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Supreme Court upholds rule against penalties and provides new test

Emily Parris
04/11/2015
After much speculation that the Supreme Court would either abolish the rule against penalties or narrow its scope to exclude commercial bargains, today the Supreme Court has unanimously upheld the After much speculation that the Supreme Court would either abolish the rule against penalties or narrow its scope to exclude commercial bargains, today the Supreme Court has unanimously upheld the validity of the rule while reformulating it.

Cavendish Square Holding BV (Appellant) v Talal El Makdessi (Respondent); ParkingEye Limited (Respondent) v Beavis (Appellant) [2015] UKSC 67.

The rule against penalties is a longstanding rule under English law, based on public policy, that a contractual provision is invalid and unenforceable if it seeks to punish a party for failing to comply with the contract, i.e. if it is penal in nature.

Until recently, the courts have rarely had to apply the rule to anything other than straightforward liquidated damages clauses. As more complex cases have come before the courts, the test for determining whether a contract provision is penal or not has evolved. The approach of the courts, before today's judgment was broadly:

1. Decide whether the provision is "unconscionable and extravagant", designed to deter a party from breach, or a genuine pre-estimate of loss (by applying the four-part "test" from Dunlop Pneumatic Tyre Company Ltd. v New Garage and Motor Company Ltd. [1915] AC 79)

2. If the clause is unconscionable or extravagant, or not a genuine pre-estimate of loss, assess whether it is nonetheless commercially justifiable.

The Supreme Court today:

1. Said that, in the past, the courts have taken an over-literal reading of the test in Dunlop. The courts have tended to treat the test as definitive; and that is unfortunate, as it was never intended to be applied in that way.

2. Criticised the often-drawn distinction between a penalty and a genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent.

3. Expressed misgivings about the concept of "commercial justification". A clause could be commercially justified but nonetheless have the purpose of a deterrent.

4. Refused to abolish the rule against penalties. Instead the Supreme Court set out the correct approach. The courts should identify what legitimate interest the innocent party has in enforcing the other party's primary obligation (i.e., the obligation that, if breached, will trigger the alleged "penalty"). The question then is whether the alleged penalty "imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.".

5. Recognised that the innocent party's "legitimate interest" could be to obtain compensation for the default, but that the innocent party might have other legitimate interests, for example, maintaining a system of trade between a group of trading partners.

6. Said that in negotiated contracts between properly advised parties of comparable bargaining power, there is a strong presumption that the parties themselves are the best judges of what is legitimate in a provision dealing with consequences of a breach.

7. Confirmed that the rule against penalties applies only where the alleged "penalty" is a consequence of a breach of contract. The Supreme Court recognised that this means that it is possible to draft around the rule.

Commercial parties use liquidated damages provisions to provide certainty and to incentivise proper performance, so it's important to get the formulation right to prevent the clause being invalidated as a penalty. The lowest risk approach to drafting a liquidated damages clause is to ensure that any obligation to pay a specified sum is not activated on breach of a contractual obligation, but rather it is expressed as payable on the contingency of a specific event (which isn't breach).

For example, if a customer wants to provide for liquidated damages for delay, one option would be to prescribe an amount payable by a supplier for each day the delivery of goods is delayed, without including a contractual obligation to deliver by a certain date. This means that the primary obligation would be to pay the liquidated damages, and the liquidated damages wouldn't be a punishment for breach of a contractual obligation (and therefore potentially construed as a penalty). However, we would suggest that this approach is only suited to low-risk areas of performance, or aspects of performance where the innocent party is willing to limit its recovery rights to the amount of liquidated damages, and does not require the full quota of contractual rights and remedies (e.g. damages, contractual termination rights and/or common law rights on the other party’s repudiatory breach).

Keep an eye out for a more detailed analysis and what this means for your business.

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