How To Avoid Penalty Clauses

by Brian Taggart on April 24, 2014

  • SumoMe

On coming to a commercial agreement and contracting with another business or individual, it is important to agree what will happen on a breach of the contract. Such a clause will help prevent the matter from going to court or litigation as the parties have previously agreed what to do in the event. Doing so, however, is a matter fraught with difficulty. It is not possible to enforce a clause which is deemed to be a penalty clause, where it is possible to enforce one which is deemed to be a liquidated damages clause. It is vital, then, that anyone considering entering into a contract take sound legal advice on the matter.

It is a distinction of great importance to international businesses intending to do business in the UK. Many civil law jurisdictions, in contrast to the UK, allow penalty clauses to some degree. Businesses based in other jurisdictions may not have encountered such difficulties when drafting contracts in the past. Indeed, companies based in civil law jurisdictions should review any template documents they have to allow for these differences.

What is a Penalty Clause ?

A penalty clause is, as the name suggests, a clause which penalises a party for their breach of  a contract. A provision in a contract which allows the innocent party to withold monies or which requires the transfer of assets may constitute a penalty clause. Furthermore, a clause which is either “extravagant or oppressive” will usually also constitute a penalty. So where a clause went further than necessary to compensate a breach, it will be regarded as a penalty.

What is a Liquidated Damages Clause?

In order to compensate the innocent party in a breach, parties must have agreed in advance to a clause which seeks to genuinely pre-estimate the loss involved in any breach.  Where the amount of loss is difficult to pre-estimate then the amount written into the contract must be a reasonable estimate of the amount lost as a result of the breach.  However, care must be taken as anything which goes further than what is reasonable could be deemed a penalty and will be therefore unenforceable.

How Do I Avoid a Penalty Clause?         

The best way is to follow the guidelines set down in a recent court case. Ask the following questions of the clause:

Is there a commercial justification for the terms? Does the breach include something along the lines of bringing an end to the relationship or reduction of payments due as a result of the breach?

Are the terms extravagant or oppressive? If the clause goes beyond what is necessary to compensate the innocent party it is likely to be considered a penalty clause. Estimate, then, only what is necessary to adequately address any loss caused by a breach.

Is the purpose to deter a breach?  The clause must not seek to deter a breach. It should only pre-estimate loss.  A deterrent is considered a threat of penalty by the courts.

Are the terms of the agreement equally weighted between the parties? Does the agreement as a whole benefit one party over the other? If so, it is likely that this clause may be considered a penalty as it will likely be relied upon by the stronger of the parties in the agreement. Balancing the agreement is important if you wish to use such a clause successfully.

At Verto Legal, our commercial solicitors have a strong background in drafting such agreements and strive to ensure the validity of liquidated damages clauses. Contact me  for a free initial consultation at b.taggart@vertogrouplegal.com or call 0203 078 5767.

Brian Taggart
I founded Verto Group Legal in 2010. I am the head of Commercial Contracts and Franchising at VGL. I handle all commercial and corporate matters including: franchise law, company structures, shareholder rights and agency agreements.
Brian Taggart
Brian Taggart

Latest posts by Brian Taggart (see all)

Previous post:

Next post: