Penalty Clauses – ‘significant implications’ for businesses following changes
Pannone Corporate

English law upholds the principle of contractual autonomy, granting parties the freedom to negotiate and establish terms tailored to their specific needs and objectives. Contractual certainty is business critical in order to clearly delineate duties and obligations and to provide recourse for an innocent party in the event of a breach.

For contracting parties, it is important to note that contractual autonomy is not absolute and operates within legal frameworks aimed at ensuring fairness and equity in contractual relationships. This article explores the limitations designed to prevent abuse and safeguard parties from unfair or oppressive clauses.

Understanding Penalty Clauses

A contractual term that specifies predetermined consequences for a breach of contract is known as a “liquidated damages” clause. The purpose of this type of clause is not to punish the breaching party but rather to estimate, in a reasonable and realistic manner, the likely losses that would result from the breach. Importantly, the pre-estimate must be made at the time the contract was made (Clydebank Engineering v. Castaneda). This should not be confused with a penalty clause, which imposes excessive financial penalties to deter breaches and can be unenforceable if challenged in court.

The complexity of distinguishing between these two types of clauses often leads to legal challenges, with courts examining the true nature of the clause and the context of its inclusion in the contract. Factors that can be considered include the rationale behind the clause, the bargaining power of the parties, and whether the sum stipulated is excessively high or unconscionable.

Understanding whether or not a clause may amount to a penalty clause could have costly consequences. If a clause is deemed to amount to a penalty clause, it could be struck out as unenforceable.

Evolution of the Test for Penalty Clauses

The legal framework surrounding penalty clauses in UK law has significantly evolved, especially following key judicial decisions that have reshaped their assessment and enforceability.

Historical Perspective:

Historically, the assessment of penalty clauses revolved around the concept of exorbitance in relation to common law damages. In Dunlop Pneumatic Tyre Co Ltd v. New Garage & Motor Co Ltd [1915], the court held that a clause would be considered a penalty if it was not a genuine pre-estimate of costs or sought to impose a detriment on a party out of proportion to the innocent party’s legitimate interest in enforcing the contract.

Shifts in the legal test:

In recent years, the UK courts have moved away from the strict prohibition of penalty clauses. The Supreme Court judgment in Cavendish Square Holding BV v. Talal El Makdessi and ParkingEye Limited v. Beavis [2015] noted that the Dunlop test had taken on the status of a “quasi-statutory code”, which was never the intention.

Lords Neuberger, Sumption and Carnwath took a more nuanced stance, emphasising that the rule on penalty clauses does not permit the courts in every instance to review the fairness of a contractual term when parties can be said to have equal bargaining power. Instead, the focus will be on whether the term in question is a primary or a secondary obligation.

Key principles when assessing penalty clauses:

  • Primary vs. secondary obligations: A primary obligation refers to an obligation that arises independently of a breach of contract, while a secondary obligation is triggered by a breach. The Supreme Court emphasised that the penalty rule applies only to secondary obligations. This distinction is crucial in determining the enforceability of penalty clauses, as primary obligations are not subject to the penalty rule.
  • Legitimate interest and proportionality: The court highlighted the importance of assessing the legitimate interest in enforcement of the clause in question. The penalty rule will not be engaged if the clause serves a legitimate commercial purpose and is proportionate to the interest being protected. This requires courts to consider the context and commercial rationale behind the clause when determining its enforceability.
  • Unconscionability or exorbitance: Even if a clause constitutes a secondary obligation, it may still be enforceable if it is not unconscionable or exorbitant in relation to the legitimate interest which is served by the clause. The courts will assess whether the clause imposes a penalty that is disproportionate to the loss suffered or the legitimate interest being protected. This requires a contextual analysis that considers the specific circumstances of the case.

The following can act as a checklist when considering whether or not a clause is likely to fall foul of the law of penalties: