In our previous edition, we dealt with service level agreements. In this issue, we deal with the topic of penalty clauses, often called service credits, in technology transactions.

Often in service level agreements, parties will agree that in the event of non-adherence to contracted service levels, and in the absence of relief events or excused performance events being applicable, the service provider will be liable to pay the customer some form of penalty. Such penalties are often expressed as a percentage of the service fees payable in the measurement period but sometimes may also be fixed amounts.

In most jurisdictions, penalty clauses are valid and enforceable subject to certain exceptions. Under the Conventional Penalties Act, 1962 (South Africa):

  • penalty clauses are enforceable;
  • penalties may take the form of a sum of monetary payment or delivery or performance
  • the customer is not entitled to claim damages in lieu of a penalty, save where the contract expressly provides for otherwise; and
  • a Court is empowered to reduce a penalty if the penalty appears to the court to be disproportionate to the prejudice suffered by the customer.

In practise, a well-crafted service level agreement must not only take into account the effect of the Conventional Penalties Act on penalty clauses, but should also strike a balance between incentivising proper behaviour on the part of the service provider versus penalising a service provider for failures. Penalty clauses should also not be drafted in isolation without consideration of the parties other remedies in the agreement, and specifically the interplay between penalties and claims for damages needs to be carefully considered.

From a customer perspective, some dubious arguments made by service provider's against the inclusion of penalty clauses include:

  • the service provider did not build penalties into its pricing;
  • the inclusion of penalties will have the effect of destroying morale of service provider staff; and
  • penalties act as a deterrent to the service provider to actually want to rectify a breach of a service level or the impact of such breach.

Customers often cite the fact that a penalty mechanism is merely a slap on the wrist as the customer is still liable to pay the service provider the full service fee in the event of defective performance on the part of the latter.

From a service provider perspective, some arguments advanced include:

  • penalty clauses are naturally of concern to the service provider as it directly impacts on revenue generated from a customer and is not acceptable;
  • some customers notoriously use penalties as a mechanism to claw back fees paid or future fees payable, especially where the customer feels that the pricing being paid is too high or that insufficient value is being received for the money paid or where customer staff are incentivised to drive cost savings;
  • the service provider should be entitled to claw back or earn-back penalties in the event of improved performance in future;
  • the service provider should be financially rewarded for exceeding performance expectations; and
  • customers themselves should be penalised in the event of certain types of non-performance on the part of the customer.

The negotiation of penalty clauses is often one of the more commonly debated aspects in contracting for services and sometimes legal counsel are excluded from this process often with disastrous consequences especially where there is a failure to consider both legislation as well as the impact on other remedies under the agreement. However, with sound advice from an experienced commercially minded legal team, the drafting and negotiation of penalty clauses should be a relatively painless process.

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.