Law on Contract Penalties Redefined

Posted: Wednesday, 2 December 2015 @ 11:23

It is quite common for pre-estimated compensation for specific breaches of contract to be provided for in the written contract at the outset, avoiding the difficult and costly process of calculation of loss when breach occurs. The other advantage is of course certainty, allowing each party to understand their risks and obligations from the beginning. Such clauses are referred to as “liquidated damages”.

These clauses can be most often found in commercial contracts, particularly in the construction and engineering industry where completion dates are time critical. But they can also be found in common day to day usage by all walks of life, who are unlikely to be aware that taking part in certain activities involves entering into a contract.

The most obvious example is that of the parking charge. By entering and parking in the car park you are deemed to be contracting with the car park operator and deemed to accept their terms and conditions. It does not matter that your have not read them. They will be displayed, and invariably show the charges which apply if you breach the conditions, such as overstaying in a pay and display, or losing your ticket in a pay on exit car park.

The charges can be, for example, ten times the hourly rate and cost of your overstay, and it could be said that those charges greatly exceed the loss to the car park operator. They are pre-determined “liquidated damages”.

However, for well over 100 years there has been a defence to such claims for liquidated damages. In English common law, if it can be shown that the relevant charge is a penalty, it is unenforceable. A penalty is a charge greatly in excess of a genuine pre-estimate of loss.

The law on penalties has just been considered by the highest court in the land, the Supreme Court. It dealt with 2 cases on the law of penalties, one a complex commercial case involving a liquidated damages clause of $44M, the other a simple matter of an excess parking charge of £85. But the principles involved are basically the same. The court took the opportunity of examining the law in detail and provided a definition more in keeping with the modern world.

In the cases of Cavendish Square Holdings against El Makdessi, and ParkingEye against Barry Beavis, the court took a close look at the law, and found in each case that the charges were not penalties, and were therefore enforceable. Their reasoning was that in each case the parties relying on the liquidated damages clause had a legitimate interest which went beyond the realistic financial loss. They had a legitimate commercial interest which they were entitled to protect.

In Cavendish the parties were sophisticated commercial enterprises with the benefit of legal advice, and the liquidated damages clause was not meant as a punishment, but was all to do with Cavendish achieving its commercial objective in acquiring the business form Makdessi. The amount was not extravagant, exorbitant, nor unconscionable.

In Beavis the £85 excess parking charge had 2 main objectives. The first was to manage the efficient use of the parking space, for the benefit of the retail outlets served by the car park as well as other users of the car park. The second was to provide an income stream to enable ParkingEye to meet the running costs of the operation. It was not a penalty, as ParkingEye had a legitimate interest which went beyond the recovery of any loss. I am sure that Mr Beavis was disappointed with the outcome, but at least he had his day in the highest court in the land over a mere £85.

So in the end the Supreme Court confirmed the rule on penalties, but redefined it to meet modern requirements. To quote Lord Neuberger and Lord Sumption, the test for a penalty is whether the “…provision imposes a detriment on the contract breaker out of all proportions to the legitimate interests of the innocent party…”.

In future, if a contract clause for liquidated damages is challenged as an unlawful penalty, it will be necessary to identify firstly the reasonable amount of the loss incurred by the innocent party, and if it is more than expected, to look at whether the amount is reasonable to protect the wider legitimate interest of the party looking to enforce it.

Nigel Musgrove
Business and Litigation Solicitor
Tel: 0845 003 5639










This blog is not intended to constitute legal advice, nor is it intended to be a complete and authoritative statement of the law, and what we say might be out of date by the time you read it. You should always seek legal advice to confirm whether or how any information in this article applies to your particular situation. We offer a free telephone consultation to discuss your particular circumstances.

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