(1) Where the contract provides that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party is entitled to that sum irrespective of its actual harm.
(2) However, notwithstanding any agreement to the contrary the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the harm resulting from the non-performance and to the other circumstances.
1. Agreed payment for non-performance defined
This Article gives an intentionally broad definition of agreements to pay a specified sum in case of non-performance, whether such agreements be intended to facilitate the recovery of damages (liquidated damages according to the common law) or to operate as a deterrent against non-performance (penalty clauses proper), or both.
2. Agreed payment for non-performance in principle valid
National laws vary considerably with respect to the validity of the type of clauses in question, ranging from their acceptance in the civil law countries, with or without the possibility of judicial review of particularly onerous clauses, to the outright rejection in common law systems of clauses intended specifically to operate as a deterrent against non-performance, i.e. penalty clauses.
In view of their frequency in international contract practice, paragraph (1) of this Article in principle acknowledges the validity of any clauses providing that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, with the consequence that the latter is entitled to the agreed sum irrespective of the harm actually suffered by it. The non-performing party may not allege that the aggrieved party sustained less harm or none at all.
1. A, a former international football player from country X, is recruited for three years to train the players of B, a football team from country Y, at a monthly salary of AUD 10,000. Provision is made for a severance allowance of AUD 200,000 in the event of unjustified dismissal. A is dismissed without any justification after six months. A is entitled to the agreed sum, even though A was immediately recruited by another team at double the salary received from B.
Normally, the non-performance must be one for which the non-performing party is liable, since it is difficult to conceive a clause providing for the payment of an agreed sum in case of non-performance operating in a force majeure situation. Exceptionally, however, such a clause may be intended by the parties also to cover non-performance for which the non-performing party is not liable.
In the case of partial non-performance, the amount may, unless otherwise agreed by the parties, be reduced in proportion.
3. Agreed sum may be reduced
In order to prevent the possibility of abuse to which such clauses may give rise, paragraph (2) of this Article permits the reduction of the agreed sum if it is grossly excessive “in relation to the harm resulting from the non-performance and to the other circumstances”. The same paragraph makes it clear that the parties may under no circumstances exclude such a possibility of reduction.
The agreed sum may only be reduced, but not entirely disregarded as would be the case were the judge, notwithstanding the agreement of the parties, to award damages corresponding to the exact amount of the harm. It may not be increased, at least under this Article, where the agreed sum is lower than the harm actually sustained (see however Comment 4 on Article 7.1.6). It is moreover necessary that the amount agreed be “grossly excessive”, i.e. that it would clearly appear to be so to any reasonable person. Regard should in particular be had to the relationship between the sum agreed and the harm actually sustained.
2. A enters into a contract with B for the purchase of machinery which provides for payment in five instalments of EUR 50,000 each. The contract contains a clause allowing immediate termination in the event of non-payment by A of one instalment, and authorises B to keep the sums already paid and to recover future instalments as damages. A fails to pay the third instalment. B keeps the EUR 100,000 already paid and claims, in addition to the return of the machinery, the EUR 150,000 representing the three outstanding instalments. The court will reduce the amount since A’s non-performance would result in a grossly excessive benefit for B.
4. Agreed payment for non-performance to be distinguished from forfeiture and other similar clauses
The type of clauses dealt with in this Article must be distinguished from forfeiture and other similar clauses which permit a party to withdraw from a contract either by paying a certain sum or by losing a deposit already made. On the other hand a clause according to which the aggrieved party may retain sums already paid as part of the price falls within the scope of this Article.
3. A undertakes to sell real estate to B for EUR 450,000. B must exercise the option to purchase within three months and must pay a deposit of EUR 25,000, which A is entitled to retain if B does not exercise the option. Since this is not an agreed payment for non-performance it does not fall under this Article and the sum cannot be reduced thereunder even if grossly excessive in the circumstances.
4. A enters into a contract with B for the lease of a machine. The contract provides that in the event of A’s failure to pay one single rental the contract will be terminated and that the sums already paid will be retained by B as damages. The clause falls under this Article and the agreed amount may be subject to reduction.