I. About This Article
A contractual penalty is one of the most frequently used legal mechanisms in business contracts. It is used to determine in advance the financial consequence of breach of obligation and to give the other party an additional incentive to perform the contract properly, on time and in good faith.
In business practice, contractual penalties appear in almost all types of contracts: contracts of work, lease agreements, supply agreements, service agreements, public procurement contracts, construction contracts, distribution agreements, partnership agreements and other commercial relationships.
However, a contractual penalty is not simply a sanction that is automatically and unlimitedly imposed on the party in breach.
The practice of the Supreme Court of Georgia shows that a contractual penalty clause must be assessed in light of its function, the nature of the breached obligation, the amount of the penalty, the status of the parties, the burden of proof and contractual balance.
A high contractual penalty is not reduced merely because it is high. However, a disproportionately high contractual penalty may be reduced by the court.
In practice, many disputes related to contractual penalties begin where the penalty clause is inserted into the contract mechanically, without the parties properly considering its legal nature, method of calculation, connection with the breached obligation and the risk of possible reduction by the court.
This article will help you understand what a contractual penalty means, what function it has in a contract, what the difference is between a fixed penalty and default interest, and what preconditions must exist for claiming a contractual penalty.
The article discusses the written form of contractual penalty, the importance of breach of obligation, whether damage must be proved, preconditions for reduction of contractual penalty by the court, burden of proof, calculation of contractual penalties and recent practice of the Supreme Court of Georgia.
It also explains the role of contractual penalties in contracts of work and lease agreements, their connection with withdrawal from contract and termination of long-term contracts, and when a contractual penalty clause may become legally problematic.
II. What Is a Contractual Penalty?
Under Article 417 of the Civil Code of Georgia, a contractual penalty is a monetary amount determined by agreement of the parties, which the debtor must pay for non-performance or improper performance of an obligation.
This means that a contractual penalty is a pre-agreed monetary sanction for breach of obligation. It does not arise merely because the contract contains a penalty clause. There must be a breach of obligation and a valid agreement on the contractual penalty.
A contractual penalty is an accessory obligation. Its existence depends on the principal obligation. If the principal obligation does not exist, or if its breach is not established, the claim for contractual penalty loses its legal basis.
In practice, a contractual penalty may be imposed for delay, quality breach, non-performance, partial performance, failure to submit documentation, delay in returning property, defective work or another contractual breach.
III. What Function Does a Contractual Penalty Have in a Contract?
According to the practice of the Supreme Court of Georgia, a contractual penalty has two main functions.
The first is the preventive function. The risk of imposing a contractual penalty psychologically affects the debtor and gives the debtor an additional incentive to perform the obligation properly, within the agreed time and according to the agreed procedure.
The second is the function of simple and quick compensation for damage. A contractual penalty allows the creditor, in case of breach of obligation, to claim a pre-agreed amount without proving the existence and amount of specific damage.
However, this does not mean that a contractual penalty should become a source of unjust enrichment for the creditor or a self-standing mechanism for punishing the debtor. The purpose of a contractual penalty is to secure performance of an obligation and fairly protect the breached contractual interest.
In practice, well-drafted contractual penalty clauses often reduce dispute risk, while vague or disproportionate penalty clauses may themselves become the main subject of dispute.
IV. In What Form Must a Contractual Penalty Be Agreed?
An agreement on a contractual penalty requires written form. This means that, for claiming a contractual penalty, there must be a written clause defining the basis of the penalty, its amount or the method of its calculation.
The parties should specify in the contract which breach of obligation will trigger the debtor’s obligation to pay the contractual penalty. A general clause is often insufficient if, in a dispute, it is unclear which specific breach was covered by the agreed sanction.
A contractual penalty may be determined as a fixed amount, percentage, amount accrued for each day of delay or through another calculation mechanism. The main point is that its amount or calculation method must be identifiable.
V. What Is the Difference Between a Penalty and Default Interest?
The main forms of contractual penalty are a fixed penalty and default interest or accrued penalty.
A fixed penalty is usually imposed as a predetermined amount or through a specific calculation method for non-performance or improper performance of an obligation. Its purpose is to protect the creditor’s interest in proper performance of the contract.
Default interest or accrued penalty is most often used where an obligation is not performed within the agreed time. It is usually calculated daily, weekly or with another periodicity and increases according to the duration of delay.
Therefore, when drafting a contract, it is important to define whether the contractual penalty is a one-time fixed sanction, an accumulating amount for delay or a combination of both.
VI. When Does the Right to Claim a Contractual Penalty Arise?
The right to claim a contractual penalty arises when three main preconditions exist: a written agreement on the contractual penalty, breach of the principal obligation and a type of breach that is connected with the contractual penalty provided in the contract.
A contractual penalty cannot be imposed merely because the contract generally contains a penalty clause. It must be established that the specific obligation was breached and that the breach corresponds to the penalty clause relied on by the creditor.
For example, if one contractual penalty is provided for delay in performance of work, while another penalty is provided for failure to remedy defects, the creditor must prove that the specific factual circumstance corresponds exactly to the precondition of the sanction being claimed.
VII. Is It Necessary to Prove Damage When Claiming a Contractual Penalty?
As a rule, when claiming a contractual penalty, the creditor is not required to prove the existence and amount of specific damage. It is sufficient to establish breach of obligation and a valid agreement on the contractual penalty.
This is one of the main practical advantages of a contractual penalty. It allows the creditor to claim the pre-agreed amount quickly, regardless of what specific damage was caused and whether the creditor can prove that damage with documents.
However, if the creditor also claims damages exceeding the contractual penalty, then the additional damage must be proved under the general rules. A contractual penalty does not exclude a damages claim, but the additional amount of damage must be substantiated independently.
VIII. When Can the Court Reduce a Contractual Penalty?
Under Article 420 of the Civil Code of Georgia, the court may reduce a disproportionately high contractual penalty in light of the circumstances of the case.
One important distinction should be made: a high contractual penalty is not reduced automatically. Only a contractual penalty that is disproportionately high in the specific circumstances may be reduced.
The court assesses whether the contractual penalty is clearly disproportionate to the consequences of the breach. In this assessment, relevance may be given to an especially high penalty rate, insignificant amount of damage, short period of breach, degree of the debtor’s fault, financial condition of the parties, the creditor’s real interest and other circumstances.
Court intervention in a contractual penalty is an exception from the principle of freedom of contract. On the one hand, parties have the right to determine the contractual penalty themselves. On the other hand, this freedom is not absolute and should not become an unfair or disproportionate burden.
IX. What Must a Party Prove When Requesting Reduction of a Contractual Penalty?
A debtor requesting reduction of a contractual penalty must substantiate why the agreed or claimed penalty is disproportionately high. A general statement that the amount is “large” or “unfair” is not sufficient.
The debtor should refer to specific circumstances: duration of the breach, value of the breached obligation, partial or full performance, real scale of the creditor’s interest, degree of fault, possible damage, economic burden and other circumstances.
On the other hand, the creditor must substantiate why the claimed contractual penalty corresponds to its contractual interest and the consequences of the breach.
X. Why Does Reduction of a Contractual Penalty Not Mean Its Cancellation?
The practice of the Supreme Court of Georgia has repeatedly emphasized that reduction of a contractual penalty does not mean cancellation of the penalty.
If a contractual penalty is cancelled entirely or reduced to a symbolic amount, it loses its main function — preventive securing of performance and protection of the creditor’s minimum interest in case of breach.
The court’s task is not to cancel the contractual penalty, but to reduce it to a fair and reasonable amount. A contractual penalty should be proportionate, balanced and reasonable in relation to the breach.
This is especially important where the debtor is an entrepreneur. Court practice indicates that an entrepreneur, as a professionally acting person, is held to a higher standard of understanding contractual risks. Therefore, where breach is established, a contractual penalty imposed on an entrepreneur should not be reduced to a merely symbolic amount.
XI. How Should a Contractual Penalty Be Calculated – From the Total Contract Value or the Value of the Breached Obligation?
Calculation of a contractual penalty is one of the most important and disputed issues in practice.
According to the practice of the Supreme Court of Georgia, where only part of an obligation is breached, the contractual penalty should generally be calculated not from the total value of the contract, but from the value of the obligation that was actually unperformed or improperly performed.
Calculating a contractual penalty from the total contract value may contradict the standards of security of civil circulation and good faith if the breach concerns only a partial or minor obligation.
For example, if the contract has a high total value, but only a small part is breached, or delay concerns only specific work, calculating the penalty from the entire contract value may lead to a disproportionate result.
In practice, when drafting a contractual penalty clause, a business should define in advance whether the sanction will be calculated from the total contract value, the value of a specific stage, the value of unperformed work or the unpaid amount. This reduces the risk of future dispute.
XII. What Is the Importance of Contractual Penalty in a Contract of Work?
In a contract of work, a contractual penalty is often used for delay in performance, defective performance, non-performance of work or breach of the acceptance-handover process.
In contract of work relationships, it is especially important that the penalty clause be precisely connected with a specific obligation: completion deadline, intermediate stage, remedy of defect, quality standard or another defined duty.
If a contractual penalty is drafted vaguely in a contract of work, a dispute may arise over what case it applies to — delay, non-performance, defect or termination of the contract.
For more information about the main legal risks of contracts of work, see our blog: Contract of Work in Georgia — What Businesses Should Know About Performance, Remuneration and Termination.
XIII. What Is the Importance of Contractual Penalty in a Lease Agreement?
In a lease agreement, a contractual penalty may relate to late payment of lease rent, improper use of property, delay in returning the property, early termination of the contract or another contractual obligation.
In lease relationships, contractual penalty clauses should be drafted particularly carefully because they often concern periodic obligations, long-term relationships and accumulating financial sanctions.
In case of non-payment or late payment of lease rent, default interest or an accrued penalty may increase daily or with another periodicity, which can create a significant amount over time. In such a case, the court may assess whether the claimed contractual penalty is proportionate to the nature of the breach and the creditor’s interest.
For more information about legal risks in lease agreements, see our blog: Lease Agreement in Georgia — What Businesses Should Know About Rent, Termination and Dispute Risks.
XIV. Contractual Penalty and Termination of Contract
The relationship between contractual penalty and withdrawal from or termination of contract requires particular attention.
As a general rule, if the creditor seeks termination of the contract, the possibility of claiming a contractual penalty depends on how this issue is regulated in the contract and what type of contractual penalty the parties agreed on.
The practice of the Supreme Court emphasizes that, in case of unilateral termination of a contract, imposing a contractual penalty is lawful where the contract directly provides for payment of a specific penalty amount in case of withdrawal from or termination of the contract.
For the general standard of terminating a long-term contract, see our blog: Termination of a Long-Term Contract in Georgia – What Businesses Should Know About Article 399 of the Civil Code.
If the contractual penalty is connected with withdrawal from or termination of the contract, the parties should clearly define: when the obligation to pay the amount arises, whether it is a contractual penalty imposed for breach of obligation or a penalty amount agreed for withdrawal from contract, and whether it may be claimed together with other claims.
XV. When Can a Contractual Penalty Clause Become Legally Problematic?
A contractual penalty clause may become legally problematic in several cases.
First, if the contractual penalty is clearly disproportionate to the consequences of breach. In such a case, the court may reduce it under Article 420 of the Civil Code of Georgia.
Second, if the contractual penalty is determined in a way that disturbs contractual balance and is actually used not to secure performance of an obligation, but to impose an unreasonable financial burden on the other party.
Third, if the contractual penalty clause is vague and it is unclear which specific obligation it relates to. In such a case, establishing the legal basis for claiming the penalty may become difficult in a dispute.
Fourth, if the contractual penalty clause contradicts mandatory legal requirements or is used to circumvent the law. In such a case, not only reduction of the contractual penalty, but also validity of the relevant contractual clause may become an issue.
For more information about general legal standards related to unlawful contractual clauses, see our blog: Unlawful Transaction — When Can a Contract Be Declared Void?
XVI. What Should a Business Consider When Drafting a Contractual Penalty Clause?
When drafting a contractual penalty clause, a business should first define what purpose the penalty serves. Different approaches are required where the contractual penalty is intended to secure timely performance, quality of work, consequences of withdrawal from contract, return of property or delay in payment.
The contract should define: which breach of obligation triggers the contractual penalty; whether the penalty is a fixed penalty or default interest/accrued penalty; in what amount or by what formula the amount is calculated; when accrual begins; when accrual stops; with what other claims the contractual penalty may be requested; whether additional damages may also be claimed; and what happens in case of termination of or withdrawal from the contract.
In practice, proper drafting of a contractual penalty clause is especially important in business contracts where risks related to deadlines, stage-based performance, payment, delivery, quality of work or return of property are high.
XVII. How TB Legal Can Help
Within our contract law services, TB Legal assists businesses with drafting contractual penalty clauses, legal assessment of existing contracts, and development of strategies concerning imposition or reduction of contractual penalties, withdrawal from contract, damages and contractual disputes.
Our approach is based not only on formal analysis of the contract text, but also on assessment of the parties’ real commercial interests, court practice, evidence and possible dispute risks.
If you plan to include a contractual penalty in a contract, already have a dispute concerning imposition of a penalty or want to assess whether reduction of the contractual penalty is possible, it is important to obtain legal advice before making a decision.
XVIII. Conclusion
A contractual penalty is an important legal instrument in a contract. It simultaneously performs the function of securing performance of an obligation and providing minimum financial compensation in case of breach.
However, a contractual penalty clause should not be mechanical. It should be connected with a specific obligation, have a clear calculation method and maintain a reasonable balance between the creditor’s interest and protection of the debtor.
The practice of the Supreme Court of Georgia shows that the court protects the parties’ freedom of contract, but, in case of a qualified objection, may reduce a disproportionately high contractual penalty. Therefore, the best approach for businesses is not only to include a contractual penalty in the contract, but to formulate it in a legally correct, proportionate and practically enforceable way.
Contact TB Legal if you need preparation of a contractual penalty clause, assessment of an existing contract or a strategy for a dispute related to contractual penalties. We will help you analyse legal risks, choose the right approach and protect your business interests.
XIX. Supreme Court Decisions Used
This article is based on the following decisions and rulings of the Supreme Court of Georgia:
- Supreme Court of Georgia, case No. AS-1171-2021, 18 March 2022, Tbilisi.
- Supreme Court of Georgia, case No. AS-1182-2025, 27 November 2025, Tbilisi.
- Supreme Court of Georgia, case No. AS-862-828-2016, 24 February 2017, Tbilisi.
- Supreme Court of Georgia, case No. AS-1052-2024, 30 October 2024, Tbilisi.
- Supreme Court of Georgia, case No. AS-1221-2024, 17 October 2024, Tbilisi.
- Supreme Court of Georgia, case No. AS-918-2024, 11 October 2024, Tbilisi.
- Supreme Court of Georgia, case No. AS-890-2024, 7 August 2024, Tbilisi.
- Supreme Court of Georgia, case No. AS-946-2024, 7 August 2024, Tbilisi.
- Supreme Court of Georgia, case No. AS-1389-2023, 30 January 2024, Tbilisi.
- Supreme Court of Georgia, case No. AS-330-2023, 31 October 2023, Tbilisi.
- Supreme Court of Georgia, case No. AS-400-2023, 20 October 2023, Tbilisi.
- Supreme Court of Georgia, case No. AS-941-2022, 31 October 2022, Tbilisi.
- Supreme Court of Georgia, case No. AS-1268-2020, 21 June 2022, Tbilisi.
- Supreme Court of Georgia, case No. AS-525-2020, 11 May 2022, Tbilisi.
- Supreme Court of Georgia, case No. AS-827-2021, 3 December 2021, Tbilisi.
Disclaimer
This article has been prepared for general informational purposes only and does not constitute individual legal advice or a legal opinion. The issues discussed in this article may be assessed differently depending on the specific factual circumstances, contract terms, conduct of the parties and relevant evidence.
Before making a decision in a specific matter, it is recommended to obtain individual legal advice from a qualified lawyer.
