Define: Penalty Clause

A penalty clause, also known as a liquidated damages clause, is a provision in a contract that specifies a predetermined amount of damages that one party must pay to the other party in the event of a breach of contract. The purpose of a penalty clause is to provide certainty and clarity regarding the consequences of breaching the contract, as well as to compensate the non-breaching party for the harm caused by the breach. Penalty clauses are commonly used in contracts to incentivize performance and deter breach by establishing a clear financial consequence for failing to fulfil contractual obligations. However, penalty clauses are subject to legal scrutiny, and courts may refuse to enforce them if they are deemed to be punitive or disproportionate to the actual damages suffered by the non-breaching party. Therefore, penalty clauses should be carefully drafted to ensure that they are reasonable and proportionate to the anticipated damages resulting from a breach of contract.

A term in a contract that imposes some fixed, punitive payment in the event of a default on some duty in the contract. As a general rule, penalty clauses will not be enforced by the courts. However, it is open to a person who seeks to rely on such a clause to argue that it is a liquidated damages clause, that is, it genuinely reflects the loss that flows from the default.

The rule that penalty clauses will not be enforced is not an absolute one, and there are circumstances in which policy considerations outweigh the potential injustice of upholding such a clause. One example is the Forfeiture of deposit clause in contracts for the sale of land.

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 29th March, 2024.