In the United States, a liquidated damage clause is intended to estimate damages in the event of non-performance or breach of contract. A liquidated damages clause will be enforced where the court finds that the harm caused by the breach is difficult to estimate, but where the amount of liquidated damages is reasonable compensation and not disproportionate to the actual or anticipated damage. The intent of liquidated damages is simply to measure damages that are hard to prove once incurred. If the liquidated damages are disproportionate, they can, however, be declared a penalty. The clause is then void, and recovery will be limited to the actual damage that results from the breach.
The treatment of liquidated damage clauses varies slightly among different jurisdictions within the United States, but generally the courts consider two elements to determine whether a liquidated damage clause is enforceable. The first is the uncertainty element; whether the harm caused by the breach is difficult to calculate. The second element is whether the amount of the liquidated damages is reasonable in proportion to the actual or anticipated harm. If it is not, then it is a penalty, which is against public policy, and therefore the clause is unenforceable.
The American approach to liquidated damages can be illustrated by both the Uniform Commercial Code and the Restatement 2d Contracts: Restatement 2d Contracts § 356:
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.
UCC § 2-718:
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.
Most other common law countries such as England, Australia, Ireland and Canada have similar rules with regard to liquidated damages, and do not allow for liquidated damages that are used as a penalty.1 One exception to the rule is India, where the Contracts Act makes no distinction between liquidated damages and penalties, and allows for contractual damages for failure to perform even if the intention is to penalize.2
It is significantly more difficult to find a consistent application of the concept of liquidated damages or other contractual “penalties” in civil code countries in the international marketplace. The UN Convention on Contracts for the International Sale of Goods (“CISG”), which has generally been an important tool in developing a more uniform international sales law, regulates neither liquidated damages nor penalty clauses. In fact, the framers of the CISG agreed to leave these clauses out of the convention, in favor of regulation by domestic law, because of widely divergent approaches in different legal systems.3 The enforceability of liquidated damage and penalty clauses thereby depends on domestic law.
One dilemma in the comparison between common and civil law is the confusion of terminology with regard to liquidated damages. This confusion arises because in some countries, whether under civil code or doctrine or case law, both concepts are recognized and the terms are used interchangeably.
In the UNICITRAL uniform rules relating to liquidated damages and penalty clauses, this problem has been solved by simply referring to both as “contract clauses for an agreed sum due upon failure of performance.”4 According to the UNICITRAL rules, an agreement between parties of a contract to pay a certain sum in the event of non-performance is generally allowed, whether as a penalty or compensation. However, the amount can be reduced by the courts if it is “substantially disproportionate to the actual loss.”5
Liquidated Damages and Penalty Clauses in Civil Codes
In civil law countries, the attitude toward contractual penalties is quite different from the common law approach. The Napoleonic Code, upon which most civil codes are based, allowed for penalties to encourage performance of contractual obligations. (This is the precise rationale that is rejected in the United States.) In recent years, however, there has been a widespread trend in civil law countries toward narrowing the scope of such penalties, and allowing courts to reduce the amount if they find it excessive.
Traditionally, in civil code countries, no distinction was made between liquidated damages clauses and penalty clauses.6 Recently, a more common approach seems to distinguish between liquidated damages clauses that are used to estimate damages in case of non-performance, based on the concept that there has been an actual harm to the plaintiff, and penalty clauses that are used to establish a penalty to be paid in case of non-performance with the intent to encourage performance. The latter does not require proof of any real damage.
Penalty clauses in civil law jurisdictions can be described as the kind of liquidated damages that would not be enforceable in the United States because of public policy prohibiting liquidated damages designed to punish the nonperformer. Although penalty clauses have been generally enforceable in civil law countries, they can now be mitigated by the court in most jurisdictions.7 The Council of Europe issued a “Resolution on Penalty Clauses” in 1971, with the aim of recommending a uniform application of penalty clauses for the member states to use. The resolution allows penalty clauses, but the penalty amount may be reduced by the courts if they are manifestly excessive, or if part of the main contractual obligation of the contract has been performed.8
The explanatory memorandum to the Resolution provides a list of factors in determining whether a penalty is manifestly excessive. They include the comparison of the pre-estimated damages to the actual harm; the legitimate interest of the parties, including non- pecuniary interests of the promisee; what category of contract it is and under what circumstances it was concluded, with emphasis on the relative social and economic position of the parties; whether it was a standard-form contract; and whether the breach was in good or bad faith.9
Many, but not all, civil codes seem to have followed the precedent of the Resolution to allow courts to reduce an excessive penalty, as demonstrated by the following examples:
France: Articles 1226 to 1233 of La Code Civil regulates “la clause penale” (penalty clause), and article 1152 regulates “dommages-interets” (liquidated damages). The former may be reduced by a judge if part of the main contract obligation has been performed and if it is “manifestly excessive.” Liquidated damages may also be adjusted if “obviously excessive or ridiculously low.”10
Italy: Both concepts, “clausola penale” (penalty clause) and “liquidazione convenzionale del danno” (liquidated damages), exist in doctrine, but not in the Civil Code.11 Penalties are generally enforceable but can be mitigated if “manifestly excessive” or if part of the main contract obligation has been performed.12 13
Spain: Article 1154 of the Codigo Civil regulates penalty clauses (Clausula Penal), which can be reduced by a judge if part of the main contract obligation has been performed. There is no provision regarding mitigation of the penalty because of excessiveness, which makes Spain one of the few countries that has not amended its Civil Code to allow a reduction of a penalty amount.
Germany: There is a distinction between liquidated damages (Schadenspauschale) and contractual penalties (Vertragsstrafe) in the German Civil Code, and both are allowed accordingto article 340 and 341 of the BGB. The difference between them is that the latter can be mitigated if “disproportionate or excessively high.”14
Netherlands/Switzerland: Both of these countries have rules similar to Germany, except that a penalty may be mitigated in the Netherlands if “manifestly excessive,” and in Switzerland if “excessive.”15
Belgium: Penalty clauses are permitted, but the amount can be mitigated if it “obviously exceeds the actual damage,” and if part of the main contract obligation has been performed.16
Scandinavia: The laws of Denmark, Finland, Norway and Sweden allow either the voiding or reformation of a penalty clause that is deemed to be “unreasonable.” Swedish law specifically provides for an evaluation of the relative bargaining power of the parties in making this determination. The Swedish Commercial Code Section 36(2) provides that “particular consideration” shall be given to protecting the party “in a subordinate position in the contractual relationship.”17
Other civil law countries outside Europe have adopted a similar approach, such as:
China: Penalty clauses in contracts are permitted, according to article 114 of the Chinese Contract Law. The amount can be increased or reduced by the People’s Court or in arbitration if “excessively higher than loss.”18
Russia: The New Civil Code from 1994 allows for both liquidated damages and contractual penalties in contracts. Both can be reduced by the court if obviously disproportionate to the actual loss.19
Application in the Courts of Civil Law Jurisdictions
It is difficult to find any uniform application of liquidated damages/penalty clauses in case law of the various European countries. In most countries, the courts never evaluate the intent behind the penalty. Whether it is enforceable depends solely on whether it is excessive in its amount. Some countries have, however, taken a more restrictive approach, and also examine the relationship between the penalty/liquidated damages and the actual loss suffered by the plaintiff. This approach is similar to the common law approach to liquidated damages.
Examples of a more Anglo-American approach:
Denmark: The Supreme Court struck down a penalty clause because of a disproportionate penalty in relation to the contract price. The penalty in question was four to six times the contract price. The court also found that the plaintiff had not proved that he had actually suffered the corresponding loss.20
Belgium: The Court established that the amount in a penalty clause can be declared unenforceable if the penalty amount “obviously exceeds actual damage.” However, the clause would not be voided, but the amount would be reduced.21
Examples of a more traditional civil law approach:
Spain: A penalty clause was found to be unenforceable, since there was no connection to the main contractual obligation. The court did not discuss whether the amount was excessive or not.22 Italy: The Court found that a penalty clause can be reduced if manifestly excessive or if the main contractual obligation has been partially performed. Mitigation may be ordered by the judge even if neither of the parties has asked for it.23
Portugal: The Supreme Court upheld a penalty clause in a car lease contract, since the penalty was in proportion to the risk of a breach of the contract and loss of the value of the car.24
Even though the development of liquidated damages clauses seems to be moving toward a more uniform approach, a contract clause penalizing one party for non-performance or breach of contract will still be met with a different response in common law versus civil law jurisdictions. In a common law jurisdiction, such a clause will not be enforced if it is not reasonable in proportion to the actual or anticipated damage, and if it is designed to penalize the breaching party. In civil law jurisdictions, the assumption is that a penalty clause is enforceable, but may be reduced if it reaches a certain level of excessiveness. In a comparison of the elements of the common law approach, the first step of deciding the difficulty of estimations of the actual damage is generally absent in civil law jurisdictions, except as one of many factors weighing in to the determination of “excessiveness.” Since a clause that is purely a penalty can be enforced in civil law jurisdictions, there is no need to decide whether the intent behind having a liquidated damage clause is based on a real difficulty of estimation foreseen at the execution of the contract. The reasonableness test of common law jurisdictions can be compared to the civil law test of whether the penalty amount is “manifestly excessive” or “excessive,” depending on the respective code. Most civil law systems will not assess the reasonableness of the penalty amount solely in relation to the actual harm, but will make an assessment based on a number of different factors. This leaves significantly more discretion to the courts to determine on a case-by-case basis what is permissible, and what may be “excessive” or “manifestly excessive”; but the Resolution on Penalty Clauses adopted by the Council of Europe provides guidelines for use in exercising this discretion.