The UK law relating to penalty clauses has often been cited as an antiquated and out of date rule which has failed to move with the times.
The Supreme Court has recently considered the rules on penalty clauses in the two cases Cavendish Square Holding BV v Talal El Makdessi  and ParkingEye v Bryant  and introduced a test that will consider the wider commercial context of a transaction.
What is a penalty clause?
In essence, a penalty clause is a provision within a contract which imposes an excessive monetary penalty on the defaulting party. Historically, penalty clauses have been held to be unenforceable by the Court if they did not provide for a genuine pre-estimate of loss.
In the case Cavendish Square Holding BV v Talal El Makdessi, Cavendish received a controlling stake in a holding company from Makdessi and subsequently became the majority shareholder. Under the terms of the contract between the parties, Makdessi was prohibited from competing with the company. If he did, he would forfeit the right to the final two payments and could have been required to sell his remaining shares in the company. Makdessi began to compete and when action was taken as a result of the breach, he argued that the clauses were in fact penalties and were unenforceable.
In an entirely different set of circumstances, the Supreme Court jointly considered ParkingEye v Beavis in which the Court of Appeal had previously held that a parking charge was not a penalty clause as it protected the legitimate interests of the company. ParkingEye owned and operated a car park located outside retail premises and provided free parking for a maximum period of 2 hours. However, the conditions of parking imposed a £85 payment if a vehicle overstayed this allocated time.
The Supreme Court agreed with and upheld the Court of Appeal's decision stating that "deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages."
What is the new test?
Under the new test, the Court will analyse whether the clause is too harsh when measured against the innocent party's interest in ensuring that the other fulfils their obligations.
There are three limbs to analyse whether a clause is enforceable:-
1. Does the innocent party have a legitimate interest in enforcing the clause?
This test requires an analysis of the innocent party's legitimate business (or wider) interests.
In ParkingEye v Beavis the Court held that the company had a legitimate interest in enforcing the £85 charge on customers who overstayed their allocated time in the car park. This interest was to encourage trade by ensuring the continuous movement of vehicles and to enable ParkingEye to generate a profit to maintain the commercial viability of the business. The charge was also similar to what other operators were charging in the region.
2. Does the clause have an adverse impact that exceeds the innocent party's legitimate interest?
This limb of the test is quite subjective, however, normally it will be measured against the greatest loss imaginable. The clause should not be "exorbitant or unconscionable" when applied against the interest being protected.
3. Is the clause a primary provision of the contract?
The Court suggested that a clause will only be considered to be a penalty clause, if it is a secondary contractual provision. Although a point of caution - a recent late change to the judgment casts some doubt on the exclusion of all primary provisions.
Key questions to ask yourself in relation to any potential penalty clauses include:
- Are you seeking to protect your client relationships or safeguard confidential information and trade secrets?
- What will be the impact in the event of a breach and are the consequences of such a breach served and protected by the clause?
- Does the clause go further than necessary to protect the company's legitimate interests?
The new test is a welcome change to the law on penalty clauses and it appears that the previous test of a 'genuine pre-estimate of loss' is no longer relevant.
This is good news for businesses as the Courts will now consider the wider commercial context of a transaction and have emphasised their reluctance to get involved where the parties are of equal bargaining power and have entered into a contract on the basis of sound legal advice.
However, the test is still not straightforward and there may be more litigation on the horizon in relation to the interpretation of the new test.