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Penalty clause in contracts

Penalty clause

We will discuss the effectiveness of penalty clauses in reducing contract risk. As such, explores what penalty clauses are, how they work, and their enforceability.

What is the definition of penalty clause?

A penalty clause is one of the clauses of the concluded contracts by and between parties to a contract, whereby one of the contractual parties has to pay a monetary compensation in favor of the counterparty, in case of breaching any obligation(s) within the implementation of a contract’s provisions.

For instance, in case of parties’ agreement to purchase a product and/or provide a service, and a party fails to implement one of such obligation(s) by virtue of a contract at the estimated time frame set forth in a contract, consequently, the defaulting such action shall be deemed as a material and the defaulting party is obliged to pay the penalty clause and compensate the counterparty.

It is worth mentioning that the penalty clause shall be expressly stated in a contract to be applied to its parties.

Types of penalty clause in contracts

  1. Penalty clause in employment contracts.
  2. Penalty clause in construction contracts.
  3. Penalty clause in commercial contracts.

Employment Contracts Penalty Clause

As employment is a fixed-term contract, it also includes an indefinite-term or contractual basis. However, employers risk employees leaving the organization within the contract period. Thus, employers include a penalty caveat in the employment contract.

If an employee terminates the contract before completion, they must pay the employer a fine.

Construction Contracts Penalty Clause

Penalties in construction contracts were unenforceable until the amendments. Now, the suffering party can claim a penalty to cover the damages.

For example, construction contracts often face liquidated damages. Here, the penalty amount is calculated based on the damages.

Commercial Contracts Penalty Clause

In commercial contracts, the defaulting party must pay the penalty to the suffering party. Such caveats are common in shareholder agreements and acquisition deal structures.

A breach refers to partial negligence, complete negligence, or incomplete performance. Similarly, in case of delay, the employer can claim a late delivery penalty from a contractor. However, the employer cannot claim a penalty for poor performance.

Enforceability of a Penalty Clause

When determining the validity of a penalty clause, the court conducts a test to find out if the clause is a secondary obligation that inflicts a detriment on the breaching party that is out of proportion to the innocent party’s legitimate interest in the enforcement of the main obligation. 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?

How to Draft an Enforceable Penalty Clause?

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.

What is the difference between penalty clauses and liquidated damages?

Both shall be applied upon any breach conducted by any party to a contract, as the defaulting party shall pay the agreed upon compensation to the counterparty.

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 than those in penalty clauses.

The compensation shall be appropriate with the damages

If one of the parties breaches any term of a contract, and it causes damages to the counterparty party hereto, the defaulting party shall pay a sum of money as a penalty to the other party as a penalty for the damages that are caused from its side.

The penalty clause must be proportionate to the parties and not excessive, and what is and isn’t proportionate will depend on the case at hand, as well as each party’s individual circumstances.

At the end, we should notice the following when drafting and reviewing penalty clauses in different contracts

Upon drafting and/or reviewing a penalty clause in different types of contracts, the following shall be observed as follows:

The said clause is governed and regulated by the provisions of Egyptian Civil Code, as such clause shall be expressly stated in a concluded contract.

The compensation shall not be entitled unless after notifying the other party, unless otherwise stated, moreover, there are a set of cases that are not entitles the said notification.

In case a contract is free from the said clause, the latter may be stated in a subsequent annex to the principal contract.