Supreme Court revises approach to ‘penalty’ clauses in contracts

Paul Snell is managing editor at Supply Management
6 November 2015

The UK Supreme Court has upheld contract clauses in two separate cases, and in doing so provided new guidance regarding ‘penalties’ for breach in deals.

Revisiting this point of law – the first time by either the House of Lords or Supreme Court for more than 100 years – the court decided not to abolish the broad principle that clauses which aim to penalise a breach of contract are unenforceable, even though it was described as “an ancient, haphazardly constructed edifice which has not weathered well”. But it also chose not to extend the rule, as recently happened in Australia.

‘Penalty’ clauses, where damages for a breach of contract do not reflect a genuine pre-estimate of loss or are intended to act as a deterrent, have generally been held to be unenforceable.

But in a judgement on the two casesCavendish Square Holding v Talal El Makdessi and ParkingEye Limited v Beavis – the judges said deterrence and genuine pre-estimate of loss were “unhelpful” concepts. Instead, the true test should be if the 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”.

Commenting on the case, law firm CMS Cameron McKenna, said: “The judgment provides welcome clarification that, although the rule remains, contractual parties are more likely to be held to their negotiated contracts where they reflect the legitimate interests of the parties concerned.

“It remains to be seen how this new formulation of the rule will be applied in future and, in particular, what will be ‘out of all proportion’ to the legitimate interests of an innocent party. Careful drafting of contractual provisions may evolve to address this issue in an attempt to avoid the rule on penalties altogether or, at least, to state their legitimacy.”

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