by Marcus Baum
1. Subject matter and purpose
A penalty clause is the undertaking by a debtor towards his creditor to pay the creditor a fixed sum of money in the event of either the debtor’s non-performance or improper performance, the sum not being dependent on the actual loss suffered by the creditor because of the non-performance or improper performance.
There are two purposes which can be pursued by means of a penalty clause. On the one hand, it can serve the purpose of putting pressure on the debtor actually to perform his obligation or to deter him from non-performance. The pressure can either come from an agreement relating to an amount which is greater than the expected damage, or from the fact that the debtor is clearly confronted with a concrete sum which he would be liable to pay. The penalty in such cases has a preventive function. As a means of applying pressure it is the opposite of a reward.
On the other hand, the penalty can serve the purpose of making it easier or unnecessary for the creditor, in case of a debtor’s non-performance, to prove either that he suffered damage at all or the exact amount of the damage suffered. That is particularly of interest in cases where proof of damage is difficult, such as cases of delayed performance, unfair competitive practices or breach of contract by executives who are in the course of changing employers and encourage employees in their present company to follow them. The purpose of the penalty is, in such cases, to make an estimate of the probable damage. A penalty meant to facilitate the recovery of damages can also allow for damages the recovery of which would otherwise either be impossible or questionable under the generally applicable rules, eg non-monetary damages or damages which might not be considered foreseeable. At any rate, both the preventive and the liquidated damages purpose overlap in practice.
A penalty can be distinguished from a guarantee in that it is meant to influence or sanction the future behaviour of the debtor. If a debtor promises to pay money in case certain events take place or certain circumstances prevail, either of which are independent of the debtor’s behaviour, the promise represents a guarantee rather than a penalty. The guarantee therefore lacks any notion of punishment or pressure. Thus, as a general principle it does not require fault to become due.
A penalty can also be distinguished from a forfeiture clause. Under a forfeiture clause the debtor, in case of his non-performance or improper performance, does not owe something but loses a right of his own.
2. Tendencies of legal development
Penalty clauses go back to Roman law. In Rome, judgments always had to be for a specific sum of money (omnis condemnatio pecuniaria). The consequence was that a large number of contractual promises were not directly enforceable, ie all promises where the performance had no—direct—pecuniary value for the recipient. It is here that Roman law came to the aid of the creditor with the so-called non-genuine or independent penalty clause. The debtor declared that he would pay the creditor a certain sum of money if he, the debtor, would not perform a certain act. As a consequence the desired act would not become directly, but indirectly, enforceable. Roman law also recognized clauses which provided a pre-estimate of the damage likely to be suffered in case of a breach of obligation and thus aided the creditor by relieving him of having to prove the damage actually suffered by the debtor’s non-compliance. Such clauses are genuine or accessory penalty clauses.
While contractual promises to pay a specific sum of money on the occurrence of certain events are in principle known in all European jurisdictions, there are still a number of fundamental differences. These primarily concern the purposes for which such promises can be used and the relationship between the contractual promise to pay a specific sum and claims for damages under the general principles of law. There is, above all, a fundamental distinction to be made between civil law and common law jurisdictions.
Penalty clauses are known and enforced in all civil law jurisdictions. The individual rules within the national jurisdictions allow the adoption of penalty clauses for both purposes, ie the purpose of putting pressure on the debtor to perform his obligation or deterring him from non-performance as well as the purpose of making it easier for the creditor to recover his damages suffered. In the civil law jurisdictions, eg France, Italy, Germany and Sweden, once a penalty has been agreed upon it is consequently not necessary for the creditor to prove the size of his loss or that he suffered any loss at all. Because both purposes are accepted in civil law jurisdictions, these jurisdictions often do not clearly distinguish between penalty clauses and liquidated damages clauses.
Several civil law jurisdictions, eg Austria, Denmark, Finland, Germany, Sweden, the Netherlands, Italy and France, recognize a right of the debtor to obtain the reduction of an excessive penalty clause by court order. That is by no means a matter of course. Roman law, with great respect for the free will of the parties, did not interfere with what the parties had agreed upon. The judicial power to reduce excessive penalty clauses is a fairly recent development in all jurisdictions where it is recognized today and makes allowance for the fact that often the debtor, when agreeing to a penalty clause, is in an inferior bargaining position. Germany and Austria consequently do not recognize a judicial power to reduce excessive penalty clauses in commercial contracts. French law also recognizes the possibility of increasing a ridiculously low penalty (peine dérisoire).
Although there is a common understanding of penalty clauses in the civil law jurisdictions, especially as to their double purpose, the rules on the relationship between penalty clauses and claims for damages vary considerably. In most civil law jurisdictions (eg France, Italy or Spain) the stipulated payment replaces the general claim for damages for improper performance or non-performance with the consequence that the creditor cannot alternatively claim his damages even if he can actually prove them and they happen to be higher than the stipulated payment. A claim for higher damages under the general principles of the law of damages is only possible if the parties have expressly agreed that the creditor can make such a claim. This is by no means the only solution as, for example, both Austrian and German law prove. In Austria, even if a penalty has been agreed upon, a creditor may claim damages over and above the stipulated sum. If, however, the debtor is a consumer (consumers and consumer protection law), that right has to be agreed upon in advance. The German Civil Code (Bürgerliches Gesetzbuch (BGB)) also expressly reserves the right for a creditor to claim his full damages under the general rules even if a penalty clause has been agreed upon (§ 340(2) BGB); the sum of the penalty, of course, has to be deducted in order to avoid over-compensation.
Whether fault on the part of the debtor is necessary for the penalty to become due depends on the individual penalty clause.
In principle, most civil law jurisdictions agree on the relationship between the aggrieved party’s right to claim performance and his right to claim the agreed payment. Generally, a distinction is drawn depending on the purpose pursued with the penalty clause. If it serves to sanction the non-performance of a debtor, once the creditor claims the penalty he can no longer claim performance. The situation is different if the penalty is meant to secure proper, especially timely, performance. Then a cumulation of penalty and claim for performance is possible.
The common law jurisdictions distinguish strictly between penalty clauses and liquidated damages clauses. While liquidated damages clauses are enforceable, penalty clauses are not. Penalty clauses in the common law are clauses stipulated in terrorem, that is in order to coerce the debtor to perform the principal obligation. Liquidated damages clauses in the common law are clauses by which a genuine or reasonable attempt is made to pre-estimate the loss likely to be suffered by a breach of the promise. The invalidity of penalty clauses goes back to the principles of equity in the 17th century. It was then common practice for a creditor (usually a bank) to have the debtor promise in a sealed bond that his failure to pay a certain sum of money by a certain date would result in a higher, usually doubled amount becoming due. While such clauses were originally used to circumvent the ban on interest, later penalty clauses were used as a means to coerce specific performance which could not be achieved at law. It is here that the courts of equity intervened.
Whether an agreed sum is a valid liquidated damages clause or an invalid penalty clause is decided upon from an ex ante perspective, ie from the point of view when the promise was made. If the clause is valid, then liquidated damages are owed irrespective of the fact whether higher or lower damages actually occurred. If the clause constitutes a penalty then it is set aside completely; it is not reduced to a reasonable amount. The creditor then, however, can claim his full damages under general rules; this means, inter alia, that he fully has to prove his damages. Because valid liquidated damages clauses in English law do not serve the purpose of securing performance, the right to claim performance is not lost when liquidated damages are claimed. Consequently, the creditor does not have to choose between liquidated damages and performance.
3. Uniform law projects
Penalty clauses provide the possibility, especially for cross-border contracts, of avoiding an arduous assessment of damages. It is for this reason that from an early date there have been endeavours to unify the rules on penalty clauses.
A first attempt was made with a convention of the Benelux countries of 26 November 1973 (Benelux). The starting point for this project was that the jurisdictions of the Benelux countries did not recognize a judicial power to reduce excessive penalties. It is remarkable that the convention exclusively contained rules on penalties, which again proves the importance of the institution for legal practice. Because the plans for such a unified law in the Benelux countries were abandoned in favour of the greater aim of uniform law projects on a European Community level, the convention was never ratified. However, it influenced a resolution passed by the Council of Europe on 20 January 1978. While having no direct legal effect in the Member States, this resolution recommended that rules on penalty clauses corresponding to the convention should be included in the national laws. It should be noted that English legal experts were involved in the work on this resolution.
The Principles of European Contract Law (PECL) (Art 9:509), the UNIDROIT Principles of International Commercial Contracts (PICC) (Art 7.4.13), the Draft Common Frame of Reference (DCFR) (Art III-3:712) and the Avant-projet (Code Européen des Contrats (Avant-projet)) (Art 170) deal with penalty clauses in an almost identical way. The Acquis Principles, in contrast, do not contain rules on penalty clauses. The comments on the PECL, the UNIDROIT PICC as well as the DCFR allow for penalty clauses to serve the purposes of facilitating the assessment of damages as well as acting as a deterrent against non-performance. The Avant-Projet does not contain such explicit statements but obviously also allows penalty clauses to serve both purposes. A judicial power to reduce a penalty to a reasonable amount is embraced by all model laws if and when a penalty is grossly excessive in relation to the actual loss suffered or other circumstances. The model laws as well as the comments do not contain more detailed guidance as to what grossly excessive actually means. However, it seems fair to assume that a penalty will not only be reduced if it is contra bonos mores, but already at a certain degree of unreasonableness below this threshold. According to the Avant-projet a reduction is also possible if the debtor made a part performance and the creditor did not refuse it.
According to the comments on the PECL, the DCFR and the Avant-projet, if a penalty clause has been agreed upon, it conclusively resolves the question of damages. The courts must then disregard the loss actually suffered by the aggrieved party and must award neither more nor less than the sum fixed. Consequently, the aggrieved party is under no obligation to prove that it has suffered any loss. The UNIDROIT PICC can be interpreted as following the same line. However, it is always possible for the parties to agree that the penalty shall only be the minimum sum payable by the party in breach of his obligation and reserve for the aggrieved party the right to recover a higher figure if he can prove that his loss exceeded the minimum amount. It is not clear from the model rules or their comments whether a penalty only becomes due in instances where the non-performing or improperly performing party is at fault. Whether fault is a pre-requisite will therefore depend on the specific promise.
All model laws therefore, in principle, follow the civil law jurisdictions. In addition, the Avant-projet states that penalty clauses in standard contract terms are invalid as far as they operate to the detriment of a consumer.
Although the draftsmen of CISG (sale of goods, international (uniform law)) decided not to deal with penalty clauses, a UNCITRAL proposal on Uniform Rules on Contract Clauses for an Agreed Sum Due upon Failure of Performance was formulated in 1983. The UNCITRAL proposal expressly states that a penalty can be used as a means of coercion as well as a means to facilitate the assessment of damages. Similar to the other model texts, the UNICTRAL proposal provides for a judicial power to reduce the penalty if it is substantially disproportionate to the loss actually suffered. As in the case of the other model texts, there are no more detailed criteria. The proposal also contains provisions on the relationship between the penalty and other claims of the creditor. Thus, it states that only if the contract provides that the creditor is entitled to the agreed sum because of a delay in performance, he is entitled to both performance of the obligation and the agreed sum. If the promise is made for a failure of performance other than delay, the creditor is only entitled—in principle—to either performance or the agreed sum. The UNCITRAL proposal also contains an express rule on the relationship between the penalty and a claim for damages under general principles. In principle, if a penalty has been agreed upon, the creditor is not allowed to claim further damages under general principles. However, he is allowed to do so without an agreement to that effect if the sum agreed upon is substantially exceeded by the actual loss. Furthermore, the UNCITRAL proposal expressly provides that the creditor is not entitled to the agreed sum if the debtor is not responsible for the failure of performance. A direct influence of the UNCITRAL proposal on the UNIDROIT PICC can neither be traced in the wording nor in the substance of the UNIDROIT PICC.
In summary, it can be stated that according to all model laws penalties can be used to facilitate the assessment of damages as well as a deterrent against non-performance. All model rules recognize a judicial power to reduce a penalty. Also, all model laws in principle understand a penalty as a conclusive determination concerning possible claims for damages. Only the UNCITRAL proposal strictly requires fault on the part of the debtor for the penalty to become due.
4. Provisions in the CISG and CMR
The CISG (sale of goods, international (uniform law)) contains detailed rules on damages. It does not, however, mention penalty clauses. Nevertheless, the parties can, of course, agree on a penalty clause in a contract to which the CISG is applicable. The validity of the clause is then to be determined by the national law applicable under conflict of law rules. For international carriage of goods by road contracts there is a general limitation on the extent of liability in Art 23 no 6 CMR (UN Convention on the Contract for the International Carriage of Goods by Road). Further, Art 41 CMR states that agreements relating to a higher level of liability are null and void. Therefore, penalties are invalid within the scope of the CMR’s application.
Rolf Knütel, Stipulatio Poenae (1976); Georg Bucksch, ‘Rechtsvergleich zu Vertragsstrafe und/oder pauschaliertem Schadensersatz’ (1984) RIW 778; Guenter H Treitel, Remedies for Breach of Contract (1988) 208 ff; Ralf-Peter Sossna, Die Geschichte der Begrenzung von Vertragsstrafen (1993); Reinhard Zimmermann, The Law of Obligations (1996) 95 ff; Klaus Peter Berger, ‘Vertragsstrafen und Schadenspauschalierungen im Internationalen Wirtschaftsvertragsrecht’ (1999) RIW 401; Isabel Steltmann, Die Vertragsstrafe in einem Europäischen Privatrecht (2000); Peter Gottwald, ‘Zum Recht der Vertragsstrafe’ in Festschrift Alfred Söllner (2000) 379; Harriët Natalie Schelhaas, ‘Art 9:509’ in Danny Busch, Ewoud H Hondius and others (eds), The Principles of European Contract Law and Dutch Law (2002); Harriët Natalie Schelhaas, Het boetebeding in het europese contractenrecht (2004); Harriët Natalie Schelhaas, ‘The Judicial Power To Reduce Contractual Penalty, Judgements of the Dutch Supreme Court, Commentary’ (2004) 12 ZEuP 386; Alessandra Mari, ‘Art 9:509’ in Luisa Antoniolli and Anna Veneziano (eds), Principles of European Contract Law and Italian Law (2005); Hugh Beale (ed), Chitty On Contracts, General Principles (2008) 1681 ff; Ewan McKendrick, ‘Art 7.4.13’ in Stefan Vogenauer and Jan Kleinheisterkamp (eds), Commentary on the UNIDROIT Principles of International Commercial Contracts (PICC) (2009); François Terré, Philippe Simler and Yves Lequette, Droit Civil, Les Obligations (2009) 874 ff; Edwin Peel, Treitel on the Law of Contract (13th edn, 2011).