All change – Moving the goalposts on penalty clauses

Commercial contracts often contain clauses which proscribe the amount that will be payable by one party to another in the event of a breach. Such clauses require careful drafting – if they are found to be a penalty, they are unenforceable.

For the last hundred years, the test for determining whether a clause was a penalty was to consider whether the amount payable was a genuine pre-estimate of loss (see Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79). If it was, the clause would be binding and enforceable. If it was not and the clause instead provided for an amount which went beyond what was a genuine pre-estimate of loss, the clause would be a penalty and so of no effect.

However, this is no longer the case. The Supreme Court has this month rewritten the rules which determine whether a clause is as a penalty (Cavendish Square Holdings BV v El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67.

The key point now in determining whether a clause is a penalty is to look at the innocent party’s legitimate interest in keeping the defaulting party to their contractual obligations and then consider whether the clause in question is out of all proportion to that interest. Put simply, this means that the Court will now consider:

• Whether there is any justification for the clause – for example, to ensure compliance with restrictive covenants in a share purchase agreement to preserve the goodwill in the company purchased; and
  
• If there is such a justification, whether the clause is unconscionable or extravagant, taking into account the particular circumstances of the case.
  

The key is now proportionality. If the detriment to the party in breach is out of all proportion to the interests of the innocent party in keeping the parties to the bargain they have made, the clause will be a penalty and so will be unenforceable.

The move away from considering whether the clause is a genuine pre-estimate of loss stems from the presumption that parties of equal bargaining power negotiating a contract are the best persons to judge what should be the consequence of a breach. The Courts should therefore only interfere with that freedom to contract if upholding the clause would give rise to an unconscionable or extravagant result.

It is worth bearing in mind that the rule against penalties only comes in to play if one party is breach. Clever drafting may avoid this (such as making a payment conditional on performance rather than requiring a sum to be paid for a breach). However, the Supreme Court has said that it will look at the substance rather than the form of contractual clauses when determining if a clause in unenforceable as a penalty.

It should now be easier for commercial parties to include terms in contracts which are designed to deter breaches without fear of such clauses later being found to be unenforceable as penalites. These cases are a further indication of the Court’s increasing reluctance to interfere with commercial terms entered into by parties of equal bargaining power have. Never has it therefore been more important to ensure that the drafting of your agreements are clear and unambiguous.