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Penalty clauses in contracts - are they enforced

7/10/2009

Most of us know the meaning of a penalty in a sporting context. If a player breaks a rule, the other team gains an advantage. Who could miss the roar of disappointment from Eels fans when a penalty was called against Fuifui Moimoi, helping the Storm to achieve their recent NRL grand final win?

Penalty clauses in the business world are not dissimilar, designed to give the contractor a significant financial advantage if the terms of a contract are breached. The difference is, penalty clauses are not enforceable by law. Nor should they be.

In the world of business contracts, it’s important to know the difference between a liquidated damages clause and a penalty clause. A liquidated damages clause is a genuine estimate of the financial cost to the contractor if the terms of a contract are breached. For example, if you borrow money and don’t pay it back at the agreed time, this will affect the lender’s cash flow. So you might have to pay an additional amount on top of the amount you owe, to compensate the lender for their financial loss. This type of clause is enforceable in court, provided the amount arrived at is legitimate and can be proven.

If the figure seems inflated, it may be deemed a ‘penalty clause’ (though it is called a liquidated damages clause in the contract). This means the amount payable for breach is far more than the actual loss would be to the contractor. So it effectively serves as a threat which courts won't enforce.

While a penalty clause is unenforceable, it’s not actually illegal. A shonky businessman won’t go to jail for including a penalty clause in a contract.

That begs the question; if the courts don’t enforce penalty clauses, who does? Enter an underworld of criminal activity and McGurk‐like menacing behaviour which will ensure penalty fees are paid.

Otherwise law abiding citizens often forget that when they engage in criminal activity ‐‐ such as smoking marijuana ‐‐ the money they pay props up an underworld which enforces its contracts in a manner very different to the courts on which the rest of us rely.

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