Penalty Clauses in Pennsylvania Are Not Enforceable
Our Pittsburgh attorneys regularly see contract disputes go into litigation. We represent clients who face claims for non-payment of “penalty” clauses. Clauses that are obvious attempts to punish, will not be enforced. Some creativity in contract drafting is needed to effectuate punishment that is enforceable, as we’ll discuss.
General Rule: Clauses Drafted to Punish Will Not Be Enforced
The courts will deem most penalty clauses against public policy in the Commonwealth of Pennsylvania. In PA, the appellate case law is clear: a contract cannot be used to punish or penalize another party. See 22 Am.Jur.2d Damages § 245 (1965); 5 Corbin on Contracts § 1077 (1964); 25 C.J.S. Damages § 120 (1966); C. McCormick, Law of Damages § 81 (1935), Hoy v. Gronoble, 34 Pa. 9, 75 A.D. 628 (1859), DiGregorio v. Keystone Health Plan East, 840 A. 2d 361 (Pa.Super. 2003), Thorsen v. Iron and Glass Bank, 328 Pa.Super. 135, 476 A.2d 928 (1984), DiGregorio v. Keystone Health Plan East, 840 A. 2d 361 (Pa.Super. 2003).
Contracts Are For Compensation – Not Punishment
In fact, the winning party in civil litigation cannot expect the loser to pay his attorney fees. This is the American Rule. So even if you prove another has breached, you cannot “punish” via an award for attorney fees or punitive damages. To the contrary, the goal of contract law is to put each party in the position he or she would have enjoyed, had the contract been fully performed, giving each person the “benefit” of his or her bargain, without “punishment.”
Why Do We See “Penalty Fees” in Contracts?
So why, then, do we see so many claims by parties seeking to punish and recover “penalty” fees, in state and federal court in PA? Businesses routinely include “penalty” language in contracts with other businesses, even where sophisticated counsel is involved and knows better when drafting the contracts. We also defend consumers sued by credit card companies, seeking money for the non-payment of “penalty” interest, and late fees. We also see landlords trying to enforce penalties for “late fees.” How, then, are these penalty clauses taken seriously enough to become the subject of litigation? The answer is, such clauses are not enforceable, except in two instances.
Stipulated or Liquidated Damages
Under Pennsylvania law, the party alleging a breach of contract has the burden of proving damages resulting from that breach. Spang & Co. v. U.S. Steel Corp., 545 A.2d 861, 866 (Pa. 1988); Corestates Bank, N.A. v. Cutillo, 723 A.2d 1053, 1058 (Pa. Super. Ct. 1999). Further, damages must be established with “reasonable certainty” and may not be recovered if they are too speculative, vague or contingent. Spang. Proof of the exact amount of loss or a precise calculation of damages. However, is not required as long as the evidence “with a fair degree of probability” establishes a basis for the assessment of damages. Id., quoting Aiken Indus., Inc. v. Estate of Wilson, 383 A.2d 808, 812 (Pa. 1978) (plurality opinion).
For the above reasons, stipulated or liquidated damages are allowed — and even encouraged — when assessing actual damages would be too difficult. For example, a party suffering lost profits may struggle to prove how much profit he “would have made,” but for the Defendant’s conduct. Thus, businesses suing each other in commercial litigation often stipulate the value of such damages.
Other Difficulties Ascertaining Costs and Damages
Parties and the courts struggle to set a value for “administrative costs.” Take, for example, a small-time landlord who rents only a few units and manages the properties himself. There, if one rent check is late, the landlord must expend time to follow up himself. Thus, taking this into account, this landlord might want to insert in his leases a couple things. First, he should state in the contract the difficulty of ascertaining damages from late payment. Then, the stipulated value of the damages for breach must be reasonable in relation to the breach. It cannot sound punitive, in other words.
Stick Prohibited – Carrot Allowed: Rewarding Compliance is OK
While a party may not penalize another via contract, a reward is generally OK. So, in the above example, the landlord could alternatively offer a “discount” for the payment of rent on-time. The lease could read: if the rent is paid on-time, the tenant gets a discount. Otherwise, the “true” rent price (a higher charge) becomes due and payable. This is a reverse penalty, but when stated as a reward, it is generally enforceable, unless the fee is clearly excessive.
We see “reward” language used successfully in non-compete litigation cases. Courts generally disfavor non-compete agreements (unless the agreement is reasonable to protect the employer’s interests), just as the courts dislike punitive damages, but enforcement of both is more palatable for the courts if phrased as a reward. For example, in non-compete cases, the savvy employer might word the non-compete to say, the: the employee shall receive a payment of $5,000 for not competing with the employer for six months following termination. With this, the employer need not prove the enforceability of the non-compete, which is described here.
Penalty Clauses That Are Not Likely Enforceable
Some clauses, even when characterized as a “reward” or “liquidated damages” will never be enforceable. This is true when stipulated amount bears no reasonable relationship to the possible damages that could have been sustained from non-performance. There, the clause looks primarily punitive, in nature, as mentioned.
Below is a specific example of the type of argument we made in court. We were representing a debtor sued by Discover bank, a credit card company in Allegheny County, PA. Discover was suing in part for the non-payment of its “penalty” fees and interest. In so many words, we argued:
Discover [Bank] claims it had the right to charge a late payment “penalty” and also late payment “penalty” interest in the amount of 28.24 percent. See Plaintiff’s Amended Complaint, Exhibit 2. That said, Discover failed to allege — much less attempt to prove — how it was actually damaged by any late payment. This is because there was no damage. In fact, every credit card company practically salivates at the idea of late payment, so it can permanently charge a higher “penalty” interest rate, making the “penalty” a windfall for the bank. As a result, all of Plaintiff’s claims for “penalties” should be dismissed with prejudice.
Our objections to the lawsuit filed by Discover were sustained. In short, courts will look closely at whether a “liquidated damages” clause or “reward” is actually thinly veiled penalty.
Call or email our Pittsburgh litigation lawyers if you need further assistance with your contract related matter.
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