updated on 31 May 2016
QuestionWhat is a penalty clause?
Breaching a contract can have significant adverse consequences for the innocent party and many agreements contain clauses which try to manage the risk resulting from potential specific breaches. These clauses may oblige the breaching party to pay a pre-calculated sum to the innocent party in the event of a specific breach. Such sums are often referred to as liquidated damages.
While in general clauses for liquidated damages are part and parcel of many agreements, problems may arise if the sum payable under the contract for the breach does not represent a genuine pre-estimate of the loss suffered by the wronged party. The court may view the sum as extravagant or unconscionable, and could consequently regard the clause as a penalty clause. Such clauses are regarded as unenforceable.
Contracting parties are keen to avoid having a clause held to be a penalty clause by the courts because the unenforceable nature of such clauses means that the innocent party may be unable to claim the liquidated damages originally set out in the agreement. On this basis, commercial lawyers need to make sure any agreements featuring liquidated damages are reasonable and in keeping with case law.
Until very recently, the courts tended to approach the question of penalty clauses by focusing on whether the clause amounted to a "genuine pre-estimate of loss" and whether the purpose of the clause was to compensate the innocent party, as opposed to deterring breach. In June 2015 the Supreme Court was asked to decide whether the law on penalties should still apply and if so, whether its scope should be extended and/or clarified. This took place in the context of two key cases: ParkingEye v Beavis and Cavendish Square v El Makdessi.
In ParkingEye, an individual, Mr Beavis was fined the eye-watering sum of £85 for overstaying in a car park in a retail shopping centre in Chelmsford. Beavis had argued that the fine was far too high to be a genuine pre-estimate of the loss ParkingEye had suffered as a result of the breach and consequently, the fine couldn't be enforced.
The facts in Cavendish related to the sale of shares in an advertising agency whereby the terms for some of the payments to the seller, Mr Makdessi, were based on his fulfilling the terms of a non-compete clause. When the non-compete clause was breached, Makdessi claimed that the provisions relating to a reduction in payment for his shares were in effect a penalty clause and should therefore be unenforceable.
In considering the cases, the Supreme Court decided that the law on penalty clauses should remain in place and declined to extend it any further. But in an effort to clarify the law, the court set out the following test: a clause is likely to be considered to be penal in nature if “the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract”.
Crucially, the court also commented that clauses may now be justified even where they do not amount to a genuine pre-estimate of loss and/or are imposed as a deterrent, provided that the purpose of the clause is legitimate and the remedy is not out of all proportion to that legitimate interest.
As for the cases themselves, the Supreme Court, in what some in the media regarded as a surprising decision given that it went against the underdog, ruled that the overstay charge in ParkingEye was legitimate because it helped to deter abuse of the free car parking facility, and given that the charge was broadly in line with other charges levied by local councils for abusing parking times, it was not “exorbitant or unconscionable”. Similarly in Cavendish the court found that the buyer had a legitimate interest in limiting the payment for the shares in deterring Makdessi from breaching the non-compete clause. Although the clause seemed harsh, the court did not find it manifestly excessive when compared with the interest that the buyer was seeking to protect.
So how does this help commercial lawyers? If anything, it is now likely to be more difficult to challenge clauses as penalties in cases where both parties are well advised and of comparable bargaining power. That said, it remains difficult to say where the line is drawn between a clause which is "legitimate" and one whose effect is so disproportionate that it would amount to a penalty. As ever, much is likely to fall on the facts of the individual scenario. In relation to liquidated damages clauses, the purpose of the provision is usually to provide a mechanism to recover compensation for loss without having to go through the courts. Given this, a clause which allows recovery of amounts significantly higher than the innocent party's likely loss may still be vulnerable to challenge as a penalty.
Francesca Pole is a paralegal at Travers Smith.