Contractual penalties and judicial reduction

The contractual penalty is a popular tool because it solves two problems at once: it creates an incentive to honour the contract, and it saves having to prove the amount of loss in a dispute. Both of these, however, hold true only to a limited extent.

The judicial power to reduce

An agreed contractual penalty is subject to the court's judicial power to reduce it: if it is excessive in relation to the actual detriment, the court may reduce it. Factors taken into account include, among others, the nature and degree of fault, the parties' financial circumstances, and whether any loss actually occurred at all. Towards consumers and in employment contracts the limits are narrower than in dealings between businesses.

What the contract should clarify

Three points are regularly forgotten. First: does the penalty apply in addition to damages or instead of them – and is any loss going beyond it separately recoverable? Second: does forfeiture require fault? Third: does the penalty accrue per breach, per day or as a single sum, and is there a cap?

The practical consequence

A penalty that is realistically sized and demonstrably tied to a specific detriment holds up better in proceedings than an eye-catching figure. Anyone who sets the penalty high to make an impression risks ending up with only a fraction of it – and risks the clause meeting resistance during negotiations that it need not have caused at all.