By Damian Songowicz, Xue Yang Geng, Hannah Fox and Pierre Mousseron, University of Montpellier, Centre du Droit de l'Entreprise, Program of Master 2 "Droit du Commerce International"
Overview
The aim of a liquidated damages clause is to specify in advance the indemnification for a party that suffers from a breach of contractual obligations. Non-performance of a contract, without any evidence of actual damage, is grounds for pre-estimated compensation. This clause obviously limits the necessity to seek indemnification in court and is in demand in business contracts. However, if challenged, its efficiency may be greatly reduced by the intervention of a judge who has the power to modify the amount of the compensation determined in the contract.
Distinction Between Liquidated Damages And Penalty Clauses
That distinction has a greater impact in common law countries than in those influenced by Civil Code tradition.
In Dunlop v. New Garage 1915, the English House of Lords held that the liquidated damages clause aims to pre-estimate damage in case of breach of contract whereas the penalty clause aims to punish the defaulting party. According to this case, the penalty clause is voidable under UK law and the liquidated damages clause cannot be modified by the judge. However, the judge may properly qualify a contractual provision so that it reflects its real nature, regardless of the term used by the parties. Therefore, a liquidated damages clause requiring payment of an extravagant sum compared to the actual loss may be qualified as a penalty clause and voided.
In France, under civil law system, such distinction is virtually non-existent. Both liquidated damages clauses and penalty clauses are covered by article 1226 of the French Civil Code under the concept of a clause pénale. Article 1226 defines a clause pénale as a provision by which one party commits to pay something to the other in case of breach of contract. In practice, there are two terms that can be found in contracts - indemnité forfaitaire for liquidated damages and clause pénale for penalty clauses. Some French scholars refer to indemnité forfaitaire as a clause de dommages-intérêts forfaitaires; as to clause pénale, those scholars name it clause à fonction comminatoire. That distinction is based on the objective of clause pénale and refers to the proportionality of the sum stipulated compared to the actual or estimated damage resulting from the breach of a given obligation. This does not alter the application of article 1152 of the French Civil Code. For convenience, in France any contractual provisions specifying an award to pay in case of a breach of contract are often simply regarded as a penalty clause. Thus, the judge has the power to modify liquidated damages clauses as well as penalty clauses.
Power Of Adjustment Of French Court
According to article 1152 of the French Civil code, "Where an agreement provides that he who fails to perform it will pay a certain sum as damages, the other party may not be awarded a greater or lesser sum.
Nevertheless, the judge may, even of his own motion, moderate or increase the agreed penalty, where it is obviously excessive or ridiculously low. Any stipulation to the contrary shall be deemed unwritten."
A penalty clause that evaluates the consequences of the non-performance of a contractual obligation falls into the scope of article 1152. The amount of the penalty is subject to a possible judicial review. This power of review is merely an option for French judges; they can refuse to adjust the penalty (Case n° 81-10376) even without explaining their reasoning and simply apply the contract.
In Domestic Contracts
Empowered by article 1152, the French court may, of its own motion, "reduce or increase" the penalty which is "manifestly excessive or insignificant." Since the damages suffered by the injured party will be compensated by the parties' prior evaluation, such evaluation shall correspond to actual damages. Otherwise, either the loss will be overcompensated, or the compensation will be insignificant.
However, article 1152 does not specify upon which criteria the amount of penalty will be assessed by the judge. One possible criterion would be the importance of the wrongful act, as gross fault merits penalty. Another would be the burden on the alleged defaulting party, as the penalty will be considered excessive if it is accompanied by the restitution of the contractual subject (Technique Contractuelle, 2010, p.394) One more criterion would be usages. To evaluate if the penalty is excessive, the court may also take into account the usages in any particular business (Case n°12/03215).
Even though the adjustment power is clearly stated in article 1152, the judge must follow the case law to exercise it.
To reduce a manifestly excessive penalty, it must be established that there is a disproportion between the penalty stipulated in the contract and the actual loss to the injured party. The mere fact that the penalty is "slightly higher" than the loss is therefore insufficient for a judge to reduce the penalty (Case n° 76-11611).
The court has a wide power with regard to the adjustment (Case n° 95-10851). It may or may not limit the amount in the actual loss, but under no circumstances should the adjusted penalty be less than the actual loss (Case n° 77-11170).
Concerning the purpose of the clause, only penalty clauses which aim to compensate the non-performance of a contractual obligation shall be subject to this possible judicial review. If a provision may also be interpreted as ensuring or even compelling one party to perform, there will be no possible application of article 1152, since the judge "must take into consideration the purpose of the penalty" (Case n° 83-15291). However, if the penalty aims only to compensate the non-performance, whether total or partial, or even a delay in performance, then the clause shall be subject to the judicial review of article 1152. It is therefore logical that the performance of the contractual obligation shall not be granted in addition to such a penalty. This is confirmed by article 1229-2 of the French Civil Code, according to which a penalty clause is the compensation for damages suffered from the non-performance of the principal obligation, and cannot be claimed at the same time as the performance of such obligation. The same logic is upheld by article 1231 of the French Civil Code: "Where an undertaking has been performed in part, the agreed penalty may, even of his own motion, be lessened by the judge in proportion to the interest which the part performance has procured for the creditor, without prejudice to the application of Article 1152. Any stipulation to the contrary shall be deemed not written."
Although the purpose of the penalty will be taken into consideration for the assessment of its amount, the judge's power of judicial review does not depend on it. The French Court of cassation specified that in order to exercise the adjustment power there will be no need to distinguish between a delay in performance, partial or complete non-performance, once the amount is manifestly excessive (Case n° 76-14087).
To increase insignificant penalties, the court still has to establish the insignificance of the amount compared to the actual loss (Case n° 98-16202; CCC 2001, n° 168, note Leveneur). As to the revaluated amount, it is subject to judicial discretion (Case n° 92-42298).
In International Contracts
Different perspectives concerning liquidated damages or penalty clauses among the courts of different countries give rise to the question of whether or not the adjustment power is public policy in France.
The answer is positive as far as domestic contracts are concerned. This results from the fact that both articles 1152 and 1231 of the French Civil Code consider any clause limiting that adjustment power as deemed unwritten. However, as to international contracts, there is no clear solution provided.
Although the decision of the Court of appeal of Paris in 1983 (Laurent v Société Reuters Ldt.) is an isolated solution, there is no widely-known contradictory one. In this instance, the parties to an international contract chose English law to be applicable. There was a penalty clause provided and one of the parties asked the judge to moderate its amount. Nonetheless, the French judge decided that the French international public policy was not violated even though English law does not allow the review of such clauses. However, in this particular contract, the parties had provided that the penalty would be proportional to the length of the non-performance. In an argumentum a contrario, some scholars (Revue critique DIP, 1984, p. 490) had argued that the judge would have recognised his adjustment power in the absence of such a specific contractual provision.
Approach Of Other European Countries
The equivalent of the adjustment power of French court can be found in a number of European countries whose legal system is based on a Civil Code. This is related to both the broad definition of penalty clause and the adjustment power of the judge. The principle forbidding the overlapping of the performance of an obligation and the compensation, unless stipulated for a delay only, is also widely recognised.
For instance, article 340 of the German Bügerliche Gesetzbuch entitles the creditor of an obligation to contractual compensation, provided for, that should reflect the minimum harm he has suffered because of the non-performance of that obligation. Further damages can be asserted if the harm exceeds the penalty clause. Article 343 adds that a judge may reduce the forfeited penalty if it is disproportionately high, but only upon the debtor's request. However, the possibility to adjust a penalty clause that has already been paid is expressly excluded.
The Italian Civil Code provides a similar solution to French law, but the terms of the articles are more direct and provide a clear answer. Article 1382 defines a penalty clause as any contractual compensation in case of breach of contract or simple delay in performance. Moreover, no proof of damage is required. Article 1384 states that "the penalty may be reduced equitably by the court if the principal obligation has been partly carried out, or if the amount of the penalty is manifestly excessive."
Article 6.91 of the Dutch Civil Code does not distinguish between liquidated damages or penalties as such, all is covered by the single notion of penalty clause: "A contractual penalty clause is every contractual provision stipulating that the debtor, if he fails to perform his obligation correctly, has to pay a sum of money or deliver another performance, regardless of if this sum of money or other performance is meant to be a compensation for damages or just an incentive to perform the obligation." As far as the moderation by the judge is concerned, article 6.94 provides that "The court may, upon the request of the debtor, reduce the contractual penalty if this is required by standards of reasonableness and fairness, on the understanding that it cannot grant the creditor less than the applying compensation for damages that would have been due by virtue of law." Furthermore, §3 of that article defines this rule as a rule of public policy: "Every contractual provision in derogation from paragraph 1 is null and void."
In Poland, article 483§1 of the Civil Code admits penalties that must be paid in case of improper performance or non-performance of a contract. Article 484§1 adds that the sum of money is due regardless of the actual damage. Finally, article 484§2 gives the possibility to the debtor of a contractual obligation to ask a reduction of the penalty clause in justice, but only if he partially performed the obligation or the penalty is manifestly exaggerated.
The last example, which differs from previous ones, is article 1154 of the Spanish Civil Code. The scope of penalty clauses covers indemnification and interests. The power of the judge to moderate penalty clauses is admitted, but only in cases where the obligation has been partially or irregularly performed. The possibility to moderate an excessive penalty clause is not expressly recognised.
Conclusion
Unlike under English law, judges in Civil Code tradition countries have the power to modify the amount stipulated in the liquidated damages clause. Therefore, to guarantee that this clause does not suffer any modification, the drafting should justify the amount of the predictable damages and may have additional punitive function. In practice, it belongs to parties to establish in court the alleged excessiveness of the penalty.