SUMMARY:
1. Definition; 2. Purpose; 3. Legal nature; 4. Amount; 5. When may the penalty clause be triggered?; 6. Prohibition of accumulation of the penalty clause with the main obligation, pursuant to Article 1383 ICC; 7. Power to reduce the penalty amount conferred to the judge, under Article 1384 ICC; 8. When is the penalty clause deemed as unfair?; 9. Penalty clause, confirmatory or penitential deposit and penitential sanction. Main differences; 10. Is it possible to set in the agreement both a deposit and a penalty clause?; 11. The penalty clause in the Italian case law.
The penalty clause comes in handy if the Parties have serious intentions to perform their respective obligations provided in the agreement.
In order to strengthen the interest to a correct compliance with the agreement, the Parties negotiate in advance the amount due for damages concerning failure to perform.
Definition
The penalty clause is an agreement by means of which the Parties provide that, in case of failure or delay to perform, the non-performing Party shall perform a certain obligation, typically payment of a lump sum.
Purpose
The penalty clause pursues a triple purpose:
- contractual obligations’ strengthening;
- pre-determination of the amount for damage concerning failure or delay in performing, and
- limitation of the due damage.
Therefore, the non-performing Party shall pay only the damage set in the agreement without need for the performing Party to provide proof of the damage and its amount.
The pre-determination of the damage amount is useful also to the obliged Party as it allows the latter to know in advance the damage amount set for failure or delay in performing.
Legal nature
The prevailing Italian legal theory considers the penalty clause as an accessory agreement pursuing a double purpose:
- pre-determination of the compensation for damage, and
- punitive function, as the amount is due regardless of damage proof.
Amount
When negotiating a fixed penalty amount, the following rules should be considered:
- the amount cannot be derisory, especially if the penalty clause is provided in the obliged Party’s interest. In the latter case, such a penalty clause could be deemed as void, pursuant to Article 1229 ICC. The aforementioned Article provides in fact that any agreement, that exclude or limit in advance the obliged Party’s liability for intention or gross negligence, shall be deemed as void, and
- in addition, the amount cannot be manifestly excessive as it runs the risk to be reduced by the judge to a fair amount. The Italian Supreme Court (Italian Supreme Court no. 21066/2006) has stated that the power to reduce the penalty amount conferred to the judge corresponds to a general interest of the legal order and it shall be exercised regardless of any agreement providing the irreducibility of the set amount.
Is it possible to set the penalty amount based on the severity level of the breach?
The Italian Supreme Court delivered a favourable decision on such matter, as long as the penalty clause provides a minimum and maximum cap of the amount (Italian Supreme Court. no. 1189/2018).
When may the penalty clause be triggered?
The penalty clause can be triggered only in case of failure to perform attributable to the non-performing Party. Nonetheless, the latter is not liable if the failure to perform is not due to its behaviour or it is a justified failure to perform, like in the case of withholding performance, pursuant to Article 1460 ICC. The withholding performance is justified if it is carried in good faith or if it is justified by a non-slight failure to perform of the other Party.
Prohibition of accumulation of the penalty clause with the main obligation, pursuant to Article 1383 ICC
Article 1383 ICC provides that the performing Party cannot ask for both the penalty amount and the main obligation, unless the penalty clause provides compensation also in case of delay in performing.
Power to reduce the penalty amount conferred to the judge under Article 1384 ICC
Article 1384 ICC provides that the judge has the power to reduce the penalty amount. The judge may reduce the penalty amount in case of partial performance or if such amount is manifestly excessive at the time of the conclusion of the contract.
These requirements are considered alternative though they pursue common ratio and effects. Even in case of partial performance, the penalty amount is not reduced by default as it shall be considered whether the initial amount is in fact manifestly excessive with regard to the actual residual performance. Article 1384 ICC does not apply if the penalty amount becomes manifestly excessive, as a result of unexpected events arisen after the contract conclusion.
Lastly, it should be noted that the judge has the power to reduce the penalty based on its own motion or the Party’s motion.
The Italian Supreme Court, in resolving a case law contrast, has stated that, the power to reduce the penalty to a fair amount conferred to the judge corresponds to a general interest of the legal order. Therefore, the judge may exercise it also based on its own motion in order to return the freedom of contract as worthy of protection (Italian Supreme Court, United Sections, no. 18128/2005).
When is the penalty clause deemed as unfair?
In standard contracts, characterized by information asymmetry, the weak Party of the contract might find itself weighed by a serious of additional obligations or a penalty clause, that transfers the risk of unexpected objective circumstances that may prevent the performance.
Article 33 of the Italian Legislative Decree 6 September 2006 n. 206 (“Consumer code”) qualifies as unfair the penalty clause that provides and amount manifestly excessive. Outside the Consumer Code, Article 1341 ICC does not include as unfair the penalty clause and the prevailing case law considers that the penalty clause has adequate protection by means of the power of reduction conferred to the judge pursuant to Article 1384 ICC.
Penalty clause, confirmatory or penitential deposit and penitential sanction. Main differences
Confirmatory deposit
The confirmatory deposit is paid in advance in order to guarantee the exact performance of the contractual obligations and eventually as advance performance on such obligations.
If the Party that paid the deposit fails to perform, the other Party may withdraw from the agreement and retain the received deposit. Viceversa, if the Party that received the deposit fails to perform the other Party may withdraw from the agreement and ask for the payment of twice the amount of the deposit.
The penitential deposit, on the other hand, is a sort of damage compensation that one Party pays to the other as a consequence of an eventual withdrawal.
Differently from the penalty clause, the deposit is provided only for contracts with reciprocate obligations. Secondly, the deposit is not provided in case of delay in performing. Finally, the deposit does not seek to pre-determine in advance the damage compensation and the performing Party may withhold it as a downpayment if it engages in legal proceeding for contract termination or forced performance and asks for damage compensation.
The deposit cannot be reduced to a fair amount as provided for the penalty clause as an application by analogy of Article 1384 ICC is excluded.
The penitential sanction
The penitential sanction clause is the price of withdrawal conventionally established by the Parties. Such clause provides that an amount shall be paid upon withdrawal but not in advance as provided for the deposit.
Differently from the deposit and the penalty clause, the obligee may choose between damage compensation or the amount of the penitential sanction.
Is it possible to set in the agreement both a deposit and a penalty clause?
The Italian Supreme Court was invested of a dispute concerning a contract that provided both the deposit and the penalty clause.
The key point was the type of termination which the Party availed itself (the Italian legal order provides for both withdrawal, known as “recesso”, and termination, known as “risoluzione”).
It should be borne in mind that, the second paragraph of Article 1385 ICC provides that the deposit may be withheld if the Party chooses to withdraw and not terminate the contract. In fact, if the Party terminates the contract for failure to perform of the other Party, the former shall pay back the deposit as the justifying cause no longer exists. Pursuant to the provision of a penalty clause in the same agreement in which the deposit clause was provided, the performing Party, in addition to the repayment of the deposit, is entitled, upon termination of the contract, to the penalty amount without proving any damage whatsoever.
The penalty clause in the Italian case law
Security services contract
A penalty clause to be paid by the supplier, that limits the damage compensation to the amount of the monthly instalment paid in exchange of the security service, is to be considered as derisory, if a hold harmless clause in favour of the supplier for robberies is provided. According to the Italian Supreme Court, such penalty clause is to be considered unlawful as it constitutes a typical key element of the circumvention of liability limitations prohibition, pursuant to Article 1229 ICC (Italian Supreme Court no. 18338/2018).
Asset transfer leasing contract
In case of termination due to the User Party’s failure of perform, a penalty clause, that confers to the Grantor Party the entire amount of the leasing contract and both the property and possession of the asset, is manifestly excessive.
According to the Italian Supreme Court, such an agreement awards more benefits to the Grantor Party than otherwise normally obtained during correct performance of the contract (Italian Supreme Court no.20840/2018).
From an international leasing law point of view, it should be considered that, the Ottawa Convention 28th May 1998, ratified in Italy as law no. 259 on 14thJuly 1993, provides that the damage compensation which the Grantor Party is entitled shall bring the same benefits as a contract entirely performed.
On the contrary, a penalty clause providing that the User Party may not demand the instalments already paid but it may receive an eventual amount deriving from the asset future sale’s proceeds net of the amount due to the Grantor Party.
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