Understanding Penalty Clauses in Commercial Contracts

From time to time a business may become involved in a contractual dispute whereby a large monetary penalty is sought. These disputes sometimes relate to penalty clauses that have been incorporated within a contract and understanding whether such penalties may or may not be enforceable is crucial to determining the extent of a defaulting party’s liability.

What is a penalty clause?

In simple terms, a penalty clause is a contractual provision that requires the defaulting party to provide monetary compensation to the innocent party in respect of a breach of a secondary obligation contained within a contract.

When is a penalty clause enforceable and which case law has changed the way we interpret penalty clauses?

In the landmark combined judgment of Cavendish Square Holdings BV v Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67, the Supreme Court sought to clarify the way in which penalty clauses should be interpreted in commercial contracts. The last case to substantially consider their enforceability was over 100 years ago in the case of Dunlop Pneumatic Tyre Company Ltd v New Garage Motor Co Ltd [1915] in which Lord Dunedin set out four key tests to be applied when determining whether the clause in question is a genuine pre-estimate of liquidated damages or a penalty.

The key tests applied under Dunlop involved assessing whether the extent of the monetary compensation sought was ‘unconscionable’ and ‘extravagant’ in comparison to the loss incurred by the innocent party. Consideration was also given to whether the loss was so disproportionate it could only be intended to deter a breach of contract. If the loss was found to be wholly disproportionate, it would be construed as a penalty and unenforceable.

The decisions of both Cavendish and ParkingEye reconsidered the tests to be applied when considering the enforceability of penalty clauses. They established that a clause can only be considered to be penal where it is a matter of substance, not form. In particular, in order to consider whether a clause in question is a penalty clause depends entirely upon whether the clause relates to a primary or secondary contractual obligation. If a breach of the obligation gives rise to a new one, this would be construed as a conditional primary obligation. However, in the instance that the breach gave rise to an obligation that would not otherwise exist, it would be a secondary obligation that is an alternative to damages and could be found to be a penalty clause.

The Supreme Court were keen to uphold the doctrine of penalties and, while acknowledging that Lord Dunedin’s key tests were still relevant, the majority held that the commercial approach to adopt was to have regard to the innocent party’s interests, whether these were being legitimately protected and whether the remedy the clause seeks to impose is proportionate to the innocent party’s interest. If these two tests can be established, the penalty clause will be enforceable.

Can a penalty clause be disputed?

A penalty clause may be disputed if the party to which the penalty is imposed against is of the opinion that the penalty sought far exceeds the innocent party’s attempt at quantifying a genuine pre-estimate of a loss incurred and which also seeks to act as a deterrent to the innocent party ever committing a breach of the relevant clause. Ordinarily, penalty clauses imposed in respect of primary obligations are enforceable. However, secondary obligations are not. It will be a matter of interpretation as to whether a penalty clause is enforceable applying the tests established following the Supreme Court’s judgement in Cavendish and ParkingEye.

For advice and assistance in relation to the drafting of a penalty clause within a contract or understanding the enforceability of any penalty provisions, contact Christopher Buck, Associate Partner & Commercial Solicitor within our Business Services team on 01908 660966 / 01604 828282 or email christopher.buck@franklins-sols.co.uk.