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Supreme Court reaffirms law governing contractual penalty clauses

This month, the Supreme Court has reaffirmed its position on contractual penalty clauses[1]. Looking at what can and can’t be described as an unenforceable penalty, this is the first time in 100 years that the Court has reconsidered the principles underlying such clauses.

When entering into a commercial contract, it’s not unusual to structure the agreement to allow for compensation in the case of a breach.

A useful tool to help do this, ‘liquidated damages’ (LD) clauses set out a specified sum of money to be paid by the ‘guilty’ party in the event of a breach (for example a delay in delivery or a failure to meet agreed targets).

LDs deliver a degree of certainty to buyers and suppliers in the case of a breach. However, these clauses are not always straightforward.

Indeed, if a provision imposes a penalty that is not proportional to the potential loss suffered, and instead, is designed merely to deter parties from breaching a contract by penalising poor performance, it will be unenforceable under English law.

Liquidated Damages v Penalty Clauses

What’s the difference? Well, in simple terms, while LDs ensure that the amount payable is comparable to the loss suffered by the innocent party, penalty clauses seek an amount that far exceeds the damages sustained.

Penalty clauses are unenforceable as, under the current law, contract terms cannot be used to help one party profit due to the breach of another.

Businesses have traditionally been encouraged to include comprehensive pre-estimates of loss in contractual agreements to ensure that any LDs are enforceable. However, calculating the full amount of damages that may arise in the case of a breach can be tough, and there has been concern that commercially justifiable clauses are being dismissed unfairly.

The Courts, being alive to such issues, have more recently attempted to move away from such a rigid method of assessing of penalties, and instead, have sought to apply a ‘commercial justification’ test. Through this assessment, they have examined whether such provisions are extravagant or commercially justifiable.

However, this has led to increasing confusion, and, this latest case has resulted in some much needed clarification.

The Supreme Court case, which was presided over by seven judges, found that the rule relating to penalty clauses is an “ancient, haphazardly constructed edifice which has not weathered well’. However, it also agreed that it should not be abolished.

Instead, the Court stated that whether or not a clause is penal, depends on its purpose. Therefore, a damages clause may be entirely justified depending on the way it is constructed and whether it is proportionate to the enforcement of the primary obligation.

So what does this mean for business owners?

The result of the Supreme Court decision is that even if a clause does not represent a genuine pre-estimate of loss, it may no longer be automatically unenforceable.

Instead, it’s now up to the wronged party to demonstrate that there is some other justifiable commercial reason for the sum to be set at a level greater than the actual damages arising from the breach. Where there is a commercial justification for such a deterrent, then the clause could be upheld.

It’s important, therefore, for all business owners to consider, when devising contracts, not only the foreseeable direct loss likely to arise in the event of a breach, but also the wider implications of the breach, and the importance of deterring any breach.

In addition, to protect your business in light of the recent Supreme Court decision, it is strongly recommended that you review any existing terms and conditions to ensure your best interests are protected.

Concluding thoughts

There’s no doubt that the judgement represents a significant shift in the way the Courts analyse penalty clauses and will help both sides to better protect their legitimate business interests. However, it will be interesting to see how this judgement plays out in business disputes over the next few years as, while there is now an argument for clauses that exceed a genuine pre-estimate of loss, the Courts are unlikely to look favourably on over inflated LDs.

If you are concerned about the implementation of clauses in your business contracts, or if the terms and conditions set out in a commercial contract are being used against you, please contact Linder Myers today for help.

Find out more about our Commercial Litigation department Contact us

 

[1] Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67

 

 

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