Liquidated damages and the penalty clause: a brief summary of the change in the law
On 4 November 2015, the Supreme Court changed the previously well-established law relating to liquidated damages and the penalty clause, in the case of Cavendish Square Holding BV v Talal El Makdessi; Parkingeye LTD v Beavis  UKSC 67.
A liquidated damages clause in a contract usually requires a party who has breached its obligations under the contract (such as where there has been delay in performance) to pay the innocent party a fixed sum of money in damages, rather than leaving damages to be determined by the courts (potentially after an expensive and long-running dispute). Liquidated damages clauses, when they work, give parties a quick and certain outcome where contracts go wrong.
However, if the contract-breaker can successfully argue that the clause amounts to a penalty clause, the clause will be unenforceable. The courts have always been reluctant to interfere with the parties’ freedom to contract upon whatever terms they want. Equally, English Law opposes scenarios whereby one party achieves a windfall. Consideration of whether a liquidated damages clause actually amounts to a penalty has long been a hotly contested area of litigation and regularly rears its head in commercial disputes.
The position until now
For 100 years, the law in this area was fairly well established. The test for determining whether a clause was a penalty clause (and unenforceable) or not was broadly based on the following principles, established in Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Ltd  AC 79, 86-87:
- Whether the sum payable under the clause is a genuine pre-estimate of the loss that would be suffered as a result of the breach; and
- Whether the sum payable under the clause is extravagant and unconscionable in comparison to the greatest loss which could have followed from the breach.
So, if the amount payable under the clause was a genuine pre-estimate of the loss that would be suffered, it was enforceable. But if it was so far off the maximum loss that could reasonably have been expected to flow from the breach and was more of a deterrent to breach, it was deemed to be a penalty and unenforceable. The test was clear but, as it was applied on the facts of each case, there has long been scope for argument over its application.
The position now
In the Cavendish case, the court said that the primary consideration should be whether the clause was extravagant or unconscionable and the court should take account of the wider interests of the innocent party. Accordingly, the court held that the test for establishing whether a clause amounted to a penalty was whether the clause: “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.”
The court confirmed that it was necessary to consider what legitimate business interest of the innocent party is served and protected by the clause, and whether the remedy provided for the breach is exorbitant or unconscionable in the context of that interest.
What this means
The decision reflects a strengthening of the courts’ reluctance to interfere in commercial contracts. The ‘out of all proportion’ benchmark is a high one. Previous considerations of whether the sum provided for is a genuine pre-estimate of the innocent party’s loss, or intended as a deterrent, will no longer be at the forefront of the court’s mind when deciding whether a clause is enforceable. Rather, the court has an arguably bigger task in trying to establish the legitimate interests of a party (which may not be solely financial), before deciding whether the clause is out of all proportion to that interest. This new test is far wider and less rigid. It will no doubt remain a contested area in commercial disputes but it shifts the goalposts in favour of the innocent party.
Parties to commercial contracts should think carefully about this new test when drafting or entering into contracts that provide for payments triggered by a breach. From the point of view of the drafter, proper consideration should be given to what legitimate commercial interest is served by the clause at the time that the contract is negotiated. Liquidated damages clauses will continue to be challenged but if proper reasoning can be evidenced, it will put that party in a much stronger position to enforce that clause at a later date and, better still, avoid any protracted dispute.
From the point of view of parties being asked to agree liquidated damages provisions, it is worth noting that the courts are more likely to hold you to those terms. That said, if faced with an onerous claim for liquidated damages, it will often be worth a brief review of the position to see if there are any arguments that can be made to improve your negotiating position.
If you have any queries in relation to the penalty clause or any of the other issues raised in this article, please contact our Commercial Litigation team.
Posted on Feb 3rd, 2016 by Lyons Davidson