If your contract contains a term which amounts to a ‘penalty’, the term will not be enforced by a court.
Penalties and contract law
Under Australian contract law, if a party to a contract breaches any of its contractual obligations (the “Defaulting Party”), the other party (the “Innocent party”) is generally entitled to be compensated for losses caused by the breach. The amount of compensation is ordinarily determined by a court.
In order to avoid the delay and uncertainty of having a court determine the amount of compensation, a contract may include a clause which sets a dollar value on the amount of this compensation. Great care should be taken in drafting such a term because if this agreed compensation is excessive (i.e. is not a genuine pre-estimate of the Innocent Party’s corresponding loss), there is a risk that a court will determine the clause is in fact, a ‘penalty’ clause.
What is a penalty?
A penalty is a contractual term, activated upon a breach of contract, which imposes an additional contractual burden upon the Defaulting Party, that is “extravagant and unconscionable” or “out of all proportion”, when compared to the greatest loss the Innocent Party would suffer as a result of the breach.
A court will consider various factors in determining whether a clause is a penalty including, the nature and purpose of the contract (at the time it was formed not breached) and whether the clause applies equally to all contractual breaches. Importantly, the subjective views of the parties to the
contract are irrelevant.
Practical significance of a penalty
If a clause is determined to be a penalty it will be unenforceable. For this reason :
- penalty clauses should be avoided when drafting fresh agreements; and
- an Innocent Party should consider pursuing ordinary contractual
damages for the breach (at an amount to be determined by a court)
rather than attempting to enforce a penalty clause.
- Whether a term amounts to a penalty is to be determined by a court – not the subjective views of the parties to the contract;
- If a court decides that a term of your contract amounts to a penalty it will not be enforceable; and
- You should seek legal advice before drafting, or seeking to enforce, a term which could be a penalty.