In this landmark decision the law on penalty clauses was reviewed, for the first time in a century, by the Supreme Court, which reset and clarified the penalty test.
For a full briefing on this, please see the Banking and Financial Disputes article.
It's common for commercial contracts (though much less common in employment contracts) to include a clause stating that, if one party breaches the contract, a particular remedy will apply – for example, clawback, payment or forfeiture of a specific amount of money.
In the employment context, these clauses are most commonly seen in shareholders' agreements or share/business purchase agreements. They are also sometimes used in consultancy agreements. In Cavendish, the clause related to the breach of restrictive covenants in a share purchase agreement.
Until now, the test of whether such a clause was enforceable was whether it was a genuine pre-estimate of the loss that would result from the breach, in which case the clause would be enforceable, or whether it was excessive and/or punitive, in which case it would be considered to be a penalty, and therefore unenforceable.
The Supreme Court has now held that the true test as to whether a clause was penal (and therefore unenforceable) is whether it is a secondary obligation that imposes a detriment on the contract breaker which is "out of all proportion to any legitimate interest of the innocent party" in enforcing the primary obligation breached.
What this means for employers
As indicated penalty clauses are most commonly seen,in the employment context, in shareholders agreements or share/business purchase agreements. They are also sometimes used in consultancy agreements. In Cavendish, the clause related to the breach of restrictive covenants. This case is helpful to employers who wish to rely on such clauses, bringing flexibility and clarity, and should be taken into account in drafting commercial contracts.