The Penalty Clause in International Contracts
The penalty clause is the agreement by which the parties of a contract establish to pay a certain sum as compensation due to failure or delay of performance.
The purpose of this clause is to limit compensation to an agreed amount, other than urging the contract to perform the obligation.
Penalty clauses are common in international contracts. However, when identifying the legal framework under which the regulation of the contract must fall, care must be taken to ensure that the clause is correctly formulated and to the distinction between Civil Law and Common Law countries.
Common Law systems
In Common Law systems, a distinction must be made between penalty clauses and liquidated damages clauses.
The penalty clause refers to an agreement that merely aims to punish the contract as deterrence, without a real prediction and proportion between damages and compensation. In this case, the penalty clause is considered null and void.
The liquidated damages clause, on the other hand, is a preventive estimate of the damages resulting from the non-performance and is considered as a valid clause. In Common Law systems, such a clause will not be enforced if it is not reasonable in proportion to the actual or anticipated damage.
Civil Law systems
Traditionally, in civil code countries, no distinction was made between liquidated damages clauses and penalty clauses. The deterrent/punitive function is not considered invalid in itself, because it is mitigated by the general provision of the power of the Court to reduce the amount of compensation on an equity basis.
Under Italian Law, concepts of penalty clause and liquidated damages exist in doctrine, but not in the Italian Civil Code. According to Article 1382, the non-performing party is liable regardless of proof of the damage, unless, according to jurisprudence, it is demonstrated that the failure to perform is not imputable to the contracting party.
The main characteristic of Italy, as well as some other Civil Law countries, is that penalties are generally enforceable, but can be mitigated if manifestly excessive or if part of the main contract obligation has been performed.