We can gain a broad perspective on penalty clauses in private law from a comparative law perspective by contrasting three legal systems: Continental Europe, England, and Brazil. In France, Italy, Spain, and Portugal, two models of penalty clauses coexist harmoniously: the compensatory and the punitive. As the names suggest, under the former, the parties predetermine the damages resulting from a potential breach of contract. The compensatory penalty clause provides for a predetermined amount in the event of delay or default, thereby sparing the non-defaulting party the need to spend time, money, and energy proving in court the damages resulting from the breach of the contract. In contrast, the penalty clause itself is an agreement in which the contracting parties stipulate a civil penalty as a punitive sanction for breach of the contract. Its function is not compensatory but deterrent, in the sense of inhibiting and discouraging the breaking of one’s word. To achieve this purpose, the amount of the penalty must, of course, exceed the value of the goods or services being negotiated. For example, if A and B negotiate the purchase of equipment for conducting cancer screenings, the penalty clause will be R$ 200,000.00 if that amount corresponds to the actual damages and loss of profits of the aggrieved party, but it may reach R$ 400,000.00 if the objective of A and B was to establish a penalty that would discourage either party from withdrawing from the contract, regardless of the actual assessment of any loss. Generally speaking, under European law, the imposition of a contractual penalty is considered legitimate to the extent that it preserves proportionality, in accordance with the circumstances of the case. However, its amount will be subject to judicial reduction if it exceeds the reasonable “quantum” necessary to produce the deterrent effect and amounts to an abuse of rights.
And how is the penalty clause formulated in the various common law jurisdictions? With minor variations, these countries also distinguish between a penalty clause—which is of a compulsory nature—and a liquidated damages clause.1 The former is a mechanism to compel performance; the latter, however, consists of a simple agreement to pre-estimate damages, through which the parties can protect themselves against potential losses and avoid the costs of litigation, as well as the loss of their most precious asset: time.
In England, the approach has traditionally differed from that of continental Europe, as English courts developed the contractual system based on commercial practices, while the civil law system placed greater emphasis on interpersonal relationships. The roots of the penalty doctrine date back to the 16th century, stemming from the courts’ concern to prevent the exploitation of one party by another at a time when credit was scarce and borrowers were particularly vulnerable. The term “penalty” refers to the payment of a contractually stipulated amount that is not enforceable if it proves to be exorbitant as an alternative to damages that would be determined in court. In other words, in keeping with a deep-rooted appreciation for the liberal Enlightenment, judges and courts consider it commendable that the parties sought to avoid future disputes by establishing liquidated damages as a true estimate of compensation for damages based on the likely loss to the contracting parties. This clause is fully enforceable.
However, penalty clauses—under which either contracting party would be financially penalized for failing to perform—have not been recognized, as no one is obligated to “tie themselves” to a contract. Hence the English tolerance for a party’s autonomy to withdraw from contracts, choosing instead to pursue other economic relationships that seem more profitable, without being required to pay anything more than an estimate of the damages caused to the aggrieved party. Unlike in the context of continental Europe, default is not regarded as an unlawful act, but rather as an exercise of freedom; which is why, in the English tradition, the penalty clause is not even reduced to a reasonable amount but is simply invalidated, leaving the creditor with the option of proving its actual loss in court.2
While in German law the “Vertragsstrafe” and “Schadenpauschale” clauses coexist peacefully, each within its own sphere, in common law the penalty clause has historically been excluded from the legal system and deemed null and void—and not subject to reduction—if included in a contract. Under English law, the nullity of a penalty clause is not limited to cases of manifest abuse; it is a general rule, applicable to both professionals and laypeople. The prevailing argument has long been that the parties cannot create forms of private coercion that allow the creditor to “intimidate” the debtor, thereby compelling compliance. In contrast, liquidated damages clauses are valid and beyond the reach of the courts.3
The so-called “penalty doctrine” reflects the common law’s resistance to penalty clauses that bear the nature of a penalty. Unlike in tort law, common law jurisdictions tend to avoid introducing any form of punitive damages for breach of contract because, supposedly, the mere availability of a private penalty would seriously undermine the stability and predictability of commercial transactions—a vital factor for the efficient functioning of the modern economy. While, on the one hand, a liquidated damages clause is welcome for anticipating losses and damages and avoiding litigation, penalty clauses are inconsistent with the common law’s liberal view of the freedom to terminate contracts, under which parties cannot be perpetually bound by an obligation and consequently punished for noncompliance.4
Underlying this argument is a historical resistance in Anglo-American law to the possibility of a creditor seeking specific performance of obligations to deliver, perform, or refrain from performing. So-called specific performance may only be enforced if the court finds that an action for damages does not serve as an adequate remedy in the specific case. Now, if injunctive relief is relegated to a secondary role—precisely because it pressures the debtor to comply—then, by logical consistency, the common law system could not permit the validation of a penalty clause whose very purpose is to compel the debtor to comply, in terrorem.
It is important to note that the distinction between a penalty clause and a liquidated damages clause will be made in light of the particularities of the specific case, based on the content of the clauses—notably the relationship between the amount set by the contracting parties and the approximate estimate of damages in the event of a breach. Thus, if the court finds that the fixed amount is extremely high compared to the estimated damages—even if the parties have labeled the clause a “liquidated damages clause”—it will be presumed to be a “penalty clause” and, consequently, invalidated.
On the other hand, more than 50 years ago, the U.S. legal system introduced an innovation in this area. The Uniform Commercial Code of 1967, in § 2-718, replaced the subjective criterion of the parties’ intent with the objective criterion of reasonableness, under which it must be assessed whether the amount agreed upon as a penalty clause was reasonable in light of the debtor’s actual and current damage. This legislation—influenced by the Restatement (2d) Contracts—established two conditions under which the stipulated amount does not fall under the definition of a prohibited penalty clause: (i) the stipulated amount must be reasonable (that is, not disproportionate) in light of the damages anticipated by the parties; (ii) due to subjective assessment, uncertainty, difficulty in producing evidence of damage, or any other measurement problem, it must be difficult or impossible to measure—and thus prove—the presumed loss. Therefore, today courts in the United States apply a single two-part reasonableness test—namely, the disproportionate nature of the agreed-upon sum and the difficulty of proving the loss—to determine whether an indemnity clause is, in fact, merely a disguise for a penalty clause.5
However, the major turning point regarding penalty clauses occurred in England in 2015. In two landmark rulings, the Supreme Court of England and Wales reversed its long-standing position on the prohibition of penalty clauses. The SCOTUK rejected the traditional test that assesses whether a penalty clause is a “genuine estimate of damages” of a compensatory nature (validity of liquidated damages) or a penalty clause intended to deter breach of contract (invalidity of penalty clauses). It was established that penalty clauses may be effectively enforced even if the amount exceeds the estimate of damages—or even if no damages exist at all— provided that the requirement of proportionality between the predetermined amount and the innocent party’s legitimate interest in securing performance of the contractual obligations is met. The prevailing view is that the parties—and not the judges—are best suited to determine how their interests will be represented in the contract. Of course, this greater flexibility will apply according to the circumstances of the legal relationship, always on the premise that the parties are in a position of relative equality of strength and bargaining power. Thus, the British system has become “Europeanized” by holding that what matters is not the label of the penalty clause, but the concrete assessment of whether or not it is “grossly excessive.”6
We can conclude that the mitigation of the penalty doctrine represents a step forward compared to systems that still fail to distinguish the penalty clause, in the strict sense, from the indemnity clause. In fact, Fernando Araújo argues that the economic analysis of law vehemently rejects the strictness of the penalty doctrine, viewing it as an expression of paternalism that disregards contractual autonomy. After all, the parties are free to determine the allocation of contractual risk according to their respective ability to bear that risk. The establishment of the punitive regime is a means of fostering contractual exchanges, which makes relationships more transparent and prioritizes the superiority of self-discipline over hetero-discipline, expanding the area of consensus between the parties and allowing for the establishment of balancing factors that, for whatever reason, cannot be ensured by the simple mechanism of market prices.7
Above all, this serves as a warning to Brazilian private law. Our legal doctrine and case law cannot shy away from the debate taking place in other civil law and common law jurisdictions. In our country, over the past two centuries, the penalty clause has been shaped according to a unitary standard. It is a hybrid legal model, serving both compensatory and punitive purposes, capable of anticipating the assessment of damages and compelling the debtor to perform. This modus operandi of the penalty clause is limiting and stifling, as its uniform and dual-purpose framework restricts the various possibilities that contractual autonomy could afford it, given that a single legal model cannot simultaneously serve as both a penalty and compensation for damages. Once the function the parties wish to assign to the penalty clause has been assessed, we can outline its various effects under two distinct legal models, depending on whether it is a penalty clause in the strict sense—which does not aim to compensate for a loss, but rather to impose a penalty on the party causing the harm—or a clause for the advance determination of damages, of a purely compensatory nature, which is particularly effective in cases where a judicial determination of the amount would be difficult, costly, and time-consuming. The penalty focuses on deterring the offender, while compensation aims at redress for the victim. Precisely for this reason, the penalty is not related to the concept of equivalence between the damage caused and its redress, since its purpose is to pressure the debtor into performance through the threat of an additional payment whose value exceeds ordinary damages.
The renewal of the penalty clause does not require legislative reform. The various effects of both penalty clauses are already addressed in Articles 408 through 416 of the Civil Code. With the recent strengthening of Article 421-A, II, of the Civil Code and the LLE in general — conventional risk management embodies contractual freedom so that, in the creditor’s interest, there is the option of establishing either a damages clause or a penalty clause in the strict sense, both subject to review for validity under Article 413 of the Civil Code, in accordance with their specific characteristics.
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- Regarding liquidated damages clauses, Harriet Zitscher explains that in common law jurisdictions, no distinction is made between non-performance, defective performance, or default. The contract is understood as a promise to ensure the performance of the obligation. Therefore, anything other than the stipulated performance is considered a breach of the guarantee—a breach of contract. ZITSCHER, Harriet Christiane. Introdução ao direito civil alemão e inglês, p. 152
- In the early 20th century, the ruling in the case of Dunlop Pneumatic Tire Co. v. New Garage & Motor Co. Ltd. [1915] AC 847 (Dunlop) reaffirmed the penalty rule, providing four tests designed to be “useful or conclusive” in determining whether a clause was an enforceable penalty. The Dunlop ruling distinguished between penalty clauses (which were unenforceable) and liquidated damages, which would be enforceable provided that the specified amount was a genuine pre-estimate of losses—this terminological dichotomy has become widespread in English commercial contracts over the past 100 years.
- Summarizing the criticisms of the English system, Anne Sinay-Cytermann explains that a blanket prohibition on any penalty clause, across all areas, is excessive. Only truly unfair terms should be subject to invalidation. It is excessive to condemn the punitive function of penalty clauses rather than to curb abuse. (Clauses pénales et clauses abusives: vers un rapprochement. :GHESTIN, Jacques. Les clauses abusives dans les contrats types en France et en Europe, p. 209.)
- CARTWRIGHT, John. "In many civil law systems there is a judicial control of penalty clauses: the courts are given the power to reduce manifestly excessive or disproportionate penalties. This is not, however, the approach adopted in English law. Proportionality is now included within the test to determine whether the clause is a penalty, but if the stipulated sum is excessive or disproportionate and is held to be a penalty, it is not reduced (to, for example, a 'reasonable penalty), but is simply struck out and the claimant is left to prove his actual loss by way of damages". In An introduction to the English law of contract for the civil lawyer., Third Edition, p. 224.
- VITKUS, Simas. Penalty clauses within different legal systems. Social Transformations in Contemporary Society', 2013, p. 4.
- Cavendish Square Holding BV v. Talal El Makdessi (El Makdessi) and ParkingEye Ltd. v. Beavis [2015] UKSC 67 (ParkingEye). Of the two judgments that served as the basis for the Supreme Court of England’s revised understanding, the second appears clearly problematic, as it exceeds the limits of a European consumer protection directive. A private parking lot charged £85 to a car owner who left the vehicle on the premises for a period exceeding the 2-hour grace period. Clearly, this was not a liquidated damages clause, as the parking lot suffered no actual loss. Despite the clear objective of discouraging drivers from remaining in the parking lot beyond the permitted time, the amount was not considered extravagant or exorbitant, as it was justified both from a commercial standpoint—which requires the entrepreneur to make a profit—and by the need for efficient use of the space, allowing scarce parking spots to be available to a greater number of people.
- ARAÚJO, Fernando. Teoria econômica do contrato, p. 932. Thus, the professor at the University of Lisbon concludes: “It is no wonder, then, that many proponents of the economic approach view the Roman law tradition and the prevailing solutions in the realm of ‘civil law’ with undisguised sympathy, where it is quite naturally enshrined, the possibility of resorting to penalty clauses in the broad sense, whether they establish maximums or minimums, or fixed amounts to guide or replace the empirical calculation of damages.”