Penal clauses in commercial agreements

The parties to commercial agreements can agree on different mechanisms to ensure the compliance of the obligations set forth in such agreements. Penal clauses are one of the methods used to ensure compliance. The purpose of a penal clause is to ensure the fulfilment of a contractual obligation by assessing in advance the damages payable by the debtor if he fails to perform his obligation. A penal clause is often used in services agreements, sale transactions and shareholders’ agreements, or to ensure the compliance of confidentiality, non-competition and non-solicitation obligations in commercial agreements. If the debtor fails to perform obligations subject to a penal clause, the creditor of such obligation shall be entitled to the amount of the stipulated penalty without having to prove the injury he suffered.

LEGAL FRAMEWORK

Articles 1622 to 1625 of the Civil Code of Quebec (“C.C.Q.”) are the main rules applicable to penal clauses. According to Section 1622 C.C.Q, a penal clause is a clause “by which the parties assess the damages in advance” in case the debtor fails to perform his obligation. The creditor can then be entitled to avail himself of the penalty clause instead of suing the debtor for damages. As stated in Section 1623 C.C.Q., the creditor of an obligation is entitled to the amount stipulated in the clause without having to prove the injury he has suffered.

OBJECTIVES

Firstly, a penal clause is used to create a deterrent effect on the debtor of an obligation. At the signature of the agreement, the debtor is already well aware of the foreseeable consequences of the non-performance of his obligation. The amount to be paid in case of a violation and the fact that the creditor does not have to prove injury he has suffered are factors that are probably considered by the debtor in his decisions to perform or not his obligation.

Then, a penal clause can help the creditor avoid all sorts of trouble related to the protection of his rights and his claim for damages. First, since the damages are assessed in advance, he avoids any evaluation of such damages by the courts, which can be a significant advantage in cases where it is difficult to evaluate the direct damages caused by the violation. Then, as stated in paragraph 1 of Section 1623 C.C.Q., the creditor is entitled to the penalty without having to prove the injury he suffered. Furthermore, a penal clause is tied to an obligation to do or not do something is an efficient protection measure for the creditor, because it is often difficult to obtain an injunction order to force the debtor to perform his obligation because of the strict rules applicable to such type of relief. Moreover, the enforcement of the penal clause is the creditor’s choice. He can opt for penal clause or choose to seek the other remedies at his disposal, depending on which option is the best for him.

Consequently, a penal clause can constitute an efficient protection mechanism for the creditor. However, we will look closely at certain factors to take into consideration for the drafting and enforcement of a penal clause.

ENFORCEMENT AND PROOF OF INJURY

The enforcement of a penal clause is subject to the civil law rules applicable to default. As such, a demand letter sent to the debtor is an essential formality for any creditor who wishes to avail himself of a penal clause[1]. However, the creditor is exempt from such formality when the debtor is in default by the sole operation of the law pursuant to section 1597 C.C.Q.

Then, although the creditor does not have to prove the injury suffered to enforce the clause, this rule is subject to certain clarifications. First, the enforcement of a penal clause requires a fault or a failure to perform an obligation. Then, paragraph 1 of section 1623 C.C.Q. only exempts the creditor from the burden to prove injury. Pursuant to the general rules of civil liability, a creditor must have suffered an injury to invoke a penal clause. If a debtor contests the claim because of the absence of injury, the court may require the creditor to make a prima facie proof of the injury suffered, or else the court may cancel or reduce the penalty amount[2]. Consequently, the proof of injury becomes indirectly an essential condition for the application of the penal clause. However, it should be pointed out that, when it comes to penal clauses, the judge doesn’t have the sovereign power to analyse the injury. The proof of the injury, as well as it’s magnitude, has to be limited to the analysis of the circumstantial and subjective characteristics of the abuse[3].

CLAIM FOR DAMAGES

In general, the creditor is not entitled to obtain the stipulated penalty and seek damages for the same fault of the debtor. As such, the creditor who avails himself of the penal clause waives his other remedies for the same breach. However, there are certain exceptions to this rule. The first occurs when the penalty is applicable to the delay in the performance of the obligation. Then, it is possible to seek additional damages when the penalty clause is only applicable to certain specific damages, which enables the creditor to seek additional compensation for the damages not which are not covered by the penal clause. Finally, an additional remedy in damages is possible when there is a failure to perform a pecuniary obligation under paragraph 3 of section 1617 C.C.Q., since the creditor can stipulate in the agreement that he shall be entitled to additional damages, if he can prove such damages.

ABUSIVE CLAUSE

Pursuant to section 1623 paragraph 2 C.C.Q., the stipulated penalty amount can be reduced if the creditor has benefited from partial performance of the obligation or if the clause is abusive. A penal clause can be abusive if the penalty amount is completely disproportional to the damages truly suffered by the creditor, although this factor is evaluated by the courts based on the circumstances of each case. In the case of a contract of adhesion, meaning a contract in which the essential conditions were imposed by one party, the penal clause will be null or the obligation arising from it will be reduced according to section 1437 C.C.Q.

SPECIFIC PERFORMANCE

As stated in paragraph 2 of section 1622 C.C.Q., the creditor cannot enact both the penalty and the specific performance of the obligation. However, when the penalty is applicable for each breach of the obligation of each day of such breach, it is possible to cumulate the penalty for the past breach and an injunction order to prevent against future breach[4].

DAILY PENALTY

Penal clauses often provide for penalty calculated on a daily basis for each day of breach. This method can be advantageous in certain situations such as penalties for delay in performance or non-competition covenants. However, in other circumstances such as confidentiality covenants, such method might not be the way to calculate the penalty, because the debtor can divulge all of the creditor’s confidential information in a single day. Consequently, it could be useful to provide different calculation methods depending on the nature of the breach.

Information provided in this article is intended as general introductory information only. The information provided in this article is not legal advice. It should not be construed as legal advice and should not be relied upon as such. Should you want legal advice regarding the information provided in this article, please contact one of our lawyers.