[CHAPTER 16. AGREED PAYMENT FOR NON-PERFORMANCE]

All legal systems appear to recognize the validity and social utility of a clause which estimates future damages, especially where proof of actual damage would be difficult. Such a clause, sometimes referred to as a "liquidated damages clause" and sometimes as a "penalty clause", can serve both the function of estimating the damages which [one party] would suffer as a cause of the breach so as to ease the problems of proof and of creating a penalty sufficiently large to reduce the likelihood that the [other party] will fail to perform.  ⁹²⁹ 

Under the CISG, Art. 46/62, which deals with specific performance (see Chapter 3) does not have the effect of making such clauses valid in those legal systems which do not otherwise recognize their validity. In other words, the CISG consciously does not deal with penalty clauses, or so-called agreed payment for non-performance or liquidated damages. The CISG does, however, not exclude relevant contractual agreements. A liquidated damages clause agreed upon by the parties should be given full effect under the Art. 6 principle of contractual freedom to derogate from the Convention.  ⁹³⁰  Nonetheless, under Art. 4 CISG, which says that the Convention does not consider "the validity of the contract or any of its provisions", the validity of a penalty clause will likely be determined by conflicts of law rules. The vagaries of private international law will therefore decide this issue.

However, while some legal systems approve of the use of a "penalty clause" to encourage performance of the principal obligations, in other legal systems such a clause is invalid.  ⁹³¹  It is said that courts in many countries will enforce penalty clauses. Common law courts, however, do not enforce penalty clauses, for public policy reasons, but do allow liquidated damages, as provided in Uniform Commercial Code section 2-718.  ⁹³²  "National laws vary considerably with respect to the validity of the type of clauses in question, ranging from their acceptance in the civil law countries, with or without the possibility of judicial review of particularly onerous clauses, to the outright rejection in common law systems of clauses intended specifically to operate as a deterrent against non-performance, i.e. penalty clauses."  ⁹³³ 

Therefore, there is considerable support for the idea that the uniform law should regulate the subject of liquidated damages, which is not however explicitly covered in the CISG. In fact, the CISG drafting Committee felt that such regulation is particularly desirable because the rules on liquidated damages vary widely, and it would be a practical contribution to international trade to bring uniformity in their application. However, the Committee again could not agree on proper language that would avoid the technical problems associated with the proposed draft. As a result, the basic principle underlying the liquidated damages provision was not rejected in the Convention. The framers of the Convention agreed that the validity and application of such clauses were to be dealt with in terms of the applicable legal system due to widely divergent approaches in the different legal systems.  ⁹³⁴ 

By contrast, in view of their frequency in international contract practice, both the UPICC and the PECL deal with the subject of liquidated damages. Art. 7.4.13 UPICC stipulates: "(1) Where the contract provides that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party is entitled to that sum irrespective of its actual harm. (2) However, notwithstanding any agreement to the contrary the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the harm resulting from the non-performance and to the other circumstances." Art. 9:509 PECL resembles in substance Art. 7.4.13 UPICC and reads: "(1) Where the contract provides that a party who fails to perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party shall be awarded that sum irrespective of its actual loss. (2) However, despite any agreement to the contrary the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the loss resulting from the non-performance and the other circumstances."

It is stated in the Official Comment on Art. 7.4.13 UPICC that, this Article gives an intentionally broad definition of agreements to pay a specified sum in case of non-performance, whether such agreements be intended to facilitate the recovery of damages (liquidated damages according to the common law) or to operate as a deterrent against non-performance (penalty clauses proper), or both.  ⁹³⁵  Para. (1) of this article in principle acknowledges the validity of any clauses providing that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, with the consequence that the latter is entitled to the agreed sum irrespective of the harm actually suffered by it. The non-performing party may not allege that the aggrieved party sustained less harm or none at all.  ⁹³⁶ 

However, the type of clauses dealt with in Art. 7.4.13 UPICC or PECL Art. 9:509 must be distinguished from forfeiture and other similar clauses which permit a party to withdraw from a contract either by paying a certain sum or by losing a deposit already made. On the other hand a clause according to which the aggrieved party may retain sums already paid as part of the price falls within the scope of this article.  ⁹³⁷  Further, the obligee is not entitled to the agreed sum if the obligor is not liable for the failure of performance:  ⁹³⁸  "Normally, the non-performance must be one for which the non-performing party is liable, since it is difficult to conceive a clause providing for the payment of an agreed sum in case of non-performance operating in a force majeure situation. Exceptionally, however, such a clause may be intended by the parties also to cover non-performance for which the non-performing party is not liable."  ⁹³⁹ 

With regard to the relationship between such agreed payment clauses and the right to performance, para. (2) of Art. 1622 Civil Code Québec (the Québec Code is seen as a "Vehicle for Modeling a Transnational lex mercatoria") reads: "A creditor has the right to avail himself of a penal clause instead of enforcing, in cases which admit of it, the specific performance of the obligation; but in no case may he exact both the performance and the penalty, unless the penalty has been stipulated for mere delay in the performance of the obligation."  ⁹⁴⁰  However, it seems to be more persuasive that Art. 6 of UNCITRAL Uniform Rules stipulates: "(1) If the contract provides that the obligee is entitled to the agreed sum upon delay in performance, he is entitled to both performance of the obligation and the agreed sum. (2) If the contract provides that the obligee is entitled to the agreed sum upon a failure of performance other than delay, he is entitled either to performance or to the agreed sum. If, however, the agreed sum cannot reasonably be regarded as compensation for that failure of performance, the obligee is entitled to both performance of the obligation and the agreed sum."  ⁹⁴¹ 

One should note, however, the sum stipulated may be reduced by the court when it is manifestly excessive. In order to prevent the possibility of abuse to which such clauses may give rise, para. (2) of Art. 7.4.13 UPICC permits the reduction of the agreed sum if it is grossly excessive "in relation to the harm resulting from the non-performance and to the other circumstances". The same paragraph makes it clear that the parties may under no circumstances exclude such a possibility of reduction. The agreed sum may only be reduced, but not entirely disregarded as would be the case were the judge, notwithstanding the agreement of the parties, to award damages corresponding to the exact amount of the harm. It may not be increased, at least under this article, where the agreed sum is lower than the harm actually sustained. It is moreover necessary that the amount agreed be "grossly excessive", i.e. that it would clearly appear to be so to any reasonable person. Regard should in particular be had to the relationship between the sum agreed and the harm actually sustained.  ⁹⁴²  However, the agreed sum shall not be reduced by a court or arbitral tribunal unless the agreed sum is substantially disproportionate in relation to the loss that has been suffered by the obligee.  ⁹⁴³ 

Finally, it is also to be noted that reduction may be made when the principal obligation has been performed in part. In the case of partial non-performance, the amount may, unless otherwise agreed by the parties, be reduced in proportion.  ⁹⁴⁴