Penalty Clauses in Commercial Contracts
It is a well-established principle of English law that, where one party is in breach of contract, the aim of damages is to compensate the innocent party for the loss it has suffered as a result of the breach. Unlike in other jurisdictions, particularly the US, English common law does not recognise the concept of punitive or special damages.
Commonly, in commercial contracts, parties will seek to agree terms setting out the financial extent of liability on either party in the event of default. Such terms are known as liquidated damages clauses and are often used in oil and gas, manufacturing and construction contracts, when performance of the parties’ obligations is often set within tight timescales and failure to do so can have consequences on the ongoing contract. So, for instance, parties to a construction contract may agree that, if one party fails to deliver materials on time such that the project is delayed, it will pay a fixed sum of money per day, until delivery is made. It can be beneficial to use liquidated damages clauses, for various reasons.
Benefits of liquidated damages clauses are:
- They provide certainty – the parties will know the extent of their liability in the event of default.
- Ease of Enforcement – there will be a specific clause for the innocent party to rely on, making enforcement much easier.
- Limitation of liability – the parties will know the limit of their liability. This might be beneficial for a party in default if, for instance, the actual loss caused by its breach is higher than the sum imposed by the liquidated damages clause. This can be viewed as a benefit or a disadvantage, depending on whose side it is considered from.
- Preserving the ongoing commercial relationship – where, notwithstanding the breach, the parties need to continue to work together to complete the contract, litigious proceedings are a distraction at best and can be expensive and commercially very damaging. Where there is an ongoing commercial relationship between the parties, a liquidated damages clause allows them to deal with the breach quickly and effectively, so they can resume the performance of the remaining obligations of the contract.
As opposed to claims for unliquidated damages, which are often fraught with issues over causation, proof of loss and remoteness of damage, liquidated damages clauses do not carry such legal difficulties.
However, following the principle stated above, the measure of liquidated damages must be such that it is a reasonable assessment of loss and intended to have the effect of compensating the innocent party, rather than punishing the party in breach, or of simply acting as a deterrent to any breach.
Nowhere has this principle come into play more evidently than in relation to the issue of penalty clauses. Broadly speaking, a penalty clause is a contractual provision which levies an excessive monetary penalty on a party in breach of contract which is out of all proportion to the loss suffered by the innocent party. Penalty clauses are generally unenforceable in English law. In considering the issue down through the years, the Courts have differentiated between a sum representing a genuine pre-estimate of damages (an enforceable liquidated damages clause) and a sum which is out of all proportion to any damages likely to be suffered by the innocent party (an unenforceable penalty clause).
Genuine pre-estimate of loss
The history of the law in this area is best exemplified in the case of Dunlop Pneumatic Tyre Co Ltd – v – New City Garage , in which New City Garage breached a contract with Dunlop to sell tyres at an agreed price, as well as selling Dunlop tyres to certain black-listed customers. Dunlop sued and sought to enforce a provision in the contract which provided that a fixed sum would be payable in the event of any breach of the agreement. The House of Lords dismissed Dunlop’s claim on the basis that the fixed sums were penalties, not genuine pre-estimates of loss. In reaching its decision, the Court was no doubt influenced by the fact that the contract provided for a fixed price to be paid in the event of any breach, no matter the nature of that breach. Such a clause rendered it more difficult to argue that the fixed sum was a genuine pre-estimate of loss. The Court, in reaching its decision, set out the following factors for consideration:
The sum required to be paid was an “extravagant and unconscionable” deterrent, in light of the loss likely to be suffered by the innocent party:
- It exceeded the maximum possible loss
- Different breaches on the part of New City Garage gave rise to the same penalty
- It was not a genuine pre-estimate of loss, rather it was a sum clearly in excess of the loss likely to be suffered and as a result a deterrent and so unenforceable
Over the years however, there has been a shift in the Court’s approach. The Courts have slowly but surely began to accept that there were circumstances where parties could agree in their interests to have a commercial solution to a dispute which could render an agreed fixed remedy commercially justifiable. The shift in the legal landscape culminated in the cases of Cavendish Square – v- Makdessi  and ParkingEye Ltd – v – Beavis , which were heard jointly in the Supreme Court.
The decisions in these cases mark a radical change in the Court’s approach to dealing with liquidated damages clauses.
Primary v secondary obligations
The first question to consider is whether the contract imposes a primary obligation or a secondary obligation. A primary obligation is a stand-alone contractual obligation, whereas a secondary obligation is only triggered as a consequence of breach of contract and is intended to provide an agreed contractual remedy, for instance, a secondary obligation to pay a fixed sum in the event of breach of a primary obligation. The question of whether a clause is a penalty clause (and therefore unenforceable) only arises in relation to a breach of a primary obligation, when the Court may seek to review and regulate the remedy imposed by the secondary obligation.
The Court departed from the “genuine pre-estimate” rule in Dunlop. Rather, they recognised that where an innocent party could demonstrate that it was using a clause in a contract to protect a legitimate interest and the penalty is not exorbitant or unconscionable, it does not have to be a genuine pre-estimate of loss. The Court held that the true test is “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”. Therefore, the correct analysis to be applied is now as follows:
- Is the disputed contractual term a primary or secondary obligation?
- If it is the latter, does the innocent party have a legitimate interest to protect?
- If not, the clause will be a penalty clause and unenforceable. If so, is the remedy imposed by the secondary obligation out of all proportion to the interest to the innocent party in the contract being performed? Again, if it is, it will be a penalty clause and unenforceable.
It should be noted that the Makdessi case was complex and often it will not be easy to determine whether a clause in a contract is a penalty clause. The wording of the clause itself must be analysed, as well as the expectations and interests of the parties when they entered into the contract, in order to form an informed view of the position. Furthermore, care should also be taken when drafting commercial agreements to ensure that obligations and remedies within them can be justified, should there subsequently be a dispute over their terms.
This article is not intended and should not be relied upon for legal advice. Should you wish to discuss your matter, please contact Joe Reeves of our Litigation Department on 0207 481 6383 or firstname.lastname@example.org.