A penalty clause is a contractual clause that imposes liquidated damages that are unreasonably high and represent a punishment for breach, rather than a reasonable forecast of damages for the harm that is caused by the breach, are referred to as penalty clauses. These clauses allow parties, at the time of contracting, to agree to their respective damages liability if they later breach. While liquidated damages clauses are generally enforceable, courts do not enforce penalty clauses.
For example, if a landlord leases an apartment to a tenant for $1000 a month and the lease provides that if a tenant holds over, the tenant must pay $750 per day, then this would be considered a penalty clause and be invalid because the damages for holding over are excessive.
The Second Restatement of Contracts, Section 356 states:
“(1) Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.
(2) A term in a bond providing for an amount of money as a penalty for non-occurrence of the condition of the bond is unenforceable on grounds of public policy to the extent that the amount exceeds the loss caused by such non-occurrence.”
[Last updated in July of 2020 by the Wex Definitions Team]