A penalty clause is commonly known as a contractual provision that prescribes a financial penalty in the event of non-compliance or breach of contract. However, while many people view penalty clauses as forms of punishment, this is in fact a limited view of what a penalty clause can be.
Rather than merely a method of punishment, a penalty clause can be used to serve two main purposes. Firstly, it could be used to increase the deterrence of not adhering to the contract. Secondly, it could encourage commercial parties to be more proactive in the pursuit of compensation, especially if the ‘breach’ creates financial losses.
Imagine, for instance, you are stockbroker and you have recently agreed to collaborate with a financial trading company. As part of the contract, the company agrees to release weekly financial reports to you. However, if the company does not adhere to its contractual duties and fails to release the reports, a penalty clause can be employed to increase the deterrence of not fulfilling its promises.
In such a case, the penalty clause would not be intended to cause unnecessary financial losses or punish the company for not releasing the reports, but instead should allow the stock broker to financially recover any losses. This would, in turn, encourage parties to be more proactive when it comes to pursuing compensation.
So while penalty clauses may often be seen as punitive, in truth they can serve a range of purposes, ranging from discouraging breaches of contract to financially recovering any losses caused by the breach.