Broadly, a penalty clause is one which seeks to “penalise” a defaulting party for a contractual breach, so that the sum payable on a breach of contract is more of a deterrent to the wrongdoer rather than merely setting out the usual damages recoverable for breach. Penalties are usually (although not always) financial in nature.
If challenged, penalty clauses are unenforceable beyond the actual loss suffered by the non-defaulting party and are therefore to be avoided when drafting a contract. This can cause uncertainty, as pre-agreed remedies for breach of contract (e.g. clauses which set out a monetary sum as damages for breach of contract) are a popular way of parties reaching deals on risk management.
So when will the courts find that a pre-agreed remedy is in fact a penalty?
The provision needs to be a remedy for a breach of “primary” contract obligation, rather than being a primary obligation in its own right. For example if a higher price is payable if payment is received after 30 days rather than 5 days, this higher price may well be viewed as a primary payment obligation, not capable of being a penalty clause.
In any event, at least where the parties are properly advised, the court tends to presume that the parties are best placed to decide what is a legitimate pre-agreed remedy. However, the court will consider whether the contractual remedy is proportionate. An agreed clause may be viewed by a court as an unenforceable penalty if it is not. This may occur where the agreed remedy does not seek to protect a legitimate interest of the party relying upon it and/or provides a remedy which is significantly out of proportion to the breach.
To assess this, the court conducts a “multi-factorial” assessment of the circumstances and context. In one leading case, a share sale agreement required the vendors to comply with certain restrictive covenants – failing which the unpaid residue of the price would be forfeit – over 44m dollars for one vendor. On the face of it this sounds an extreme remedy. The Supreme Court decided the clauses were enforceable in the circumstances of the deal and were not a penalty. So, when including a remedy, its rationale is important. Even if the sum payable may appear to exceed the actual losses of the party enforcing it, the clause may be upheld provided it is not “exorbitant or unconscionable” in all the circumstances.
Therefore, enforceability is ultimately a matter for the courts and will depend on an assessment of the facts and circumstances if any challenge is made. For more information please contact Beverley Whittaker or any other member of the commercial contracts team at Stevens & Bolton LLP.