A penalty clause in a contract is a provision that imposes a predetermined amount of money (a penalty) on a party that fails to fulfill its contractual obligations or breaches the contract. It is intended to discourage breach by threatening a financial consequence. What Is a Penalty Clause? It specifies a fixed sum or formula that the breaching party must pay if they fail to perform as promised. The penalty is designed as a punishment or deterrent rather than a genuine pre-estimate of loss. Unlike liquidated damages, which compensate for actual or estimated loss, a penalty is usually higher than the probable loss and aims to penalize the defaulting party. Legal Position Under Indian Law Under Indian contract law, particularly guided by principles in the Indian Contract Act and case law, penalty clauses are generally unenforceable. Courts distinguish between liquidated damages (valid and enforceable) and penalties (void and unenforceable). If a clause is found to be a penalty (excessive, punitive), the court may refuse to enforce it and award only actual damages. Purpose and Effect The penalty clause intends to deter breaches by creating a financial burden. However, since it does not reflect the actual loss, it’s seen as unfair. In case of breach, courts tend to assess real losses and not enforce penalty amounts. Summary A penalty clause is a contractual provision for a fixed punitive sum payable on breach. Indian courts typically do not enforce penalty clauses if they are not a genuine pre-estimate of loss, favoring compensation (liquidated damages) over punishment.

Dear Client, When a party to the contract does some act that breaches the terms of the contract, the other party might face some harm due to such act. Therefore, there exists a penalty clause in a contract which mentions that in such an event of breach of contract, the party who has breached it has to pay a specified sum of money as a penalty to the other party. The main goal of a penalty clause is to ensure that breach does not happen and that the parties adhere to the terms of contract. However, it is necessary to note that when a breach of contract case goes to court, the court, under Section 74 of the Indian Contract Act, 1872, will only enforce the penalty clause to a reasonable extent which is generally equivalent to the actual loss suffered by the other party. This is done to ensure that such a penalty is treated as a compensation and not a punishment. I hope this answer helps. For any further queries, please do not hesitate to contact us. Thank you.