10th Nov 2015

Don't lose on penalties

One of the oldest rules of law has recently been re-stated in two Supreme Court appeal cases.

It is common when entering into commercial contracts to provide that if one party commits a breach of that contract the other may be compensated without the necessity of having to bring Court proceedings. There is a risk however that, if the provisions are not correctly drawn, they will not be effective. The basic rule, simply put, is that a provision in a contract which seeks to impose a penalty, as opposed to a genuine pre-estimate of damages for loss caused by the breach of the contract, is unenforceable.

The history of the law in this area is both long and complex. The principles were laid down in a leading judgement a century ago. Recent cases, however, have extended the rule in more complex cases and ask one to consider further issues, such as whether it is in the interests of the innocent party to look beyond mere damages for breach and whether the provision in the contract is otherwise commercially justified.

Cavendish Square Holdingsv. El Makdessi(2015) – Here the rule against penalties did not apply. An agreement for the sale and purchase of a business provided that, if the seller breached restrictive covenants, the buyer did not have to pay future instalments of the purchase price.The Court regarded this as a price adjustment clause.It was perfectly legitimate for the buyer to seek to ensure that the restrictive covenants were complied, as these were critical to the value of the business to the buyer.

ParkingEye Ltd v. Beavis (2015) - Here the rule against penalties did apply (to an £85 charge for overstaying the 2 hour limit in a privately run car park), but the charge was not a penalty as ParkingEye had a legitimate interest in charging overstaying motorists which extended beyond the recovery of loss, namely the efficient management of the car park.

The layman may consider it odd that two parties, each with (on the face of it) equal bargaining power, who reach agreement on a contract, may find that the Court intervenes at a later stage (when the parties are obviously no longer in agreement) to determine that an element of that contract is not enforceable. It is worth remembering, however, that that contract, which you thought you had cleverly negotiated to leave you more than adequately rewarded when things go wrong, may not be so clever after all.

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