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Penalty Clauses: The Rise and Fall of Freedom of Contract

by Dr Carlos Bugeja – Senior Associate

At the foundation of Maltese contract law is a dear principle to western legal systems: Freedom of Contract. At its basis, Maltese contract law seems to embrace this principle, mostly through article 992 (1) of the Civil Code, which states: “Contracts legally entered into shall have the force of law for the contracting parties”.

Article 1122 (1) of the Civil Code perhaps contains one of the most overt tributes to freedom of contract in Maltese law. The general rule is that when the performance of an obligation in contract is guaranteed with a penalty clause, “[i]t shall not be lawful for the court to abate or mitigate the penalty…”

This was clearly explained in the judgment of Baggitt Enterprises Limited vs Jeffrey Chetcuti u Glenn Chetcuti (Civil Court, First Hall, 15 April 2002 (1423/2001/1JRM)). In this judgment, while the Court showed its concern that this provision may carry some problematic implications, it recognised that “l-ebda qorti m’għandha tindaħal fi ftehim bħal dan jekk ma jkunx milqut b’xi difett li ġġibu ma jiswiex”.

It is for this reason that the judgment of Mark Calleja Urry u martu Madelene Calleja Urry vs Joseph Portelli u martu Vanessa Portelli (Civil Court, First Hall, 31 July 2008 (129/2006AE)) was a game-changer.

In the first instance, the Court quoted article 1384 of the Italian Civil Code, stating: “La penale puo’ essere diminuita equamente dal giudice, se l’obbligazione principale e’ stata eseguita in parte ovvero se l’ammontare della penale è manifestamente eccessivo, avuto sempre riguardo all’interesse che il creditore aveva all’adempimento”. It then quoted articles 1152 of the French Civil Code, providing that where an agreement provides that he who fails to perform it will pay a certain sum as damages, the other party may not be awarded a greater or lesser sum; nevertheless, the judge may, “even of his own motion“, mitigate or increase the agreed penalty, where it is obviously excessive or ridiculously low.

Whilst the Court acknowledged that unlike Italian and French law, the Maltese Civil Code did not give courts the power to abate excessive penalties, it considered that it could do so nonetheless:

Jidher għalhekk li l-ideja hi li penali eċċessivi jistgħu jiġu riveduti u mibdula. Fil-fehma tal-Qorti din is-sistema hi dik li l-iktar taghmel sens in kwantu tiżgura li irrispettivament ta’ dak li jkunu ftehemu lpartijiet, ma tinħoloqx il-possibiltà li jkun hemm konsegwenzi assurdi. Fil-liġi Maltija ma nsibu l-ebda provvediment li jgħid li l-Qorti għandha l-jedd li tnaqqas il-penali fejn din tirriżulta li hi eċċessiva. Il-principju ġenerali hu li l-kuntratt jirrifletti l-ftehim tal-partijiet u lkuntratt għandu jkun eżegwibbli.

The Court then quoted the judgment of Michael Pace vs Richard Micallef f’ismu proprju u għan-nom u in rappreżentanza tas-Soċjeta’ Polymer Conversions (Med) Limited (Court of Appeal, 7 February 2006 (726/1990/2)), in which what was deemed as an excessive penalty was reduced in mitigation of what the Court had considered as a “sproporzjon astronomiku bejn il-quantum tal-inadempjenza tal-kovenut (…) u l-quantum tal-penali likwidata (…) biex tagħmel tajjeb għall-istess inadempjenza’.

The Court proposed an interesting argument to sustain this position. It argued that in terms of article 993 of the Civil Code, “contracts must be carried out in good faith, and shall be binding not only in regard to the matter therein expressed, but also in regard to any consequence which, by equity, custom, or law, is incidental to the obligation, according to its nature”. Quoting previous judgments, the Court said that within the concept of good faith there exists a certain element of equity plus a sense of morality and practice that may be violated not only when confronted with an act specifically intended to do harm, but also with disproportionate behaviour deemed unacceptable by established norms and juridical logic; this in homage to the principle of in omnibus quidem, maxime tamen in jure, aequitas spectanda sit.

This judgment was confirmed on appeal.

This was not the first judgment that stated this, although few before had applied this principle so emphatically. In Mary Rose sive Mary Falzon Sant Manduca vs Mario Grima (Civil Court, First Hall, 8 March 2005 (411/2003JRM) had stated that it is possible that the literal effect and application of a penalty clause is redimensioned if it results that they “joffendu jew jiksru s-sens prattiku u morali tal-obbligazzjoni billi jkunu jidhru sproporzjonati jew inaccettabbli skond in-normi stabiliti tas-socjeta’ u l-loġika ġuridika“.

It can be argued that what the Court might be trying to say is that all this is an effect of article 1120, which defines the parameters of penalty clauses as representing “compensation for the damage which the creditor sustains by the non-performance of the principal obligation”. It would thus mean that if the penalties are deemed as not being a true representation of the damages suffered, the court may intervene to produce a fairer and truer penalty than that resulted. In my view, it is easier to appreciate (even if one still disagrees with it) the consistency in this argument more than in the above, particularly in light of two inherently-linked principles of civil law: (i) that the purpose of damages is to afford a full restitutio in integrum; and (ii) that the sufferer may not enrich himself through the payment of damages.

In fact, the Court quoted a judgment of Emanuel Borg vs The Two Divers Company Limited (Court of Appeal, 27 February 2008 (417/2004/1)) stating: “’hemmx dubbju illi klawsola penali f’kuntratt għandha funzjoni essenzjalment riżarċitorja intiża biex tiffissa b’mod preventiv, u anke b’mod vinkolanti, l-ammont tad-dannu f’każ ta’ dewmien jew ta’ inadempiment”.

The Court reasoned differently in another case, that of Francis Paris et vs Maltacom plc (Civil Court, First Hall, 7 October 2004 (480/2002/1TM), later confirmed on Appeal). In this judgment, the Court said that once there is a contract that the parties agreed would regulate their relationship, “huwa dak il-kuntratt li jissanzjona r-relazzjonijiet ta’ bejn il-kontendenti, u mhux xi prinċipju ieħor, anchorchè bażat fuq l-ekwità.” The Court stressed on the fact that the principle of contractual liberty is fundamental, and that the Court should not utilise its discretion to substitute what the parties agreed upon.

The questions created by these two school of thoughts are huge and far-reaching. Should the Courts adopt powers beyond what is given to it by the law (article 1122, Civil Code), for the sake of equity, good faith and fairness, or should they stay within the boundaries of the letter of the law and turn their back to what could be manifest exploitation of a party in contract? Shall our Courts take a protectionist role, and seek to correct presumed inequalities all throughout, even those purposely and voluntarily created by the parties themselves?

Freedom of contract is a concept easy to understand, but difficult to comprehend in its entirety. It is an idea which in time has been retouched and remodelled to become a complex thought-provoking principle unrecognisable from its origins. The freedom of contract versus paternalism debate is huge, far-reaching, and ideologically heavy.  The arguments made for and against the mitigation of penalties in contract in literature and court judgments resonate in a way as to affect each branch of contract law; be it consumer laws, rent laws, and employment law, to mention a few.

What is certain is that the inevitable philosophical foundations that carry the arguments makes this a timeless debate which will be had for years to come.

 

Disclaimer: This article is not to be considered as legal advice, and is not to be acted on as such. Should you require further information or legal assistance, please do not hesitate to contact Dr Carlos Bugeja on carlos@abalegal.eu.