Penalty clauses: rethinking your approach to liquidated damages article banner image

The Supreme Court has recently handed down two decisions affecting the way liquidated damages clauses (and other provisions which impose fines or punitive damages) are drafted.

In Cavendish [Cavendish Square Holding BV v Talal El Makdessi] and ParkingEye [ParkingEye Limited v Beavis [2015] UKSC 67] the court stated that the traditional test of whether a clause imposing a sum payable on breach of contract was an unlawful penalty, was no longer relevant.

In the past courts have assessed whether the sum payable was a “genuine pre-estimate of loss”, and if it was not, it was an unlawful penalty.

The new test is whether the sum is “out of all proportion to any legitimate interest of the innocent party” in enforcing the breach.

This is likely to result in an increased focus on liquidated damages regimes in contracts. The success of the parties to document their agreement on what constitutes a genuine pre-estimate of loss, has always been limited. In the past, agreed, but seemingly disproportionate liquidated damages have been held to be unlawful penalties because they didn’t represent a genuine pre-estimate of loss. Now, presumably, as long as the contract is clear on the legitimate interest of the innocent party – i.e. the reason why the liquidated damages need to be set at that level – higher liquidated damages may be appropriate.

In Cavendish, the parties had agreed a provision stating that breach of non-compete covenants in a share purchase agreement by the seller would result in the loss of deferred consideration, loss of a put option to sell remaining shares and the triggering of a call option at an unfavourable price. The Court of Appeal ruled that these were unconscionable and not a genuine pre-estimate of loss, however the Supreme Court overturned the decision stating that in some circumstances a party may have a legitimate interest in enforcing performance which goes beyond simply addressing loss. In this case that interest (protection of a business for which it had paid good consideration) was not out of proportion to the consequences of the breach.

ParkingEye was a dispute about a parking fine of £85 for overstaying a two hours free-parking period. On appeal the court confirmed that the fine was not a penalty, as the reasons for having such a disincentive were legitimate: discouraging motorists from staying too long and ensuring that there was good turnover in the car park.

The Supreme Court made it clear that it considered that the old test had become applied too rigidly and resulted in plenty of sums being disallowed, even though there were real commercial reasons why they were legitimate.

This means that while the door was always left a little ajar for challenging liquidated damages which seemed a little high even though they had been agreed to, it is going to be harder for a party to avoid payment of liquidated damages in the future where the parties have agreed in the contract that the reasons for the level of liquidated damages are reasonable. Undoubtedly, this will result in a major overhaul of the drafting of liquidated damages provisions in a number of industries, in particular construction and engineering.


Mark is a senior associate in the corporate team. If you need advice on any of the issues raised in this article please contact us by email or call 01872 265100.