Last June I wrote an article about the development of the law in relation to penalty clauses, and I mentioned the fact that the relevant cases had been referred to the Supreme Court for guidance on these issues:  see https://www.stephens-scown.co.uk/disputes-with-businesses/penalties-a-century-of-cases.

The Supreme Court has this week handed down its highly anticipated decision in the consolidated appeals in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis.

It unanimously allowed the appeal in El Makdessi, holding that the relevant contractual clauses did not engage the rule against penalties and, therefore, were not unenforceable penalties.  By a majority decision (Lord Toulson dissenting), it dismissed the appeal in ParkingEye, holding that, although the penalty rule applied to the parking charge, the charge was not an unenforceable penalty nor in breach of the Unfair Terms in Consumer Contracts Regulations 1999 (UTCCR 1999).

The decision provides much needed clarity in this complex area of the law.  It confirms that the tests established by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 a century ago (which essentially distinguished between a genuine pre-estimate of loss on the one hand, and a penalty on the other) are simply considerations, which may not apply to every case where the law on penalties is engaged.  These tests continue to be of most relevance when construing straightforward liquidated damages clauses, but are not necessarily helpful in more complex cases where a broader test is justified, namely, where the innocent party’s interest in performance extends beyond the prospect of financial compensation for the breach.

One of the key messages from the judgment is that, when considering whether a clause is a penalty, it is necessary to determine the nature and extent of the innocent party’s legitimate interest in the performance of the relevant obligation.  In other words, it is necessary to ask whether there is a justification for the clause and, if there is, whether, in the particular circumstances, the clause is nevertheless unconscionable or extravagant.  When carrying out this exercise, it must be borne in mind that, in a negotiated contract between parties of equal bargaining power, it is presumed that the parties themselves are the best judges of what is a legitimate consequence of breach.  Accordingly, because the penalty rule is an interference with freedom of contract, the focus should be on whether the clause is unconscionable or extravagant, and not on whether it is a genuine pre-estimate of loss.  From this, it follows that it is perfectly possible for a clause to be commercially justified and not a penalty, while at the same time being a deterrent for breach.

The judgment also provides guidance on the relationship between the penalty rule and forfeiture clauses.

Chris Harper is a partner and head of the dispute resolution team in Exeter. He specialises in commercial litigation and is named as a leader in his field by independent guides to the legal profession Legal 500 and Chambers. To contact Chris please call 01392 210700 or email drx@stephens-scown.co.uk