Newsletter – Damages Clauses and Penalties

Makdessi & Parking Eye

The Supreme Court of England and Wales, in the consolidated appeals in the two cases of Cavendish Square Holding BV v Talal El Makdessi (Cavendishand Parking Eye Limited v Beavis (Parking Eye), perceived a more flexible test on whether a contract term is considered penal and thus unenforceable.

The traditional English law test on penalty clauses centred on whether a clause that takes effect on breach of contract is a “genuine pre-estimate of loss” and therefore compensatory or whether it is aimed at deterring a breach and therefore penal. In construction contracts this question arises often in relation to the provisions entitling an Employer to claim and deduct damages from the Contractor where the completion of the project has been delayed and there is no entitlement to an extension of the time for completion.

The origins of the penalty rule can be traced back as far as the 16th century. It originates in the concern of the Courts to prevent exploitation in an age when credit was scarce and borrowers were particularly vulnerable.

Essentially, a penalty is a payment of money stipulated in the contract and is unenforceable against the offending party if it is an exorbitant alternative to common law damages.

At the beginning of the 20th century, the judgment in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 (Dunlop) sought to restate the law on the penalty rule by providing four tests which were designed to be “helpful, or even conclusive” in determining whether or not a clause was an unenforceable penalty. The Dunlop judgment distinguished between penalty clauses (which are unenforceable) and “liquidated damages” clauses, which are enforceable provided that the specified sum is “a genuine pre-estimate of loss” – wording which has since appeared in many English law commercial contracts over the last 100 years.

In the present cases and in the words of Lord Sumption, the rule has become, “an ancient, haphazardly constructed edifice which [had] not weathered well”.

In Cavendish and Parking Eye, the Supreme Court restated the rule by introducing a more flexible test as to “whether the impugned provision 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.” Following this decision, the question is no longer  “[is] the clause unconscionable or a genuine pre-estimate of loss”; instead, the innocent party’s wider interest will be taken into account when enforcing obligations.

Commentators have subsequently criticised this decision by highlighting the uncertainty of what will amount to a legitimate interest and the circumstances in which a clause will be considered out of proportion to that interest. This point is likely to be open to debate on a case-by-case basis. The new rule does, however, make way for greater freedom of contract; parties of equal bargaining power will be the best judges of what is a legitimate response to a breach of contract and commercially justified, even if, on the old test, this would be seen as a deterrent for breach.