Previously the law imposed restrictions on a contracting party’s ability to financially punish the other party for a breach of contract. But the legitimacy of penalty clauses in English law has recently been reconsidered at the highest level of the judicial system for the first time since 1915. This has resulted in the introduction of a more flexible test, based on whether the clause imposes a detriment on the party in breach which is disproportionate to the legitimate interests of the innocent party.
Formerly, where a clause was intended primarily to deter breach and the amount was not a genuine pre-estimate of loss at the time of the contract, the rule was that such a clause was unenforceable as a ‘penalty’. However, in the conjoined appeals of Cavendish v Makdessi and ParkingEye v Beavis, the court acknowledged that this approach was an interference with freedom of contract and undermined certainty.
The Supreme Court held that the true test for a penalty is whether the clause 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.” This applies whether or not there has been a genuine pre-estimate of loss.
That said, an innocent party cannot have a legitimate interest in simply punishing a breaching party. In a straightforward damages clause, a party’s legitimate interest will rarely extend beyond compensation for the breach and, in a negotiated contract between sophisticated parties, they themselves will be the best judges of what is a legitimate interest to be protected.
This judgment means that contracting parties will now be allowed more freedom to agree on the consequences of a breach of contract and a contract breaker will subsequently receive less protection from the law where they have freely entered into an agreement.
Furthermore, the rule against penalties will no longer apply to primary obligations of the parties or to provisions which arise as a result of any event other than a breach of contract. However, it may be possible for parties to “draft around” the rules by providing for sums to become payable on a certain event (other than for a breach of contract).
This may be relevant where schools purchase goods or services but somehow breach the terms of the contract. Previously, if the supplier then argued that it was contractually entitled to a financial sum beyond compensation, the schools could run the counter-argument that any such clause was unenforceable as a penalty. This argument will now be harder to make following this judgment.