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When is a penalty clause not a penalty?

It is common for parties to commercial contracts to agree in advance that a specified sum will be paid upon breach of a contractual provision. The general rule is that, if a clause is a liquidated damages clause, then it is enforceable and the sum is recoverable. However, if it is a penalty, then it will not be enforced beyond the actual loss suffered.

However, in two landmark decisions (Cavendish Square Holdings, and ParkingEye), the Supreme Court has upheld the validity of clauses which had been challenged as penalty clauses.   Lord Hodge considered the law from a Scots law viewpoint and confirmed that the law in Scotland and England is essentially similar.

Previously, the test for enforceability was whether the sum payable constituted a “genuine pre-estimate of loss”. That is now thought to be too narrow a test and proportionality will now be the key – does the clause in question impose a detriment  which is “out of all proportion to any legitimate interest of the innocent party”.

It remains to be seen how this new rule of “out of all proportion” will be applied in practice but the judgements do signal an increased readiness for the courts to give effect to the intention of the parties.   This calls for more focus when drafting or considering this type of clause and, where possible, demonstrating the legitimate interest to protect and the proportionate nature of the protection being sought in the clause.

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