The Supreme Court has re-set and clarified the rule against penalties for the first time since the 1915 Dunlop Pneumatic decision of the HoL. The decision in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67 involves two separate and rather different contractual terms that offered a specific remedy to one party upon the breach of a particular obligation by the other party.
In upholding the validity of the clauses in both cases, the Supreme Court provided new guidance on how to distinguish between a liquidated damages clause, which is enforceable, and a penalty clause, which is not. Some key takeaways from the judgment are as follows:
- A clause will only constitute a penalty if it 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”. (para 32 of the judgment – emphasis added).
- So the innocent party needs to have a legitimate interest in performance, or in some appropriate alternative to performance, rather than in simply punishing the defaulter. What amounts to a legitimate interest? ParkingEye were held to have a legitimate interest in charging a fine for overstay parking which went beyond the recovery of any loss ParkingEye would have suffered for such overstay.
- The penalty rule will only apply if the clause imposing the detriment is a secondary obligation. In the Makdessi case the court held that the penalty rule did not apply at all because the clause, which allowed for a substantial price adjustment upon the breach of certain non-compete covenants, was a primary obligation because a significant proportion of the price related to goodwill. Even if the penalty rule had been engaged, the court held that Cavendish had a legitimate interest in observance of the covenants because this was essential to preserving that goodwill.
- A clause that is a deterrent provision is not necessarily going to be a penalty. Nor will a clause that is not a genuine pre-estimate of loss. Rather, the real question is whether the clause is penal in nature, i.e. unconscionable, extravagant or out of proportion to its interests. ParkingEye’s £85 overstay fine was held to be none of these.
- The court will not be quick to invalidate a clause by finding it to be a penalty: “in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach”. (paragraph 35, judgment)