Supreme Court Ruling in Contract Law Clarifies Penalty Clauses Rule
The much-anticipated ruling of the Supreme Court in two contract disputes has seen a clarification of the longstanding rule on penalty clauses in English law. The decision of the majority of the panel of seven Supreme Court justices in Cavendish Square Holdings BV v El Makdessi; ParkingEye Limited v Beavis  UKSC 67 is expected to have significant impact on both the study and practice of contract law, as well as on the syllabus for the MCT assessment.
The Previous Regime
The existing rule on penalty clauses has stood since the House of Lords last visited the subject exactly 100 years ago, in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd  AC 79. In that ruling, the House of Lords held that a liquidated damages clause would be considered a penalty and therefore unenforceable, where the sum to be paid by the defendant was “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be provided to have followed from the breach”. Since then, the ruling had been understood to mean that where a sum specified in a liquidated damages clause is not a genuine pre-estimate of loss, but is a deterrent against breach, the clause is considered a penalty and is not enforceable.
The two cases considered by the Supreme Court could hardly have been more different; the Cavendish case related to the breach of a non-compete clause in a share purchase and shareholders’ agreement worth many millions, while the ParkingEye case revolved around a disputed parking fine worth £85.
In Cavendish, the failure of the party to abide by restrictive covenants was to result in a significant adjustment of the purchase price. In ParkingEye, the defendant’s failure to park in a free car park for no more than two hours resulted in a fine of £85.
The Ruling of the Supreme Court
In both cases, the Supreme Court ruled that the clauses did not constitute unenforceable penalty clauses. The court explained the decision in Dunlop had been applied too literally for the previous century. The fact that a liquidated damages clause may not be a genuine pre-estimate of loss, but a deterrent against breach, does not necessarily render it a penalty, i.e. a clause designed to punish. Rather, if the clause reflects a legitimate interest in deterring against breach and enforcing the contract, the clause will be upheld as valid. However, if the clause is out of all proportion to that legitimate interest, it will not be upheld.
In Cavendish, the price adjustment was found to reflect the legitimate interest of the buyer in ensuring that the seller remained loyal, even though the level of the price adjustment had no direct connection to any losses. Similarly, in ParkingEye, the court held that the fine reflected ParkingEye’s legitimate interests of ensuring commuters do not try to park there all day, and of funding the expenses of maintaining the free car park.
The Supreme Court also explained that the penalty clause rule only applies to clauses which require a payment in the event of a breach of an obligation. Where a party is not actually obligated to perform an act, but the other party is to receive a payment if the first party does not perform the act, this does not constitute a penalty, but a primary obligation to make a payment.
Finally, the court held that, while the legitimate interests of parties in having the contract performed must be established on a case by case basis, the courts should be less inclined to interfere with a liquidated damages clause in contract where it has been negotiated by commercial parties over time with the advice of sophisticated and experienced legal advisors.
MCT Assessment Impact
Candidates on the MCT in February 2016 (and beyond) are reminded that they are expected to apply the law as it stands on the date of the assessment. While the penalty clause rule still applies, it must now be applied with more consideration of the commercial context and interests of the parties to the contract.
Updates containing the case law discussed in this post together with other important new laws that have recently come into force are available download on our MCT Online Training System.
You are reminded that unless otherwise stated in advance, you are assessed on the law in force at the time of the MCT assessment.
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