Penalty Clauses

The Supreme Court has, for the first time in 100 years, comprehensively reviewed the law surrounding penalty clauses. The decision in Cavendish v Makdessi[1] considers the long established principles in Dunlop v New Garage[2] and recasts them.

The law concerning penalty clauses has a long and detailed history stretching back to the 16^th century practice of taking defeasible bonds to secure contractual performance. The judgment given by Lords Neuberger and Sumption traces the history back through the developments within the Courts of Equity and Common Law. In essence, the position prior to Cavendish was that a liquidated damages clause was actionable if it constituted a genuine pre-estimation of a party’s losses and unenforceable if it was not.

The Supreme Court considered that the rules gave rise to two primary considerations:

1. In what circumstances is the penalty rule engaged;
2. What makes a contractual provision penal?

The answer to the first consideration is set out at paragraph 14, thus:

‘This means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the instrument, ie whether as a conditional primary obligation or a secondary obligation providing a contractual alternative to damages at law. Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty.’

The second consideration is one which is ordinarily answered by a consideration of the 4 factors identified by Lord Dunedin in Dunlop. Those factors are set out at paragraph 21 of the judgment. They had over the 100 or so years following Dunlop ‘achieved the status of a quasi-statutory code’. That was something which Lords Neuberger and Sumption described as ‘unfortunate’. The essential question is whether the clause is one which can properly be described as ‘unconscionable or extravagant’. Whilst the four steps propounded by Lord Dunedin may be a useful tool for determining straightforward cases, they do not readily applicable to more complex ones.

The position now is that wider commercial interests, certainly in more complex cases, can be taken into account. The first step is to ask whether in fact the clause amounts to a penalty, ie whether it is in excess of a genuine pre-estimation of loss. If it is not then it is enforceable. If so, then consideration must be given to whether ‘it can properly be justified by some other consideration than the desire to recover compensation for a breach’. That, as paragraph 28 of the judgment makes clear, ‘must depend upon whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation flowing directly from the breach’.

There has therefore been a distinct unshackling of the hitherto strict approach governed by Lord Dunedin’s 4 tests. Whilst those tests are still likely to prove determinative in more straightforward cases, there is now an area of uncertainty over applicability in more complex scenarios. Consideration of such cases is going to be fact sensitive and parties to such contacts, whether negotiating or litigating them, ought to be aware of the dangers.

[1] Cavendish Square Holding BV v Talal el Makdessi 2015 [UKSC] 67

[2] Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 847