Contracts are the backbone of commercial and personal transactions and the means through which expectations of the parties to the contract are assigned and crystallised in writing. Unfortunately, sometimes obligations are not upheld, or things do not go according to plan. This is when penalty clauses and limitation of liability clauses become relevant, providing security and foreseeability and defining the boundaries of responsibility in case of breaches. This article explores the enforceability of these types of clauses under Maltese contract law, with a focus on relevant case law.
Part one: Penalty clauses under Maltese law
Penalty clauses serve a critical tool in Maltese contract law, designed to ensure the performance of obligations and to compensate for a party's loss in the event of a breach occasioned by the other party. These clauses are particularly common in agreements for specific performance where meeting deadlines is essential. Under Maltese law, the enforceability and regulation of penalty clauses is governed by Articles 1118 et seq. of the Civil Code.
Article 1118 of the Civil Code defines a penalty clause as a provision where “a person for the purpose of securing the fulfilment of an agreement, binds himself to something in case of non-fulfilment” effectively serving as a deterrent against a breach of that agreement. These types of clauses pre-determine the amount (‘quantum') of damages payable in case of default, aiming to reflect the harm caused by the failure to meet the agreed terms.
Enforceability of Penalty Clauses under Maltese Law
Are penalty clauses as laid down in a contract normally upheld, if contested in a court of law? Case law is quite divided in this respect. By way of example, in Francis Paris et vs Maltacom plc (Court of Appeal, 2008), the court upheld a penalty clause despite arguments that the penalty was excessive. Similarly, in Catherine Cauchi vs Keith Seychell (Small Claims Tribunal, 2021), a ten Euro (€10) daily penalty was upheld by the Tribunal despite the defendant's argument for mitigation due to circumstances beyond his control. The case involved an agreement where the respondent was obliged to repair a rubble wall within a specified timeframe. A penalty was stipulated for delays and the claimant sought to enforce the agreed penalty of ten Euro (€10) per day. The defendant contested the claim, arguing that the delay resulted from uncontrollable factors and requested mitigation under Article 1122 of the Civil Code. However, the Tribunal emphasized that penalty clauses serve a dual purpose: to cap and quantify damages, and to pre-determine potential damages for breach. The Tribunal highlighted that in penalty enforcement cases, the quantum of damage does not need to be proven separately as it is predetermined in the agreement. The respondent failed to present evidence contesting the penalty, leading the Tribunal to reject the mitigation request and order payment as specified in the contract.
On the other hand, in Mark Calleja Urry vs Joseph Portelli (Civil Court, First Hall, 2008), the court acknowledged that excessively high penalties could be mitigated by the court of its own motion, citing the judgement in Michael Pace vs Richard Micallef (Court of Appeal, 2004), where an excessive penalty was reduced on the grounds of good faith and proportionality (discussed below).
It should be noted that in accordance with Article 1120(3) of the Civil Code, a contracting party who has suffered a breach of the contract may sue the other party either for the performance or for the payment of the penalty; but the same party cannot claim both performance of the obligation and the payment of the penalty. This provision prevents double recovery for the same breach, ensuring that penalties serve as compensatory tools rather than punitive measures. An exception to this rule is where a penalty was specifically stipulated for mere delay (that is, where a penalty becomes payable simply by the fact that the performance was delayed, even if the obligation is eventually performed). Thus, the inclusion of the wording ‘for mere delay' in a clause should be used in situations where the delay, in itself, can cause distinct harm (which the stipulated penalty is designed to cover).
A penalty clause becomes null if the principal obligation it secures is also null. The reverse is not true, however: the nullity of the penalty clause does not in itself invalidate the principal obligation (Article 1119 of the Civil Code).
Triggering Penalty Clauses
Penalty clauses are typically triggered once the debtor is in default. Default can be established when the obligation can feasibly be executed, but the performance is still not honoured (unless the contract specifies different conditions for triggering the penalty). Commonly, the default is formalized through an explanatory judicial letter, which outlines the breach committed by the defaulting party.
Article 1122 of the Civil Code provides specific scenarios where the court may mitigate penalties. These include cases of partial execution of the obligation, where the creditor accepts the partial performance without objection. In such cases, the court can reduce the penalty to reflect the actual extent of non-performance. In Michael Pace vs Richard Micallef pro et noe (Court of Appeal, 2004), the Court of Appeal overturned the decision of the First Court which had ordered the payment in full. The Court of Appeal stated that the excessive penalty was in violation of the requirement to contract in good faith as outlined in Article 993 of the Civil Code, and in view of the fact that the majority of the work ninety-nine (99%) was completed, the Court was of the opinion that there was no reason for the exorbitant penalty. Instead, it ordered the payment of one per cent (1%) of the cost of the works, in conformity with Article 1122(2) of the Civil Code which states that the penalty should be in proportion to the part of the contract which has not been fulfilled.
The law also allows parties to waive their right to have the penalty mitigated or abated through explicit agreement by including wording to that effect in the contract. Despite this waiver, Maltese courts have on occasion still exercised discretion in assessing the fairness of the imposed penalty, ensuring that the principle of proportionality is upheld.
Part two: Limitation of liability clauses under Maltese law
Limitation of liability clauses are prevalent in contracts, especially where one party seeks to limit or exclude its responsibility for damages in the event of a breach of contract or other legal claims. These clauses manage risk and prevent excessive financial exposure for the parties involved by excluding damages for one or both parties, or at least limiting the amount payable. In today's digital world, these clauses are increasingly relevant, particularly in online platforms that include them in terms and conditions, often leaving the user with little bargaining power.
The Doctrine of Fundamental Breach
Under Maltese law, limitation of liability clauses are subject to scrutiny, especially when they attempt to exonerate a party from liability for major breaches of the contract in question. The case of Angelo Farrugia vs Louis u Lawrence Camilleri (Court of Appeal, 1993) involved defective tiles being purchased by the plaintiff. An exemption clause was relied upon by the defendant to exclude any liability for latent defects. The Court of Appeal rejected this argument and held that exemption clauses can only be relied upon for minor breaches, not for major ones. This is known as the doctrine of fundamental breach. This principle elucidates the fact that an exemption clause can never be used as a means to avoid the performance of a contract when major breaches have been committed.
In the case of Valhmour Borg vs Major Alfred Calascione M.B.E (Commercial Court, 1961), the court held that an exemption clause that exonerated the defendant from all responsibility for damages could not be relied upon when the defendant was negligent. In this case there was conformation that exemption clauses cannot exonerate a person from culpa lata (gross negligence); culpa levis (lack of exercise of ordinary prudence as a diligent pater familias would have done); and culpa levissima (slight negligence). The facts of the case involved the depositing of pears to the depositary who due to his own gross negligence failed to maintain the pears at the required temperature amounting to their deterioration. The court emphasized that the defendant, who was paid for the service, was required to act with a higher level of diligence, and the exemption clause could not be used to avoid liability for negligence. Similarly, in the case of Anna Maria Sammut vs Stanley Sullivan (Commercial Court, 1995), the court reiterated the principle that an exemption clause must be clearly stated, and there must be no negligence on the part of the party in breach, for it to be enforceable.
It should be noted that generally, if the plaintiff tries to claim that a limitation of liability clause should not be upheld by the court due to negligence on the part of the defendant, the burden of proof will shift due to the plaintiff. In other words, the party not in breach will have to prove that the party in breach was negligent. In Joseph Rizzo vs Edward Ellul Sullivan (Court of Appeal, 1987), the court shifted the burden of proof to the plaintiff when the defendant relied on an exemption clause included in a Bill of Lading. The court ruled that the plaintiff needed to prove the defendant's negligence to hold him liable, but when the plaintiff failed to do so, the defendant was exempted from liability.
A fundamental principle to keep in mind is that exemption clauses may be held invalid if the buyer is not made aware of them: in a case mentioned above (Anna Maria Sammut vs Stanley Sullivan, Commercial Court, 1995), the court ruled that if an exemption clause is not brought to the attention of the clients and there is no valid reason for a change in the vacation programme, then the exemption clause cannot be put into effect, meaning exoneration from liability is withheld.
Part three: Consumer contracts
The situation in relation to standard-form consumer contracts merits some discussion in this respect. It is quite widely held that in standard form contracts involving consumers, high penalty clauses and clauses excluding liability of the other party are often rejected as they are deemed unfair on the consumer, since consumers have little or no ability to negotiate or alter the terms in such situations. The EU Directive on Unfair Terms in Consumer Contracts (Council Directive 93/13/EEC) as transposed into the Maltese Consumer Affairs Act, plays a significant role in this context, ensuring that terms, including harsh limitation of liability clauses, are unenforceable, if deemed unfair. The Consumer Affairs Act defines an unfair term as any term in a consumer contract, which on its own or together with other terms creates a significant imbalance between the rights and duties of the buyer and seller.
Conclusion: Fairness vs. Freedom of contract
As explained in the foregoing paragraphs, judgements emanating from the Maltese courts can be inconsistent when it comes to upholding penalty clauses and limitation of liability or exemption clauses. Indeed, the tension between fairness and freedom of contract is a central theme in contract law, balancing the autonomy of parties to create agreements as they see fit with the need to protect individuals from unjust or exploitative terms.
The fundamental principle of contractual freedom as enshrined in Maltese contract law, particularly under Article 992(1) of the Civil Code, (‘contracts legally entered into shall have the force of law for the contracting parties'), reflects the legal maxim ‘pacta sunt servanda' (that is, the idea that agreements must be honoured). We have seen from the judgements quoted above, that this is often upheld by the courts when taking decisions about penalty clauses and limitation of liability or exemption clauses. On the other hand, while freedom of contract empowers parties to negotiate and define their own obligations, fairness considerations ensure that this freedom does not lead to imbalances that undermine justice and equity. Ultimately, the challenge lies in finding the right balance, where contracts are respected for their voluntary nature, yet not at the expense of fairness, particularly in situations where power dynamics are unequal. Penalty clauses should represent a fair calculation of damages occasioned by a specific breach of the contract. In the same way, limitation of liability clauses should not operate to remove the right of the party suffering a breach from receiving fair compensation. In conclusion, while penalty clauses and limitation of liability clauses are generally enforceable under Maltese law, they are not immune to judicial scrutiny. The courts have consistently emphasized the need for fairness and good faith in contract execution, ensuring that these clauses do not unduly disadvantage any party. It is thus our opinion that the principle of pacta sunt servanda can (and should) be rejected in favour of the affidamento theory: in other words, it should be good faith, and not freedom of contract, that should govern the validity of contracts and contractual terms.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.