Penalty clauses in comparative law

Penalty clause is an agreement between the obligor and the obligee, under which the obligor promises to perform a certain act or to endure a certain legal disadvantage if she breaches the contract. The act or legal disadvantage is "penal" in character, as it exceeds the predictable loss to be incurred by the obligee and the predictable damages to be awarded by the court in case of breach. As of today, penalty clauses serve two prominent functions. The principal function of penalty clause is to compel the obligor to perform the primary obligation. Penalty clause increases cost of a potential breach, so that it functions at a pre-breach stage and incentivizes obligor to perform. A rational obligor is expected to perform once the penalty clause increases the cost of breach to exceed the cost of performance. Hence, the penalty clause better protects the performance interest and serves when the remedy of specific performance falls short. If the primary obligation is still breached somehow, then the subsidiary function of the penalty clause steps in and compensates the loss incurred by the obligee. Default rules under contract law usually compensates the loss actually incurred by the obligee only partially. Yet penalty clause holds the breaching obligor to perform the whole penalty, regardless of the amount of loss actually incurred by the obligee. Therefore, penalty clause serves to compensate the obligee easily and fully, including the loss which is not to be compensated under default contract law rules. The first of those two functions particularly characterizes the penalty clause. Penalty clause consists of three main components: primary obligation, contractual penalty and the agreement. Contractual penalty has also some sine qua non characteristics. If the parties enter into an agreement which excludes those characteristics, such an agreement cannot be qualified as a contractual penalty. Firstly, the contractual penalty is accessory in the sense that it is contingent upon the primary obligation. Secondly, the contractual penalty is due regardless of the loss actually incurred by the obligee. Lastly, the contractual penalty is a promise subject to suspensive condition. Penalty clause differs from liquidated damages clause, arrhes, forfeiture money and non-genuine penalty clause in its functions and structure. The boundary between penalty and liquidated damages clauses in particular shall be carefully drawn. The conceptual boundary between those two legal concepts is the function of agreement. The principal function of the penalty clause is to compel the obligor to perform the primary obligation. It is no doubt that penalty clause functions to compensate the loss incurred by the obligee if the primary function fails and the primary obligation is breached somehow. Yet, that function still remains subsidiary to compelling performance. On the other hand, liquidated damages clause functions the other way around. Liquidated damages clause primarily serves to compensate the loss predicted to incur as a result of primary obligation's breach. The responsibility to pay a definite amount agreed in the liquidated damages clause further incentivizes the obligor to perform, compared to the responsibility to pay an indefinite amount of compensatory damages. The primary and dominant function under the liquidated damages clause still remains to compensate the obligee's loss incurred as a result of primary obligation's breach. The said difference between the functions of penalty and liquidated damages clauses may also be observed in the relationship between the predictable loss to be incurred by the obligee and the agreed amount to be paid by the obligor. The agreed amount under the penalty clause substantially exceeds the predictable loss. In that sense, it compels the obligor to perform more forcefully than the default rules under contract law. Liquidated damages clause, on the other hand, includes a genuine estimate of the predictable loss to be incurred by the obligee. In that sense, it aims to compensate the loss to be incurred by the obligee in case of contractual breach. According to TCO Art. 179, types of contractual penalties may be classified under three categories. Under "alternative contractual penalty", the obligee may choose and claim the performance of either the primary obligation or the contractual penalty. In case of an "additional contractual penalty", the obligee may claim the performance of contractual penalty in addition to the primary obligation. "Exclusive contractual penalty" allows the obligee to claim only the contractual penalty; claims regarding the primary obligation are excluded. According to the principle of contractual freedom, the parties are free to choose the type of contractual penalty they wish to adopt. Yet TCO Art. 179 sets forth some presumptions to step in if it is not possible to draw a clear conclusion on the interpretation of the parties' intents. In our view, contractual penalty agreed for the non-performance of the primary obligation is presumptively alternative (TCO Art. 179/I); contractual penalty agreed for the unduly performance of the primary obligation is presumptively additional (TCO Art. 179/II). Contractual penalty is due by itself upon the fulfillment of two cumulative conditions, if any further date is not agreed by the parties. Firstly, the suspensive condition under the contractual penalty shall be fulfilled upon the obligor's breach of primary obligation. Secondly, the obligor shall be held accountable of the said breach. Considering when the obligor is to be held accountable of the said breach, general rules under the contract law shall be followed. According to the freedom of contract principle, the parties are expected to determine the penalty amount freely without any judicial intervention. Yet the assumption the freedom of contract principle is based on, is far from reality. The first problem with the assumption is that the weaker party may not implement the decisions which maximize her own interest due to the pressure from the other party. The second problem is that the parties may not be able to make the decisions which maximize their own interest due to human psychology in the first place. Considering the fragility of the assumption that the freedom of contract principle is based on, attributing sanctity to that principle as in the 19th century liberalism seems to be fallacious. Legislators limited the principle through various legal institutions. Regarding the penalty clause, all legislators opted for a certain type of judicial supervision on the amount of contracual penalty. Despite differing on their details, those judicial supervision mechanisms all have a common purpose to prevent an unbalance between the parties' interests in an unacceptable level. TCO Art. 182/III, which sets forth the judicial supervision on the amount of contractual penalty, is a mandatory rule. In our opinion, the court's authority to reduce exorbitant contractual penalties finds its source in the prohibition to abuse rights. Agreeing on an "exorbitant" amount of contractual penalty manifests that the legal limits are transgressed and rights are abused. At that point the court steps in and determines at which level the claim of contractual penalty is permissible under good faith. The application of TCO Art. 182/III is limited by the TCC Art. 22, which holds that the reduction of a contractual penalty is not permissible for merchants. Contractual penalties agreed for the obligations of the merchants are not to be reduced for being exorbitant. In our opinion, the idea to include all merchants in the same pot without any differentiation is outdated and fallacious. Yet, the only judicial supervision on the amount of contractual penalty is not TCO Art. 182/III. Merchants may still benefit from the protection of standardized terms of contract (TCO Art. 20 et seq.) and general restrictions to the freedom of contract (TCO Art. 27). Common law systems in general adopt a more conservative approach regarding penalty clauses, so that they declare those clauses to be unenforceable. Such approach is rooted in the penalty doctrine which goes way back to early English Law. In Dunlop Pneumatic Tyre Co. Ltd. v. New Garage & Motor Co. Ltd. dated 1914, House of Lords distinguished between penalty and liquidated damages clauses and limited enforceability of penalty clauses. Yet the UK Supreme Court initiated a paradigm shift in the penalty doctrine with Cavendish Square BV v. Makdessi ve ParkingEye Ltd v. Beavis dated 2015. According to the judgment, agreed amounts which exceed a genuine estimate of loss and compel the obligor to perform are enforceable, as long as they aim to protect obligee's legitimate interest in performance and are not exorbitantly high according to that aim. Therefore, the idea of judicial supervision on the amount of contractual penalties is not exclusive to civil law systems. It is a common value embraced in all legal systems. English law which represents the common law tradition and Swiss- Turkish law which represents the civil law tradition agrees on the idea of a certain judicial supervision. Yet, different perceptions remain on how to conduct the supervision