Penalties following the Supreme Court's decision in Cavendish v El Makdessi and ParkingEye v Beavis, 4 November 2015

A century has passed since the House of Lords considered the principles underlying the law relating to contractual penalty clauses in Dunlop Pneumatic Tyre Company Ltd. v New Garage and Motor Company Ltd. [1915] AC 79 (Dunlop).  The Supreme Court's judgment in this combined appeal has therefore been eagerly anticipated by the legal profession in the hope that it would bring clarity and certainty to this complex area of law. 

Lords Neuberger and Sumption gave a joint leading judgment in which they describe the penalty rule  as "an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended.".  They consider its equitable origins and then analyse its development in the common law.

They note that the common law on penalties has largely developed in the context of damages based clauses providing for payment of a specified sum in place of common law damages.  However, they also note that this is only one of the areas that is affected by the rule, which has wider ramifications.

To set the penalty rule back on its proper course, as originally recognised in the equitable origins of the doctrine, Lords Neuberger and Sumption held that:

"The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss.  They are not natural opposites or mutually exclusive categories. …The fact that a clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal."

"To describe [a contractual provision challenged as a penalty] as a deterrent (or… "in terrorem") does not add anything.  A deterrent provision in a contract is simply one of a species of provision designed to influence the conduct of the party potentially affected".  It is not "inherently penal or contrary to the policy of the law".

"The question whether it is enforceable should depend on whether the means by which the contracting party's conduct is to be influenced are "unconscionable" or (which will usually amount to the same thing) "extravagant" by reference to some norm."

"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 some appropriate alternative to performance."

Accordingly, the key questions which, in our view, now need to be asked when considering whether a contractual provision is a penalty:

Is a provision penal?  If it is a genuine pre-estimate of loss, the provision will be valid. If a provision is not a genuine pre-estimate of loss, this is a relevant factor, but whether it is actually penal requires the consideration of other factors.

Are the means by which the contracting party's conduct is to be influenced (i.e. by the potentially penal provision) "unconscionable" or "extravagant" by reference to some norm?  It seems that this norm need not be a pre-estimate of loss, but could, for example, be by reference to some industry standard.

Is the provision 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?  In other words, if a primary obligation is breached, is there a secondary obligation that is triggered on that breach and which is penal?   

The judgment is a welcome clarification of the law in this area, which provides helpful guidance as to how the penalty rule should be applied to modern commercial contracts.  It restores the ability of parties to make their own bargains, and confirms the court's role in enforcing those bargains. However, working out what is a "legitimate interest" for the purpose of applying the new tests may not be straightforward. No doubt businesses and their lawyers will seek to set out a cogent explanation of a "legitimate interest" to justify a particular charge or sanction in the bargain reached. Whether the interests they articulate are truly legitimate may become the new battleground in subsequent challenges to the validity of such clauses.