enforceable if it is a secondary obligation, not a primary obligation. 

The difference between a primary obligation and a secondary obligation is that a primary obligation is a stand-alone obligation within the contract, or a main one. Meanwhile, a secondary obligation is an obligation that will only be triggered in the event of a contract breach. Otherwise, that obligation will remain mostly irrelevant. 

Let’s look at an example to see what this might look like in practice:

If a contract says that a manufacturer is due to deliver 3000 bricks to another business by a certain date, this would be a primary obligation. This is what the party must do in order to comply with the contract. 

Now imagine that the contract also includes a clause that says that if the bricks aren’t delivered by the agreed date, then the manufacturer must pay a late delivery fee. This obligation would only be triggered by the breach, so it is a secondary obligation, not a primary one. 

The courts aren’t interested in assessing whether or not the date the bricks must be delivered by was fair. However, they are interested in finding out whether or not the late delivery fee is fair. This is why they will only consider the enforceability of secondary obligations, not primary ones. 

2. The innocent party must have a ‘legitimate interest’

If the obligation being reviewed is a secondary one, the courts will then consider whether or not the innocent party (aka the party that isn’t responsible for the breach) has a legitimate interest in the contract being performed. 

Before we dive into the specifics of this test, let’s first explain what a ‘legitimate interest’ is. 

It’s all pretty vague, but a party will likely have a legitimate interest in the contract being performed if they have relied on the contract being performed in some way. 

To go back to our earlier example, if the construction company had promised to deliver 3000 bricks to a business, the chances are the business had made plans to use those bricks. Perhaps they even hired a builder, or they ordered other materials to use alongside the bricks on that date. 

This is one of the easier criteria to meet when trying to enforce a penalty clause. 

3. The sum must be proportionate

The hurdle that most penalty clauses fail at is this third and final one: the rule that the sum described in the penalty clause must be proportionate and not excessive. 

What is and isn’t proportionate will depend on the case at hand, as well as each party’s individual circumstances.

However, it’s fair to say that hefty sums being charged for minor breaches will never be considered proportionate. But if the breach has more significant consequences, or it causes problems on a larger scale, the sum discussed is more likely to be viewed as proportionate by the courts. 

Should you include a penalty clause in a contract?

When deciding whether to include a penalty clause in a contract, it’s important to remember that penalty clauses will generally not be enforceable. 

It’s also important to remember that even if a penalty clause is enforceable, it isn’t a great way to start a new business relationship, and including one can often cause friction during negotiations.

But that doesn’t mean you can’t discuss potential damages in the contract at all. Most businesses will use a liquidated damages clause to pre-determine damage amounts instead. 

These are much more likely to get upheld in court since they are fairer. But they still prevent parties from having to go to court to assess damages, and they provide parties with greater certainty over what happens if a contract is breached. 

What’s the difference between a penalty clause and a liquidated damages clause?

Both penalty clauses and liquidated damages clauses are used to establish what a breaching party will have to pay the innocent party if they break the agreement.

However, the difference is that a liquidated damages clause only seeks to compensate the innocent party for their anticipated losses, meaning the sums are often lower and fairer than those in penalty clauses. 

Of course, this then means that there’s a risk of the innocent party being compensated less than what they lose since the damages are based on estimates. But this is a decision businesses have to make when deciding whether to pre-agree damage amounts in their commercial contracts. 

Need help managing contract risk?

If you’re looking for ways to reduce risk in your contracts, using penalty clauses isn’t your only option. Businesses can reduce contract risk simply by managing their contracts more effectively. Contract automation software enables you to do this in a few ways. For example, Juro users can:

• Initiate simple contracts from templates pre-defined by legal users
• Use conditional logic to bake fallback clauses into contract templates
• Set up contract approval workflows for high-value contracts
• Store contracts in a secure contract repository, making it easy to manage contract obligations 
• Receive automated contract reminders for upcoming contract deadlines

To find out more about how Juro can reduce risk within your contracts, fill in the form below.