penalties and forfeitures

The object of damages for breach of contract is to place the innocent party, so far as money can do so, in the position they would have been had the contract been properly performed. The primary purpose of damages is to compensate the innocent party for the breach rather than to punish for breach. Contractual provisions which seek to impose a penalty or forfeiture as a consequence of a breach of contract or otherwise for failing to perform an obligation under a contract will be unenforceable. The claimant however will remain entitled to recover its actual loss for the party in breach.

Penalty Clauses

Some contracts provide for payment of a fixed sum upon breach of a term. Such provisions are intended to serve the purpose of enabling both parties to know the full extent of their liability. These liquidated damages clauses are designed to fix (or quantify) the liability of the party in breach, rather than leaving a potential claim for damages unliquidated. However, further to the general rule, the courts will not allow a party to recover a sum which is obviously and considerably greater than a genuine pre-estimate of the loss suffered. Such terms of contracts may therefore be divided into two categories; penalty clauses and liquidated damages clauses. A penalty clause will be a liquidated damages clause which is unenforceable, because it is an unenforceable penalty.

Penalty or Liquidated Damages Clause?

A term of a contract will be considered enforceable penalty if it provides for “a payment of money stipulated as in terrorem of the offending party”, and attempts to put pressure on a party to force him to perform the contract. If the function of the clause is to act as a deterrent against breach, it is a penalty. If on the other hand, the clause included was a genuine attempt by the parties to estimate in advance the loss as at the date of the contract which would likely result from the breach, it is a liquidated damages clause, and enforceable.

In Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd (1915), the House of Lords considered that the question is ultimately one of construction and the circumstances surrounding the formation of the contract. The Law Lords set out guidelines and factors to assist determination whether a clause is a specified damages clause or a penalty:

1. If the sum stated in the clause is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach then it will be a penalty.
2. If the breach consists only in not paying a sum of money, then if the sum stated in the clause is greater than the amount which ought to have been paid, it will be a penalty.
3. If a single lump sum is payable on the happening of one or more of several events, some of which may cause serious and some minor damage, there is a presumption that the clause is a penalty.
4. The clause can be a specified damages clause even if it is difficult or impossible to pre-estimate precisely the loss which might be caused by the breach, as in the Dunlop case itself.

In Dunlop, the House of Lords also said that although the parties may describe the clause as a penalty or liquidated damages, the wording is not conclusive. Therefore a clause may be described as a penalty in the contract but the court may decide that it is, in fact, a liquidated damages clause, and vice versa.

Enforceability of Penalty Clauses

The practical effect of this lies in the enforceability of such clauses. A penalty is unenforceable. Where the clause is a penalty, the court assesses damages in the usual way, looking at the loss to the claimant and award the sum assessed to be payable after considering remoteness of loss, causation, and the claimant’s duty to mitigate its own loss. If the innocent party’s actual loss is greater than the amount stated in the clause, the claimant would not plead for recovery of damages on the basis of the liquidated damage clause; the defendant however might look to rely on the liquidated damages clause as a partial defence to the damages claim..

Since these types of clauses are the result of the parties’ agreement and are already subject to other controls which regulate their validity and enforceability, a court may be predisposed to uphold liquidated damages clauses, in particular in the case of commercial contracts between parties of ‘comparable bargaining power’.

Commercial certainty

Setting out in advance the consequences of a breach and the amount of damages to be paid by the defaulting party increases certainty in contractual relationships and narrows disputes in litigation. Both parties may draw from the contractual documentation the amount that will be paid or received in the event of a breach as a starting position. Liquidated damages clauses are valuable because they enable both parties to know, with a reasonable degree of certainty, the extent of their liability and the risks they would run as a result of entering the contract. As long as both parties are willing to abide by the clause, the potentially high cost and risk of bringing the issue before the court can be avoided.

Forfeiture Clauses

A contract may, instead of fixing a sum to be paid upon breach, provide that a sum already paid shall be forfeited upon breach. Such a sum is usually classed as either a deposit or part-payment of a full contract price.

Deposits

A deposit is a sum of money paid as a guarantee that a contract will be performed. It is generally irrecoverable unless the contract provides otherwise. Forfeiture of a deposit is distinguishable from payment of a penalty in that it is paid before and not after breach The function of the two devices is similar and thus the law applicable to penalties applies to forfeitures.

Where a deposit is reasonable in relation to the loss likely to be suffered in consequence of breach of contract, the forfeiture is enforceable. Where a deposit is not a reasonable pre-estimate of the loss, it may be recovered by the payee (subject to any counter claim for the loss incurred by the innocent party).

Part-payment of Contract Price

A part-payment is simply a payment of part of the contract price, which is generally irrecoverable unless the contract provides the contrary.

In contracts regarding the sale of land it is generally accepted that the customary 10% deposit may be forfeited to the seller by the buyer on the buyer’s default, irrespective of the amount of the seller’s loss. A larger deposit is likely to be able to be retained only if the seller could show that it was reasonable to demand one. English courts do have a statutory discretion to order the return of a deposit which is specific to contracts for the sale or exchange of any interest in land under section 49(2) of the Law of Property Act 1925.

Where the contract is one for services to be rendered over a period of time in return for payments to be made at stated intervals, and the payee fails to keep up with payments, prior payments will not generally be recoverable as long as they “represent the agreed rate of hire (for the service) and not a penny more”. The payer will have received pro-rata what he bargained for in exchange for his payments. The position might be different if those payments contained a heavy element of ‘front loading’.

Similarly, a contract of sale may provide for payment of the price in instalments and add that, on default in payment of any one instalment, the contract will be terminated and those payments already made shall be forfeited.

Recovering forfeited instalments

Since forfeiture provisions often resemble penalties in their purpose and effect, their validity is likely to depend on the same tests that differentiate penalties from liquidated damages clauses. This would provide the court with the power to grant relief where, on these tests, the forfeiture provision is penal in nature. In most cases, such relief would take the form of ordering repayment of the forfeited instalments.

In practice, however, this is in conflict with the principle that the law should not interfere with contracts freely made and entered into by consenting parties. Consequently, the courts have historically been reluctant to allow recovery of money already paid and upset acts already performed. An order of repayment will often only be made where the vendor is guilty of “fraud, sharp practice or other unconscionable conduct”.