The penalty

Penalty clauses are often included in agreements. Think, for example, of a penalty for late delivery in an agreement for the sale and delivery of goods, a penalty for non-compliance with a non-compete clause in a shareholders’ agreement, or a penalty for breaching a confidentiality agreement. It is highly likely that at some time you have accepted a penalty clause or imposed it on someone else. It may seem to be a fairly straightforward clause, but appearances can be deceiving.

The law says that if a penalty is agreed, the creditor must choose whether he will demand compliance with the agreement after all, or payment of the penalty. It is not possible to have both. The same applies to the right to compensation. If payment of the penalty is being demanded, the right to compensation will be cancelled. Furthermore, payment of a penalty may only be demanded if the breach can be attributed to the debtor.

A penalty clause is intended as a deterrent, in order to induce a contracting party to meet his obligations. The penalty is the punishment for failure to meet the obligation. A penalty clause is therefore often included for obligations that are important for the party that can claim the penalty. It will not be his intention to waive his right to compensation or compliance. Moreover, he does not want to get embroiled in a discussion as to whether the failure to comply with the obligation can indeed be attributed to the debtor. The mere fact that the obligation has not been met should lead to the penalty being payable.

Fortunately, it is possible to deviate from the law, but this must be explicitly laid down in the agreement. The exact formulation of the penalty clause therefore needs to be given careful attention.

If you are the party liable to pay the penalty, you will want to keep the maximum costs as low as possible. You can fall back on the law for that. If you fail to meet your obligations, your creditor can choose whether he wants you to meet your obligations after all, whether you should pay the penalty, or whether you should compensate his loss, if this is higher. However, you could decide to state explicitly that the penalty takes the place of compensation or compliance. The penalty is then the only remedy for the other party, so that you know exactly where you stand if you fail to meet your obligations.

If you are on the other side, however, you want to keep your options open as much as possible. In that case it is sensible to state in the penalty clause that the penalty will not affect your right to compensation, additional or otherwise, and/or you may demand compliance. The penalty will then be in addition to your other claims. In this way, the debtor will be more likely to regard the penalty as a deterrent in the way you intended.

Incidentally, a penalty is not the same as ‘liquidated damages’ which we often see in English contracts. ‘Liquidated damages’ are not intended as punishment for a breach, but concern an amount of compensation agreed beforehand between the parties. ‘Liquidated damages’ often provide for situations where the actual loss suffered is difficult to establish, but which are certainly important and must be prevented. For practical reasons, the parties therefore agree in advance what the loss will be in such a case. It goes without saying that the way in which such a clause is formulated also requires careful attention, as the question also arises whether a creditor may demand compliance or compensation of its higher loss. In addition, the amount agreed must be a reasonable amount, otherwise the court may decide after all that the ‘liquidated damages’ qualify as a penalty.

Finally, we are sometimes asked the question whether a penalty can be insured, certainly since the introduction of the GDPR (the privacy laws) and the threat of exorbitant penalties that the Dutch Data Protection Authority can impose if the GDPR is not adhered to. The law does not contain any general ban on insuring penalties, but it is contrary to public policy to remove the punitive effect of a penalty by means of insurance. A penalty for a breach must of course be felt by the party committing the breach, since that is after all the idea behind the penalty, i.e. the incentive to demonstrate or refrain from certain conduct. The threat of a penalty under the GDPR must ensure that businesses handle our personal data properly. Contractually agreed penalties aim to enforce internal order between two contracting parties. Insurers will therefore not be very inclined to insure such penalties.

Please feel free to contact us if you would like to know more on this subject. We will be happy to help you choose the right deterrent.