The new rules on penalty clauses - what do they mean for your business?

A business entering into a commercial contract will sometimes wish to include a clause that provides a form of compensation, payable to that business if the other party breaches the contract. For example, such a clause can require the breaching party to pay a sum of money and/or transfer assets to the innocent party. However, such clauses can fail if reviewed by the courts and deemed to have fallen foul of the penalty rules. 

The penalty rules provide that a clause requiring a payment of money will be unenforceable if the amount required to be paid was not a “genuine pre-estimate” of the loss that would be sustained by the innocent party because of the breach of contract. The rule’s main purpose was to prevent a party from recovering a sum of money that did not bear any relationship to the loss suffered because of the breach.

However, the above no longer reflects the current law, as the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi and Parking Eye Ltd v Beavis [2015],  changed the penalty rules fundamentally. Whether a sum payable by a party who beaches a contract is a penalty no longer hinges on the amount being a genuine pre-estimate of loss, but instead centres on whether the amount payable imposes a detriment on the contract breaker that is out of all proportion to any legitimate interest the innocent party may have. 

A clause will not necessarily be a penalty clause if it can be shown that there is a legitimate interest, or reason why compensation for the actual loss suffered would not provide sufficient compensation or remedy to an innocent party (for example, damage to a company’s reputation where the loss cannot be necessarily quantified). This approach allows the court to consider the entire commercial circumstances in a particular context, and to determine whether a clause really is a penalty in light of those commercial circumstances, even if the sum payable or the asset due to the innocent party does not reflect a genuine pre-estimate of loss.

The Supreme Court also narrowed the scope of the penalty rule, stating that the rule only applies to “secondary obligations”, which are obligations stated in a contract that are triggered when a breach of contract occurs. Additionally, the Court stated that only if the clause itself is “exorbitant” or “unconscionable” when compared to the legitimate interests pursued by the innocent party, should a court determine a clause as a penalty and therefore unenforceable. 

The judgment in Cavendish and Parking Eye should come as welcome news for businesses that have legitimate interests they wish to protect and enable them to impose financial consequences within contracts to act as deterrents for breaches of contract by the other party, provided that those consequences are not exorbitant or unconscionable when compared to the value of the interest the clause is protecting.