A Penalty Clause in a Contract raises Questions

You will sometimes find a penalty clause in a contract. Or you might want to include a penalty clause. Or be asked to include one. It is sometimes difficult for someone to claim damages from another who has not done what they agreed they would do in a contract. Claiming damages for breach of contract can be hard. Taking action through our courts can be a long and expensive exercise. So, some people include a penalty clause or a pre-estimate of liquidated damages clause in a contract.

What is a Penalty Clause?

The essence of a penalty clause is that if one party to a contract breaches it, that party will give something to the other party. Usually money. For example, if we agree that we will have coffee tomorrow at 3pm and that if I am late, I will pay for your coffee and mine. Then that is a penalty clause. If I am late, rather than you claiming damages through the courts, I simply pay you the penalty.  The objective to dissuade the party from committing the breach for fear of the consequences – I do not want to be late for coffee because then I have to buy yours and mine.

Another example, is in the context of service levels for ICT services. If you are a vendor of ICT goods or services, be careful with penalty clauses – they can be life threatening to your business.

Questions?

Is a penalty clause enforceable? How high can the penalty be? Can it be more than the damages suffered? Can one claim damages and the penalty?

Read on for the answers

There is a whole body of law that has developed dealing with penalty clauses. You have to be very careful when drafting them and including them in contracts. You also cannot view them in isolation because other clauses in the contract that deal with breach, limitation of liability, damages and termination will all be relevant. They are intertwined.

Yes, they are Enforceable.

The Conventional Penalties Act of 1962 permits these clauses, but allows a court to reduce the amount – a court is in fact obliged to investigate the relationship between the penalty and the prejudice you suffer and see whether the penalty is out of proportion to the damages you suffer (which has to be proved by the person hit by the penalty). So don’t make the penalty outrageous.

Restrictions

Further, if you claim a penalty, you are not allowed to also claim damages for the same act or omission. You may claim damages instead of the penalty if the contract allows it.

How we can help?

We have extensive knowledge and experience regards penalty clauses in contracts. We can:

• draft a penalty clause for you,
• review an existing one,
• advise you relating to one,
• help you learn more about IT contracts.