The terms included in a contract impact the working relationship between the signing parties. They can also affect the enforceability of the agreement in the future. The integration of penalty clauses into contracts is relatively common.
Service providers include penalty clauses for late payments in contracts with consumers. Employers asking independent contractors and new employees to sign non-disclosure agreements may include penalty clauses that apply if the professional signing the agreement shares non-public information with others.
Penalty clauses can be valuable inclusions in contracts because they protect companies in two distinct ways.
Deterring contractual violations
When other businesses, professionals or consumers know that there are specific financial penalties possible if they breach a contract, they may be more proactive about fulfilling contractual obligations. Imposing a penalty can help incentivize the other party to fulfill their obligations.
Limiting organizational losses
The penalties imposed in contracts should align with the potential harm caused by a breach. Rather than being egregiously high to simply deter and punish the other party, the penalty included in the contract should relate to the likely damage that a breach of contract could cause.
Charging $30 as a penalty for a late payment is reasonable. A six- or seven-figure penalty for a non-disclosure violation is also potentially reasonable depending on the circumstances. If the other party does not fulfill their obligations under a penalty clause, the courts can potentially uphold the terms of the clause during contract litigation.
Integrating the right terms into business contracts can help protect organizations. Penalty clauses can help strengthen written agreements by motivating the other party to remain compliant and providing leverage in the event of a contract breach.