Penalty clause: how to set contractual fines
The penalty clause sets a penalty in advance in the event of a breach of contract. Setting this amount in a balanced way helps protect the business without creating excesses.
What the penalty clause is
The penalty clause is a contractual provision that establishes a penalty, usually financial, in the event of total or partial non-compliance with what was agreed. It usually serves two functions: to discourage default and, at the same time, to set compensation in advance. In general, it gives the parties greater predictability about the consequences of any failure.
Types of penalty clause
It is common to distinguish the penalty clause according to its purpose. The choice of type influences how the penalty will be applied in each situation.
- Compensatory penalty clause, linked to the total non-performance of the obligation
- Moratory penalty clause, aimed at delays in performance
- Combinations provided for according to the nature of the contract
Precautions when setting the amount
The amount of the fine usually needs to be proportionate to the main obligation. Very high penalties can be challenged and, in some cases, reduced under the applicable legislation. For this reason, setting a balanced amount consistent with the contract tends to give the clause greater security.
The fine and other losses
Depending on the drafting, the penalty clause may or may not preclude the recovery of additional losses. Making clear what the fine covers helps avoid disputes over whether penalties and compensation can be combined. The appropriate solution depends on the specific case and the parties' objectives.
Frequently asked questions
Can a fine for non-compliance be reduced?
In certain situations, yes. The applicable legislation allows penalties considered excessive to be reduced, as appropriate. For this reason, setting an amount proportionate to the obligation is usually advisable.
Are a penalty clause and default interest the same thing?
No. The penalty clause is a penalty set in advance for non-compliance, whereas default interest usually compensates for the delay in payment. Both may appear in the contract, but they serve distinct functions.
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