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 [2015] 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:

  1. 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).
  2. 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.
  3. 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.
  4. 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.
  5. 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)