Penalty Clauses in Commercial Contracts and When a Judge May Adjust Them

Many traders and companies agree in their contracts on a fixed amount that the party in breach must pay without any need to prove the extent of the damage. This agreement is called a penalty clause or liquidated damages. The Civil Transactions Law now regulates it expressly, whereas it was previously governed by judicial interpretation. This article concerns every company that signs supply, construction or service contracts and every individual who enters into a commercial obligation for a fixed term.

In Brief

A penalty clause is valid and enforceable in principle, and both parties are bound by it as they are bound by the other terms of the contract. However, the court may decline to award it if the debtor proves that the creditor suffered no damage at all. The court may also reduce it at the debtor’s request if the amount was grossly exaggerated or if part of the obligation was performed. An agreement that deprives the debtor of these defences or prevents the court from considering them is not valid.

What Is a Penalty Clause in Commercial Contracts?

A penalty clause is a term in which the contracting parties fix in advance the amount of compensation due upon breach of an obligation or delay in performing it. Examples include a daily amount payable by a contractor for each day of delay in handover, or a lump sum payable upon breach of a supply contract. This clause may appear in the contract itself or in a later agreement signed by the parties before the breach occurs.

Its purpose is to let each party know in advance the cost of its breach and to shorten the dispute over assessing damage before the court. In principle, the creditor does not need to prove the size of its loss because the parties estimated it in advance when they contracted.

Is a Penalty Clause Binding Under Saudi Law?

Yes. A penalty clause is binding in principle and is treated like all other contract terms the parties have accepted. Article 178 of the Civil Transactions Law provides that the contracting parties may fix the amount of compensation in advance in the contract or in a later agreement. This regulation was preceded by a resolution of the Council of Senior Scholars that permitted penalty clauses in contracts but excluded those relating to debts.

This binding effect is not absolute, however. The law gives the debtor means of defence and gives the court the power to review the agreed amount. These means are the focus of the questions below, and in practice they determine the outcome of many claims.

When Is the Creditor Not Entitled to the Penalty Amount?

Article 178 of the Civil Transactions Law provides that agreed compensation is not due if the debtor proves that the creditor suffered no damage. A penalty clause is an estimate of compensation and not a penalty independent of damage. If there is no damage, there is no basis for entitlement. The burden of proving the absence of damage lies on the debtor and not on the creditor, and this is the key practical difference between having the clause and not having it.

The law also requires in principle that the breach be attributable to the debtor and not to an external cause beyond its control. If a contractor proves, for example, that the delay resulted from force majeure or from an act of the employer, the clause does not apply to that period. The law further requires in principle that the debtor be served with a notice of default before compensation is claimed, unless the parties agreed to waive notice or the law provides that it is not required.

When May the Judge Reduce a Penalty Clause?

Article 178 permits the court, at the debtor’s request, to reduce agreed compensation in two cases. The first is where the debtor proves that the estimate was so exaggerated that it bears little relation to the actual damage. The second is where the debtor proves that the original obligation was partly performed, in which case the amount is reduced in proportion to what was performed.

Reduction is not made by the court on its own initiative. It requires a request from the debtor supported by evidence. If the debtor does not request a reduction or fails to prove exaggeration, the agreed amount is in principle awarded. For this reason, the party claiming under the clause needs to document its damage, and the debtor needs to document the obligations it has performed.

The law does not define exaggeration by a figure or a percentage. The court assesses it according to the circumstances of each contract and the scale of the likely damage. The court may look at the amount as a proportion of the contract value, the nature of the business and commercial custom in similar dealings.

Can the Creditor Claim More Than the Penalty Amount?

In principle, the creditor may not claim more than the agreed amount even if its actual damage exceeds that amount. Article 179 of the Civil Transactions Law makes an exception where the creditor proves that the debtor committed fraud or gross negligence. In that case the creditor may claim full compensation for its damage and bears the burden of proving this and the amount of the damage.

This rule means that a penalty clause works in both directions. It protects the creditor from the difficulty of proof and protects the debtor from unexpected claims. The amount should therefore not be set far below the expected damage, because the creditor may find itself limited to it.

May the Parties Agree to Prevent the Judge From Adjusting the Clause?

No. The law declares void any agreement that contradicts the rules on non-entitlement and reduction set out in Article 178. If a contract states that the debtor waives its right to request a reduction, that provision does not prevent the court from hearing the request. The rest of the contract remains valid in principle, and only the effect of the offending provision falls away.

Likewise, the law in principle does not recognise a clause that exempts the debtor from liability for its fraud or gross negligence. Drafting broad limitation of liability wording without regard to these restrictions may give the parties a sense of security that does not hold up in a dispute.

Is a Penalty Clause Valid for Late Payment of Debts?

This is one of the most common drafting mistakes in commercial contracts in the Kingdom. Sharia and judicial interpretation have settled that a penalty clause is not valid where the original obligation is a monetary debt. Requiring the buyer to pay an additional amount or a monthly percentage if it is late in paying the price is treated as an increase in the debt and takes the ruling of riba.

This differs from a penalty clause for delay in performing work, delivering goods or providing a service, which is permissible in principle. To protect the creditor in debts, contracting parties usually rely on other securities such as a promissory note, a guarantee, a pledge or acceleration of instalments upon late payment.

Do These Rules Apply to Contracts Signed Before the Civil Transactions Law?

The Civil Transactions Law entered into force in late 2023 and became the general legal reference for penalty clauses. In principle its provisions apply to events occurring after it came into force, and there are transitional provisions concerning earlier contracts and transactions. Older contracts in which a breach occurred therefore need specific review to determine which rules govern the dispute.

What to Do Now

Review the penalty clauses in your existing contracts and make sure each amount is tied to a specific obligation and has a commercial rationale that can be explained to the court. A clause that shows the basis of its estimate is more likely to hold up than a clause that sets a large amount with no clear link to the likely damage.

Set an overall cap on daily penalties at a reasonable percentage of the contract value, and tie the start of their calculation to a clear date and a written notice of default. Separate the penalty for delay from the penalty for total non-performance so that both amounts do not accumulate on the same event.

Keep a documented record of actual damage, including correspondence, invoices and delivery records, because the debtor may argue that there was no damage or that the amount is exaggerated. If you are the obligated party, document what you have performed and any causes of delay beyond your control as they arise.

Avoid any provision that imposes a financial increase for late payment of the price and replace it with lawful securities that protect your rights. Have major contracts reviewed by a lawyer before signing, because amending the wording at that stage is far easier than disputing it later.

Frequently Asked Questions

Must the creditor prove damage to claim under a penalty clause?

In principle the creditor does not need to prove the amount of damage because the parties estimated it in advance in the contract. The debtor bears the burden of proving that the creditor suffered no damage or that the estimate is exaggerated if it wants the amount set aside or reduced.

Can the judge increase the penalty if the damage is greater?

In principle the judge does not increase the amount even if the actual damage is much greater. The exception is where the creditor proves that the debtor committed fraud or gross negligence, in which case full compensation may be awarded.

May the court set aside the penalty clause entirely?

The court may decline to award the amount if the debtor proves that the creditor suffered no damage at all. The clause is also not enforceable if the breach was due to an external cause or if the clause relates to late payment of a monetary debt.

Do penalty clause rules differ in government contracts?

Contracts with government entities are governed by the Government Tenders and Procurement Law and its Implementing Regulations, which contain specific provisions on delay penalties and their caps. Those specific provisions should therefore be reviewed alongside the general rules in the Civil Transactions Law.

If you have existing contracts that contain penalty clauses or you are preparing to sign a new contract, the Contract Drafting and Review team at Perfect Solution Lawyers and Consultants can review them and propose balanced wording. We welcome your request through our meeting request page to arrange an appointment with one of our lawyers.

This article is based on the Civil Transactions Law, the resolution of the Council of Senior Scholars on penalty clauses, and the Government Tenders and Procurement Law and its Implementing Regulations.

This article is for general awareness and does not constitute legal advice. Each case should be presented to a qualified lawyer before any decision is made.