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Contract Penalty Clauses - What is in Your Customer Contracts?

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Most business owners do not like to think about what happens when things go wrong with their customers.  Understandably they focus on building relationships with them and find it uncomfortable chasing for unpaid sums.  Often the end result is that businesses “do a deal” for a sum less than what is outstanding or write the debt off and put it down to experience.

However, what happens when businesses price contracts over a fixed term and have incurred substantial outlay, for example, invested in new equipment, hired additional personnel and so on?  In such circumstances when contracts are terminated without fault on the part of the business they suffer significant financial loss.  The key is to ensure that the contractual arrangements adequately provide for such an eventuality and the financial model for the contract takes into account the potential for the contract being terminated early.

Damages must not constitute a penalty on the other party

From a contractual perspective the result can be achieved in a number of different ways but the key is to ensure that clauses which provide for damages in the event of early termination do not constitute a penalty on the other contracting party.  What does that mean you may say?  Well, if a clause in a contract provides that a terminating party must pay early termination fees or costs such fees and costs must be a fair and reasonable estimate of loss.  The judge in a leading case in 1983  stated:

“the main purpose of the law relating to penalty clauses is to prevent a plaintiff recovering a sum in respect of a breach of contract committed by a defendant which bears little or no relationship to the loss actually suffered by the plaintiff as a result of the breach….”

In another case a “penalty” was categorised as an amount which was intended to apply undue force to the other contracting party.

Business owners should assess their potential loss if the contract was terminated

Having regard to the principles laid down by the courts, business owners should make an assessment before the contract is awarded as to what loss they would suffer if the contract was terminated at various stages. They should take into account factors such as the ability to sell the equipment or services on, re-deploy employees and other resources.

Further, as part of the financial modelling process, business owners should give credit for the fact that if termination fees and charges on early termination of the contract are paid, they will receive monies earlier than they would otherwise have done if the contract had been performed over the specified term.  This is known as “accelerated payment”.

In summary the key is planning; both from a financial modelling perspective and ensuring the contract terms to fit the subject matter of the contract and surrounding circumstances.