Important Change to the Law on Contractual Penalties

On 4th November 2015, judgements were made in the Supreme Court that have clarified the law on penalties in contracts. The decisions on two cases mark the first authoritative final appeal court decisions in 100 years that comprehensively address and amend the law surrounding contract penalties.

Most contracts, especially contracts of a commercial nature, feature clauses known as ‘liquidated damages’ clauses. In some cases, contract law will dictate that these clauses may amount to penalties. If this happens and a liquidated damages clause is deemed by a court to be a penalty, then it cannot be enforceable. It has therefore always been vital to make sure that clauses in contracts cannot be construed as penalties.

The Cases

In the first case, Cavendish Square Holding BV v Talal El Makdessi (The Group), the owners of The Group agreed to sell a share to Cavendish. The terms of the agreement provided that Mr Makdessi, one of the owners of The Group, was required to refrain from competing activities for several years and failure to comply would mean that he would no longer be entitled to two of the payments still due, and that he could be required to sell his remaining holding to Cavendish, for a sum ignoring any value for goodwill. The case went to trial due to Mr Makdessi having breached the restrictive covenants, however he alleged that the clauses constituted penalties and were therefore unenforceable.

The second case was ParkingEye v Beavis. ParkingEye was the manager of a retail park car park. Notices placed around the car park stated that exceeding the two hour free parking limit would lead to a charge of £85. Mr Beavis had exceed the limit by almost an hour, but refused to pay the charge, arguing that it was unenforceable and unfair under the Unfair Contract Terms in Consumer Contracts Regulations 1999.

Penalties, or not Penalties?

In both cases, however, the clauses were held to not be penalties.

Previously, the penalty rule was said to have become, in the words of Lord Sumption, ‘an ancient, haphazardly constructed edifice which has not weathered well’. The Supreme Court had to consider various options, including the abolition of the rule, or its extension to make it more widely applicable. Instead, it reformulated the test for a penalty, which now stands as: ‘Whether the impugned provision is a secondary obligation which 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.’

It is now much clearer to work out whether a clause counts as a penalty, which should spell good news for businesses entering into contracts.

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