A penalty clause is a contractual provision whereby a party owes a predetermined amount in the event of a breach. In our practice, we see entrepreneurs who perceive penalty clauses as a powerful instrument, but often formulate them awkwardly in practice. Penalties can be mitigated or declared void. A good penalty clause strengthens contractual agreements — poor wording renders the clause worthless in the event of a dispute.
What is the legal problem?
A penalty clause obligates the defaulting party to pay a pre-agreed amount. Internationally, rules regarding admissibility, amount, and cumulation with damages vary. In civil law systems, penalties are accepted but mitigated in the event of excessive amounts. In common law, penalties are prohibited; only liquidated damages are permitted. The same penalty clause can be valid in the Netherlands and void in London.
What does the law say?
Under Dutch law, Article 6:91 of the Civil Code governs penalty clauses. Article 6:92 of the Civil Code states: the penalty replaces damages, unless otherwise stipulated. Article 6:94 of the Civil Code grants the court the power to mitigate upon a threshold of equity — "if equity manifestly demands this". In Intrahof/Bart Smit (HR 27 April 2007, NJ 2007/262), the Supreme Court prescribed a restrained review.
Under English law, the Cavendish v Makdessi doctrine (UK Supreme Court 2015) distinguishes between permissible liquidated damages and prohibited penalties. Under French law, Article 1231-5 of the Code Civil governs mitigation in the case of manifestly excessive penalties. The Vienna Sales Convention leaves admissibility to national law.
What risks do companies face?
A penalty that is too high can be annulled in its entirety or significantly reduced. A penalty that is too low offers insufficient incentive. Awkward wording leads to the exclusion of additional damages. Uncertainty regarding what counts as a breach opens up dispute. A clause valid under Dutch law can be rejected as a penalty in England — which leads to avoidable loss in M&A and NDAs with British counterparties.
Practical example from our practice
We represented a Dutch supplier with a confidentiality clause vis-à-vis a British purchaser, with a penalty of 500,000 euros per breach. Under English law, the High Court judged the clause to be a penalty clause and declared it void. The supplier received only actual demonstrable damages — approximately 35,000 euros. Upon renegotiation, we formulated a liquidated damages clause with a substantiated estimate of damages related to annual turnover and informational value. Under the same English court, the clause would have been enforced.
What can you do?
Align the penalty clause with the applicable law. Under Dutch law: incorporate a proportional penalty under Section 6:91 of the Dutch Civil Code. For common law jurisdictions: use liquidated damages with substantiation. Determine whether cumulation with damages is possible under Section 6:92 of the Dutch Civil Code. Keep penalties proportional to the breached obligation. Clearly define the breach. See also our article on Confidentiality Clauses That Really Work.