Contractual Penalty – What Is It and When Is It Justified?

Contractual penalties are a common tool for protecting the interests of parties in civil law contracts. Their purpose is to safeguard against potential failure to perform obligations or improper performance thereof. However, contractual penalties are not always legally justified. In this article, we explain exactly what contractual penalties are, under what circumstances their use is warranted, and when they may be challenged.

What Are Contractual Penalties?

A contractual penalty is a pre-determined amount of money that one party agrees to pay the other if they breach a contractual obligation. It serves as an effective means of protecting the interests of the party that might suffer harm from non-performance or improper performance—especially when the damages would be difficult to quantify.

Contractual penalties most often appear in agreements where specific obligations are to be fulfilled. They are found in contracts for specific work, lease agreements, service contracts, and commercial contracts. They can address various breaches, including delays in performance, failure to provide services, or breaches of confidentiality clauses.

When Can Contractual Penalties Be Used?

The use of contractual penalties depends on several key aspects. They can be an effective disciplinary tool, but the conditions for their application must be clearly defined and compliant with the applicable legal provisions.

Clear Definition of the Obligation

To enforce a contractual penalty, the obligation whose non-performance or improper performance triggers the penalty must be clearly specified. The parties must define what specific act or omission will result in the penalty. This could include late delivery, failure to complete agreed work, or breach of a non-compete clause.

Reasonable Amount of the Penalty

The penalty amount should be proportionate to the anticipated damages. If the penalty is excessive and disproportionate to the actual or anticipated harm, it may be deemed invalid or reduced by the court. Therefore, the amount should be set wisely and realistically, considering potential consequences.

Connection to Non-Performance or Improper Performance

Typically, a penalty may only be imposed when the breach results from the defaulting party’s actions. If a breach is due to force majeure or other external factors, applying the penalty may not be justified. Contracts should include clauses excluding liability in such situations.

Penalties in Consumer Contracts

When entering into agreements with consumers, special care must be taken when setting penalties. Excessive or unfair penalties may be deemed invalid under consumer protection laws. To be enforceable, penalties must be reasonable and clearly justified.

Examples of Justified Use of Contractual Penalties

Understanding typical cases can help illustrate where contractual penalties are appropriate.

Construction Contract

In a construction contract, the investor may stipulate a contractual penalty for delays in project completion. Such a penalty is justified if the contractor fails to meet the deadlines specified in the schedule, which may cause delays in delivering the investment and generate additional costs for the investor.

Commercial Lease Agreement

A lease agreement may include a contractual penalty for the tenant’s failure to return the premises within the agreed timeframe. In such cases, the penalty helps the landlord cover the loss resulting from the inability to rent the premises to other tenants.

Service Agreement

Contractual penalties are also commonly used in service agreements, such as IT or consulting services. For example, an IT services agreement may include a clause imposing a penalty for breaching confidentiality provisions. If the service provider discloses the client’s confidential information, the penalty serves as an appropriate safeguard against damages related to the loss of confidential data.

Sales or Supply Agreement

In sales or supply contracts, particularly those involving high-value goods, penalties are often imposed for delays in delivery. If the supplier fails to meet the delivery deadline, which may lead to production downtime, loss of clients, or other financial consequences for the buyer, the penalty becomes a justified form of compensation. It also encourages the supplier to fulfill their contractual obligations on time and protects the buyer’s interests.

These examples show the importance of correctly including penalty clauses in various types of agreements.

When Can a Contractual Penalty Be Challenged?

Although common, contractual penalties can be questioned in certain circumstances.

Grossly Excessive Penalty

A court may reduce a penalty if it is disproportionately high compared to the contract’s value or the breach. For instance, a penalty of PLN 100,000 in a contract for a vehicle worth PLN 5,000 may be considered excessive.

Vague Contract Provisions

If the contract lacks clarity on the circumstances triggering the penalty, it may lead to disputes. Courts may find that a vague clause is unenforceable. Penalty provisions must be precise and unambiguous.

Substantial Performance

If the breaching party has completed the majority of the obligation, the penalty may be reduced. For example, if a contractor completed 90% of the work, a full penalty may be unfair.

No Actual Damage

According to law, the creditor may claim the penalty regardless of actual damages. However, courts have debated whether a penalty is justified if no loss occurred. The issue may need to be resolved in court, possibly resulting in the penalty being reduced or dismissed.

Breach of Good Faith Principles

Penalties may also be questioned if enforcing them violates the principles of social coexistence (Article 5 of the Civil Code). If claiming a penalty would be morally or socially unjust, a court may refuse its enforcement.

How to Draft a Contractual Penalty Clause Properly?

To avoid disputes, penalty clauses should be carefully drafted. Key aspects include:

Clear Definition of Obligations

The most important element of a contractual penalty clause is a clear and detailed specification of the breaches for which the penalty will be imposed. The parties to the agreement should precisely indicate the actions or omissions that will trigger the penalty. Examples may include delays in performance, failure to deliver goods on time, or violation of confidentiality provisions. The more specific the terms, the easier it will be to enforce the penalty in the event of a breach.

Determining an Appropriate Penalty Amount

The amount of the contractual penalty should be proportionate to the foreseeable damage the entitled party may suffer. It is important to note that an excessively high penalty may be challenged and potentially reduced by the court.

Including Force Majeure and Liability Exclusions

To prevent situations where a penalty would be imposed despite the absence of fault, it is advisable to include clauses excluding liability in cases of force majeure or other events beyond the parties’ control. Such provisions help avoid misunderstandings and inappropriate penalties in cases such as natural disasters, wars, or other unforeseeable circumstances.

Compliance with Legal Regulations

Every contractual penalty clause must comply with applicable legal provisions. In contracts involving consumers, particular attention must be paid to consumer protection laws. Contractual penalties must not be excessively burdensome or unfair, as such clauses may be declared invalid. In consumer contracts, it is especially important to ensure that penalty clauses are transparent and easily understood.

Limiting Additional Compensation Claims

Summary

Contractual penalties are an effective tool for safeguarding contractual interests, but they must be used thoughtfully and in line with legal requirements. Precise wording, appropriate amounts, and clear definitions help ensure enforceability and fairness.

If you are uncertain about your penalty clauses, consult a legal adviser. Our law firm offers full support in contract drafting and review, including penalty-related advice. Contact us to ensure legal security and avoid future disputes.