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The Supreme Court has sought to clarify the so-called penalty rule arising from a breach of a commercial contract.
It was a century ago that the House of Lords considered the law relating to contractual penalty clauses in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd (1915).
A hundred years on, the Supreme Court has clarified the underlying principles of that law in the combined appeals of Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis (2015).
The law around penalties applies where a commercial contract sets out agreed sums to be paid upon a breach by a party.
The general rule is that the clause will be enforceable if it is a liquidated damages clause, but where the sum is considered to be an extravagant or unconscionable remedy and penalises the defendant beyond the actual loss incurred by the claimant, it will be considered a penalty and be unenforceable.
In the first case, Mr Makdessi entered into a sale and purchase agreement to sell Cavendish Square Holding a large proportion in a group of companies.
Mr Makdessi breached the terms of the agreement which provided remedies for Cavendish. Mr Makdessi claimed the relevant clauses were unenforceable penalty clauses.
In the second case, ParkingEye charged Mr Beavis £85 for overstaying the two hour maximum stay period in a city centre car park. Mr Beavis argued that £85 was an unenforceable penalty.
Both of the clauses were upheld by the Supreme Court as being unenforceable, and the law on penalties was reset. Lords Neuberger and Sumption held that:
“the true test is 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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.”
The key points from this judgement are that the rule against penalties will only apply to secondary obligations, rather than primary obligations, meaning that the rule will only apply to drafting which relates to the consequences of a breach of contract, rather than a clause providing for sums to be paid on the occurrence of a certain event, such as payment of a fee on exercising the right to break a lease.
The clause will not be enforceable unless it genuinely seeks to protect a party's legitimate interest, which is unlikely to extend beyond the actual loss incurred.
The decision in Makdessi and ParkingEye may have weakened the criteria for judging whether a clause is enforceable or not.
It has, however, clarified the law and should enable parties to agree remedies in commercial contract in the knowledge that, if they can show a legitimate interest, the agreement will be likely to be upheld.
The decision should be considered when drafting property contracts such as land sale agreements, as the rule against penalties will apply to clauses requiring payment of a non-refundable deposit or a deposit exceeding the customary 10%.
Agreements to make staged payments can also be considered to be penal unless there is a legitimate reason for deferred payment of part of the purchase price, or security is provided for the balance of the funds.
This article was written by Daisy Scaife.
For more information, please contact Daisy on +44 (0)20 7427 6445 or email@example.com.