The Penalty Clause: When It Works for You and When the Judge Cuts It

You signed a supply or construction contract with a clause that makes the late party pay a sum for every day of delay.

The other side ran late, you claimed the full amount, and the reply came back that you suffered no loss at all, or that the figure is excessive.

Or you are the one who ran late, and you have received a penalty claim you consider far larger than any real loss.

Either way, the answer lies in Articles 178 to 180 of the Civil Transactions Law. They are short articles, but they settle a great deal before a dispute even starts.

What the law says

Article 178 allows the contracting parties to fix the amount of compensation in advance, in the contract or in a later agreement. The law calls this agreed compensation.

No notice of default is required for it to become due.

Article 179 then sets four rules to govern it:

• Agreed compensation is not due if the debtor proves the creditor suffered no damage at all. The burden of proof here is on the debtor.
• At the debtor’s request, the court may reduce it if he proves it was excessive or that part of the original obligation was performed.
• At the creditor’s request, the court may increase it up to the actual damage if he proves the damage exceeded the agreed amount because of the debtor’s fraud or gross fault.
• Any agreement contrary to the article is void.

So the court does not reduce the amount of its own motion. Reduction is a request the debtor must make and support with proof.

Where the contract fixes no compensation, the court assesses it under the law. But in contract, a debtor who committed no fraud or gross fault is liable only for the damage that could normally have been foreseen when the contract was made, as Article 180 provides.

Money debts fall outside the penalty clause

Article 178 makes one express exception: if the obligation is a sum of money, compensation may not be agreed in advance.

That means a clause charging “a percentage for every day of late payment” does not survive this text.

That is where the Commercial Court in Jeddah landed, in first-instance judgment no. 4531041638 issued in 1445 AH.

The contract imposed 1% for each day of late payment, capped at 10% of the service value, and the circuit rejected the claim for that penalty.

It applied the Civil Transactions Law on the basis that the law extends to facts that occurred before it came into force, and it held that Article 178 is a matter of public order that the parties cannot contract out of.

The judgment is at first instance, and the data published by the Ministry of Justice does not show an appeal. A single judgment does not by itself make a settled trend, but it read the text as written.

Notice of default, and the demand before filing

The agreed amount needs no notice of default. That is the text of Article 178.

For compensation that was not agreed, the rule in Article 175 is that it is due only after the debtor has been put on notice, unless an agreement or a statutory provision says otherwise.

Notice is not needed in certain cases, including where the parties agreed that the debtor is in default as soon as the due date arrives, or where the debtor states in writing that he will not perform.

Notice may be given by any method the parties agreed or any method of service the law provides, including filing a lawsuit.

Here is a common confusion.

Being excused from notice under the substantive law does not excuse you from a procedural step in the commercial courts.

Under the Commercial Courts Law and its Implementing Regulation, the claimant must notify the defendant in writing to pay the amount claimed at least 15 days before filing.

The notification must state the parties’ details, the subject of the dispute, the requests and the document supporting the claim. It may be sent to any of the defendant’s addresses by any means, and proof of it must accompany the statement of claim, failing which the rules on non-registration of the claim apply.

The Regulation exempts from this notification claims concerning penalties under the commercial laws, claims to which a government body is a party, claims with their own filing procedures, small claims and urgent applications.

Termination clauses and exemption clauses

In a bilateral contract, if one party fails to perform, the other may, after putting him on notice, ask for performance or termination, with compensation in either case where warranted, and the court may refuse termination if the unperformed part is of minor importance. That is Article 107.

The parties may agree that the creditor can terminate on the debtor’s breach without a court judgment, as Article 108 allows, but such an agreement does not dispense with notice unless the parties expressly agreed to waive it.

So the words “the contract terminates automatically” are not enough on their own to spare you the notice.

Article 173 allows an agreement exempting the debtor from compensation for failing to perform, or delaying, a contractual obligation, except where that results from his fraud or gross fault. There can be no exemption from liability for a harmful act.

The parties may also agree that the debtor bears the risk of force majeure.

Older contracts and commercial contracts

The royal decree issuing the Civil Transactions Law provides that its rules apply to all facts that occurred before it came into force, with two exceptions:

• where a statutory provision or judicial principle relating to the facts conflicts with the law and one of the parties relies on it;
• where the matter concerns a limitation period that began to run before the law came into force.

So if your contract predates the law, do not assume it falls outside it. First ask whether your facts fit one of the two exceptions.

The decree also applies the law to commercial transactions, insofar as this does not conflict with their nature and no special provision exists in the commercial laws.

On 27 October 2026 the Council of Ministers approved the Commercial Transactions Law. Its text had not been published when this article was reviewed, so nothing is built on it until it is.

How to draft a penalty clause

I have separated what the text says directly from what we see in practice, so that law and opinion do not blur.

From the text

• Attach the penalty to non-monetary obligations, such as delivery dates, project milestones, notice periods and service levels.
• Do not write that the amount cannot be reduced, or that the debtor waives his right to seek a reduction. Article 179 makes that void.
• If you want termination without a court judgment, write an express termination clause together with an express waiver of notice.
• If you want the debtor to be in default on the due date for anything other than the agreed amount, say so expressly and name the channels for notice.
• Liability caps and exclusions do not protect against fraud or gross fault.
• A clause requiring conciliation and mediation before litigation makes that step mandatory before a commercial claim can be registered, so include it only if you mean it.

From practice, not from the text

• Express the amount as a rate per day or per week with an overall cap, and record in the contract how the two of you estimated the expected loss. That weakens any later argument that the figure is excessive.
• To protect payment, rely on security such as guarantees and retentions, together with the right to suspend performance or terminate, rather than a late-payment percentage.
• Keep evidence of your actual loss from day one, because the other side may argue that you suffered none.
• One well-drafted letter can serve both as notice of default and as the pre-filing demand.

Common mistakes

• “No penalty without a prior warning.” Article 178 does not require notice for the agreed amount.
• “A late-payment penalty is enforceable as long as it is written down.” Writing it down does not save it, because an obligation to pay money is excluded by Article 178.
• “The creditor must prove his loss first.” The burden is on the debtor to prove the creditor suffered none.
• “No reduction unless most of the obligation was performed.” The text is satisfied by performance of part of it.
• “The law does not apply to our older contracts.” It applies in principle, save for the two exceptions.
• “The commercial courts do not apply the Civil Transactions Law.” The decree extends it to commercial transactions where no special provision exists, and the Jeddah court applied it in the judgment above.

A penalty clause takes one line to write and can be invoked for years. If the sum is large, have a lawyer read the contract before you sign.