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When a contract contains a ‘penalty clause’ for breach of the contract, the clause will not be enforceable if it is punitive, rather than a genuine attempt to compensate the other party based on a estimate of the loss they would incur as a result of the breach of the contract.
Accordingly, where such a clause is invoked, the party in breach of the contract often attempts to avoid liability by claiming that the clause is a penalty, rather then a pre-estimate of loss.
A penalty clause is not unenforceable, however, just because the actual loss suffered may be less than the damages payable under the clause, provided that at the time the contract was entered into the damages for breach of contract specified in the contract sought to be a fair compensation for the loss suffered.
In a recent case involving a breach of contract connected with the building of a super yacht, the court heard a claim that a clause which required forfeiture of 20 per cent of the contract price, if the buyer breached the contract, should be enforced.
The buyer argued that it was a penalty clause because a similar contract had been undertaken by the same shipyard with a ten per cent forfeiture clause.
The shipyard argued successfully that the figure of 20 per cent was a genuine pre-estimate of loss. It pointed out that any sum it received in excess of that sum would be refunded immediately under the contract and that it would take a long time – years, possibly – to quantify the losses precisely.
The court agreed that the clause struck a fair balance between the two parties, both of which had enjoyed the benefit of expert representation when negotiating the contract and had entered into it freely..