Parties in the manufacturing world often negotiate ‘liquidated damages’ or ‘penalty clauses’ to try to ensure compliance with the contract.  A recent case on parking charges brings a significant shift in the approach of the courts to such clauses.

A penalty provision in a contract is most often described as a clause which provides for the payment of a sum of money to the innocent party upon the defaulting party's breach of contract, the predominant purpose of which is to discourage the would be defaulter from deliberately breaching their obligations.

A provision in a contract which is penal is distinguishable from a liquidated damages provision which provides for a sum which represents a genuine pre-estimate of monetary loss.

The general rule is that is a liquidated damages provision is enforceable and the sum set out in the clause is recoverable, whereas a penalty will not be enforced beyond the actual loss of the innocent party.

Are penalty clauses enforceable?

The Supreme Court in its recent decisions in Cavendish Square Holding BV v Talal El Makdessi [2015] and ParkingEye Limited v Beavis [2015] reviewed the evolution of the current law and upheld clauses viewed as penalties as being enforceable.

These two cases established that the true test of a penalty is whether the provision in question imposes a detriment on the defaulting party which is out of all proportion to any legitimate interest of the innocent party. Therefore, the validity of such a provision depends on whether the innocent party has a legitimate interest in the enforcement of the clause. The innocent party can have no proper interest in simply punishing the defaulter. The difficulty (and expected difference in opinion between the parties) will be working out what is a "legitimate interest", and what is out of all proportion to that legitimate interest.

ParkingEye v Beavis

Mr Beavis overstayed the maximum two hour parking limit in a carpark and so was charged £85.00 (there were notices throughout the carpark advising of this overstaying charge). Mr Beavis argued that the charge was unenforceable as a penalty, however, the Supreme Court held that the parking charge was enforceable and not an unenforceable penalty. The charge had two main objects: (i) efficient use of parking space in the interests of the retail outlets and their users by deterring long-stay or commuter traffic; and (ii) the generation of income in order to run the scheme.

ParkingEye had a legitimate interest in charging motorists who exceeded the two hour limit, albeit ParkingEye could not charge a sum which would be out of all proportion to its interest or that of the landowner for whom it was providing the service of the car park. However, in the view of the Supreme Court, there was no reason to suppose that £85 was out of all proportion to ParkingEye’s interests.

Points to take away

  • For straightforward breaches of simple contracts, a genuine pre-estimate of monetary loss should usually still prevent a contractual remedy from being characterised as penal and therefore a penalty, as the innocent party’s interest will rarely extend beyond compensation for the breach.
  • For more complex contractual arrangements, provided the innocent party has a legitimate interest in the enforcement of the clause and the detriment to the defaulting party is not unconscionable or extravagant by reference to some relevant norm, the clause should not be regarded as a penalty.
  • The fact that the provision is not a pre-estimate of loss does not, without more, make it penal. The provision would need to impose a detriment to the defaulting party out of all proportion to the innocent party’s legitimate interests.