Where a contract calls for one party to make a series of payments as compensation for the other party’s performance over a fixed term, the agreement also may contain a clause that requires the party paying for performance to pay an early termination fee (ETF) if it terminates the agreement prior to its expiration. An ETF clause allows the performing party to offer an attractive rate secured in the belief that it will benefit from the transaction through either payments during the life of the agreement or a combination of such payments and the ETF. The ETF also might discourage the paying party from migrating to a competitor during the term of the agreement. A lower price offered by a competitor might not be attractive when the ETF that would be owed upon termination is taken into account.
Under New York law, freedom of contract prevails in an arm’s length transaction between sophisticated parties, and a court will not relieve a party of the consequences of its bargain in the absence of a countervailing public policy concern.1 Such freedom, however, does not embrace the freedom to exact a penalty, even by agreement.2 The imposition of a penalty is exclusively the prerogative of the sovereign and a contractually imposed penalty is unenforceable.3 This judicial check upon freedom of contract may come into play when the parties agree to an ETF.4
