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A contract is only as good as the remedy you get following a breach. Contracts are legally enforceable so that if your contracting party breaks the agreement, the other party compensates you. One way that parties can get compensation is by including liquidated damages clauses in the contract. However, it is important that the court does not deem this a penalty clause. This article will outline what a penalty clause is and why you should avoid penalty clauses in your commercial contract.

Types of Clauses That Could Be Considered a Penalty

The court may consider three types of clauses to be a penalty clause.

Clause

Description

Liquidated Damages

A liquidated damages clause is a pre-determined figure that both parties agree to pay if either party breaches their contractual obligations. It allows compensation to be agreed upon before the parties sign the agreement to protect each party. 

Termination Clause

A termination clause is a provision that allows either party to terminate the agreement early. The caveat is that the party terminating the agreement may have to pay a fee. If this fee is disproportionate, then it may be classed as a penalty.

Transfer of Assets

A transfer of assets that is not underpinned by consideration may be considered a penalty. Here, consideration is the benefit or detriment that each party receives in a binding contract.

What Is a Penalty Clause?

A penalty clause is a clause that punishes the party that has to pay it. Penalty clauses might seem like a good idea to include in your contract, but they are legally unenforceable. This means the party is not legally obligated to pay the sum that was initially agreed if they were to breach the contract.

When Is a Clause Considered a Penalty?

The law has recently changed in New Zealand concerning penalty clauses. The court now considers a clause to be a penalty if it imposes a detriment that is out of proportion to the innocent party’s interest. This means a clause will not be enforceable if it is too harsh. However, it is important to note that the courts have a high standard when it comes to declaring a clause a penalty. 

Why Should I Not Use Penalty Clauses?

The main reason why you should not use penalty clauses in New Zealand is that they are legally unenforceable. This means that if your contracting party breaches the contract, they do not have to pay compensation. 

What other options are there?

Instead of using a liquidated damages clause, the courts can enforce the payment of remedies if a contract is breached. These include:

Remedy

Description

Damages

If your contracting party breaches the contract, you can apply to a court for damages. Damages are a sum of money that you receive from the party that breached the contract that is proportionate to the loss that you incurred.

Specific Performance

The court can issue this remedy, which requires your contracting party to uphold whatever obligation they breached. This is a good remedy if the breach of contract is unable to be compensated through damages.

How Can I Avoid Using Penalty Clauses?

There are a few things you should look at when drafting commercial contracts. These include the following factors. 

The bargaining position of the parties

This is the position the parties are in when they are negotiating. If one party needs the contract more than the other, they may quickly agree to unfavourable terms.

The words used in the clause

The courts will consider the wording of the clause to determine if the clause is a penalty. Clauses that a party has worded to punish one party are more likely to be deemed a penalty.

How much one party must pay

The most important thing that the courts will look at is how much one party is being asked to pay. If it is disproportionate to the loss incurred, then the courts will rule it as a penalty.

Key Takeaways

Having a predetermined clause in your contract that sets out compensation if either party breaches your contract protects both parties. However, the courts can be reluctant to enforce these clauses if they see it as a punishment rather than compensation. Therefore, a penalty clause has been deemed unenforceable by the courts. To ensure your clause is not deemed unenforceable, each party needs to be willing and able to agree to the clause without feeling pressured. In addition, the agreed amount should be proportional to the loss incurred by either party.

If you need any legal assistance on how to avoid penalty clauses, contact LegalVision’s contract lawyers on 0800 005 570 or fill out the form on this page.

Frequently Asked Questions

Are liquidated damages always a penalty?

No, they are only considered a penalty if they meet the legal test and the court deems them to be.

Can I get both damages and specific performance?

No, the courts will only usually choose to give one remedy only.

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