Supreme Court upholds rule against penalties

The parties to a contract may agree, in advance, on the level of damages payable to compensate the innocent party in the event of breach. However, such clauses will be struck down by the court if they are deemed to be penalty clauses. The long-standing view has been that a clause will be treated as a penalty clause if the sum fixed is not a genuine pre-estimate of loss (see Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1914]).

In this case, the relevant clause was held at first instance to be enforceable but the Court of Appeal allowed the appeal from that decision on the basis that it was not a genuine pre-estimate of loss (the same consequences arising on a number of different breaches, regardless of how minor the breach) and was also not commercially justifiable.

The Supreme Court has now overturned the Court of Appeal's decision. It held that the rule against penalties should not be abolished (although neither should it be extended).However, the correct test was not a "genuine pre-estimate of loss". Instead, it was whether any legitimate business interest is protected by the clause and, if so, whether the provision made for that interest is extravagant, exorbitant or unconscionable (ie there is an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach).