Articles

Penalty Clauses – Don’t be too harsh!

Business Brief January 2009
By Jean Ewang

Penalty clauses are a common and often essential provision in commercial contracts. The enforceability of these clauses is, however, not always straight forward and the prudent businessman is well advised to acquaint himself with the general legal principles around them.
 
Penalty clauses in contracts are dealt with by the Conventional Penalties Act 15 of 1962. In terms of the Act penalty clauses are enforceable. More specifically section 1(1) of the Act states that a stipulation that provides for a person to be liable upon commission of an act or omission in conflict with a contractual obligation, to pay a sum of money or to deliver or perform anything for the benefit of any other person either by way of penalty or liquidated damages, is enforceable.

However, penalty clauses have not always been enforceable in South African law. In the 1934 case of Pearl Assurance Co v Union Government 1934 AD 560 the Appellate division held that where in a contract a fixed amount is stipulated to be paid by one of the parties in the event of a breach of the contract by the other party, and such amount is not a genuine pre-estimate of damages but a penalty, the actual proved damage can alone be recovered in the event of a breach.

This decision brought the South African law in line with the English law regarding penalty clauses at the time. The English law position was that penalty clauses were unenforceable and contrary to public policy as parties were not entitled to take the matter of punishment upon themselves. The English courts did, however, recognise a clause that provided for a genuine pre-estimation of damages as valid.

The current position in our law is governed by the Act. In order for section 1(1) of the Act to apply to a clause, thus ensuring that the penalty clause is enforceable, three requirements must be met:

1. The clause must provide for the ''payment of some thing over and above whatever the debtor already owes in terms of the contract'';

2. The clause must come ''into operation on breach of the contract'', and

3. Must be intended to act as dissuasion to breaching the contract out of fear of the consequences or ''as a genuine pre-estimate of loss''.

The Act prohibits the recovery of damages and a penalty for the same breach as well as the recovery of damages in lieu of a penalty unless the contract provides for it.
An important feature of the Act is the power it gives the courts in section 3 to reduce a penalty that it considers excessive. The clause will be considered excessive if it is out of proportion to the prejudice suffered by the creditor.

In Steinberg v Lazard 2006 it was held that the onus is on the debtor to show that the prejudice suffered is out of proportion to the penalty being claimed and the extent that it is out of proportion. The creditor need not make or prove an allegation of prejudice as the clause he seeks to enforce is in his favour.  Furthermore the court held that the phrase "out of proportion" means that the penalty is markedly and not just slightly beyond the prejudice suffered and that the excess is such that it would be unfair to the debtor not to reduce the penalty.

It was also held that prejudice can best be ascertained by contrasting the positions of the creditor on the basis of the contract having been duly implemented by the debtor against the position that arises because of the debtors default.

It can be seen that penalty clauses are useful and essential in most contracts, however, case law has shown that while it is accepted that penalty clauses are punitive in nature they should not be so severe that they meet with the courts disapproval.

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Jean Ewang

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011 523 6142
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