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Suppose a contract is signed by two parties, Party A and Party B. Suppose that the contract stipulates a severe financial penalty to be paid by Party A depending on whether or not an unrelated party, Party C, performs some action.

Party A has no control whatsoever over Party C.

If Party C chooses of his own accord to perform the prohibited action, does Party A have to pay the penalty?

To me, such a contract sounds more like a form of insurance (or maybe gambling). It seems like it might be invalid simply as a business agreement between two parties who are not in the insurance or gambling businesses.

But such a case is at the heart of a threatened lawsuit, so I thought it was worth checking here to see if anyone knows of case law that might weaken the threat against Party A.

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A contract is about risk allocation. One of the risks a contract can allocate is events outside the control of the contracting parties.

For example, who is responsible if government regulations change, if it rains, if a structure collapses and if a third party does or does not do any particular thing.

This does not make the contract an insurance contract or a contract for gambling. An insurance contract involves indemnification against all third parties. A gambling contract is primarily for wagering on an outcome i.e. the consideration from both parties is a bet.

If you are unwilling to take the risk as allocated don't enter the contract.

Now, no contract can have a penalty clause - these are unenforceable. However, being required to cover someone's actual or estimated costs is not a penalty clause.

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  • How do you tell the difference between a penalty clause and a liquidated damages clause? – user6726 Jun 11 '17 at 1:18
  • A penalty clause is not a genuine pre-estimate of the damage that would be suffered, an LD is. – Dale M♦ Jun 11 '17 at 1:39
  • Do they have to be written differently, or is it sufficient for the author to subjectively have an LD rationale in mind. E.g. the same phrasing but a label "LD" vs. "Penalty"? – user6726 Jun 11 '17 at 2:01
  • @user6726 I think you should post this as a question – Dale M♦ Jun 11 '17 at 4:20
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Absolutely possible and reasonable, if we take a concrete example.

I own a piece of land, which is worth $10,000 if there is no permission to build on the land, and $100,000 if there is permission. I applied for permission. You want to buy the land from me. The real value is determined by the third party who would decide whether the permission to build on the land would be given.

So after thinking about the risks, we sign a contract that you will pay me $80,000 for the land, and I will return all but $20,000 to you if the third party refuses to give permission to build on the land.

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