When drafting contracts, businesses often include penalty clauses to ensure compliance with key obligations. However, recent Bulgarian case law reveals that such clauses are frequently scrutinized and, at times, invalidated due to conflicts good faith. This article examines when a penalty clause may be declared invalid under Bulgarian law and offers guidelines to create enforceable clauses that withstand judicial review.
When a Penalty Clause May Be Deemed Invalid
Bulgarian courts have clarified that if the penalty goes beyond its compensatory, security, or sanctioning functions it may be deemed null and void. The primary reasons cited include:
Contradiction with good faith principles: A penalty clause that disproportionately favors one party at the expense of fairness may be voided. For instance, in a 2024 ruling, the court found that a clause imposing an excessive penalty amount did not align with good faith principles, especially given the asymmetrical relationship between the parties. Clauses that go beyond what is necessary to secure the contracting party’s legitimate interests are likely to face invalidation.
Key Considerations for Drafting Penalty Clauses
To ensure that a penalty clause is enforceable, contract drafters should consider the following guidelines:
1. Proportionality and Fairness
Penalty clauses should reflect the actual potential damage caused by non-compliance rather than imposing excessive burdens on the breaching party.
2. Transparency in Contractual Terms
Penalty clauses should reflect the actual potential damage caused by non-compliance rather than imposing excessive burdens on the breaching party.
3. Avoiding Unnecessary Restrictions
While penalty clauses may protect against specific breaches, overly restrictive terms, should be avoided. Penalty clauses must be balanced to avoid exceeding their role.
In both cases reviewed, the court’s decision underscored the importance of carefully designing penalty clauses. The court emphasized that the agreed penalty amount should be tailored to the specific obligation it secures and reflect the actual damages likely to result from a breach. If the penalty goes beyond its compensatory, security, or sanctioning functions—considering the agreed amount and reasons for inclusion—then it may be deemed disproportionate. Criteria for assessing whether a penalty exceeds its essential functions include evaluating not only the clause’s content but also additional factors such as the freedom to negotiate, equality between the parties, the intended functions of the penalty, and whether the defaulting party has the means to limit the breach’s impact. This approach ensures the penalty does not become a tool for unjust enrichment.
Moreover, if a penalty clause primarily serves to enrich the creditor rather than cover actual losses caused by the debtor’s breach, it contravenes the functions and principles underlying penalty clauses. This constitutes a violation of accepted standards of good morals as they currently stand in society, standards that have been accorded legal significance under Article 26, paragraph 1, clause 3 of the Bulgarian Obligations and Contracts Act. Assessing whether an agreed penalty is appropriate thus requires a comprehensive analysis that respects these principles. Penalty clauses are essential tools for managing risk in contractual relationships. However, drafting these clauses requires a nuanced approach that respects legal boundaries and balances the interests of both parties. By ensuring proportionality, clarity, drafters can create robust, enforceable clauses that are more likely to be upheld by Bulgarian courts.
