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Paying the penalty? - Supreme Court revises the position on the enforceability of punitive clauses
As contracts have developed over centuries, parties have developed ways to encourage and motivate performance, typically made up of both ‘carrots’ (e.g. milestone payments) and ‘sticks’ (e.g. pre-agreed refunds made in the event of a delay). Whilst generally parties have been able to agree to such terms as they wish, the law has developed to restrict overtly inequitable contractual positions being enforceable. One such example is in relation to contractual terms on liability and the impact of the Unfair Contract Terms Act 1977 (amongst other pieces of legislation). Another area where the law has intervened is in relation to the enforceability of contractual provisions that might seem punitive.
On 4 November 2015, the Supreme Court in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67 handed down a judgment which fundamentally impacts the contract lawyer’s standard approach to penalty clauses under English law.
Where were we on the enforceability of penalty clauses?
It had become widely understood that if a clause required one party to pay the other a sum, and such amount was considered on the facts as punative, then such a provision would not be enforceable. This position was established back in the 1800s and is typically articulated via the ”genuine pre-estimate of loss” test established in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 and in particular the principles established in this judgment by Lord Dunedin.
The impact of this case law has meant that for years we have become used to seeing certain contractual language contained in clauses which involve the payment of sums on a failure of an obligation. For example in clauses dealing with service credits payable for service level breach or liquidated damages payments for a failure to meet a milestone. Typically such a clause would state that the parties both agree that “payments to be made following [the breach] are not a penalty” and are “a genuine pre-estimate of the loss”.
Where are we now?
In Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis, the Supreme Court has acknowledged that the penalty rule interferes with freedom of contract and that it undermines the certainty which parties who have freely negotiated a contract should be entitled to expect. In Makdessi, the Supreme Court has confirmed that the test established by Lord Dunedin in Dunlop is merely a consideration which does not necessarily apply to every case. Instead, it recognises that in some cases a party can have a “legitimate interest” in ensuring that a contract term is performed which goes beyond a desire to be compensated for their losses in the event of a breach.
Through Makdesi the Supreme Court has introduced a more flexible test as to whether a clause is a penalty and therefore unenforceable through the use of the concept of legitimate interest. What amounts to legitimate interest and whether the clause is proportionate to that legitimate interest are likely to be subject to much debate and are likely to turn on the facts of each case. Simply punishing the party in breach is not a legitimate interest but there is potentially a legitimate interest in ensuring performance or in some appropriate alternative to performance.
What are the implications when drafting punitive clauses in your agreements?
- Don’t delete your existing ‘genuine pre-estimate’ clause just yet!: It is still a sensible approach, when drafting clauses relating to payments for failures, to suggest calculating those figures to reflect your genuine expectations of loss - as this is unlikely to be found to be a penalty.
- Do think about creating an evidential trail of your ‘legitimate interest”: If you intend to include a sum which is much higher than your likely losses then you may be able to argue that this figure is not penal if you have a legitimate interest in ensuring the relevant clause(s) in the contract is complied with. This approach comes with risks however, and you must hope that the court agrees with your legitimate interest and that it finds that the clause is proportionate to your legitimate interest. It therefore makes sense that any such legitimate interest you have is clearly understood and expressed so as to support any later reliance. Making the other party aware of why you are taking such a position with an evidential trail of doing so is sensible.
- Think about some additional text: Much as we were used to the language of “parties agree…genuine pre-estimate of loss” it seems likely that we will now see additional text where “parties agree that this provision is included to protect the legitimate interests of” or such like.
- Remember, the clause can only do so much…: With such language, the law hasn’t really changed. What the parties express to be their view/intent is one thing, what a Judge on analysis of the facts might think, is another. Including the clause is only one part of helping pass the new test for your more punitive clause to be enforceable.
- Think of your alternatives: You should also keep in mind that the law on penalties is only triggered where there is an obligation to make a payment or an entitlement to withhold payment which is triggered by a breach of contract. You might be able to avoid the argument as to whether your clause is a penalty by reframing it as payment or forfeiture which is triggered by a positive obligation on the other party rather than by a breach, although the judgment does make it clear that classification of the term will depend on substance rather than form.
For the text of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd click here.