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Generally, any clause included within a commercial contract which is included for the sole purpose of punishing a breaching party is deemed a ‘penalty,’ and is consequently unenforceable in law to the extent that it extends beyond the actual loss sustained as a result of the breach.

However, the courts are now usually more reluctant to interfere with each entity’s freedom to contract with each other, but there are nevertheless several circumstances where the rule against penalties may become relevant in modern commercial relations.

Makdessi and ParkingEye

Until recently, the definition of a penalty clause derived from the 20th century case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd. Here, a penalty was described as a monetary payment designed to punish the breaching party rather than representing a genuine estimate of the damages arising due to the breach.

This understanding was revised and streamlined in the more recent case of Cavendish Square Holding BV v El Makdessi and Parking Eye Ltd v Beavis. It was ultimately decided that a clause should not be considered penal merely because it imposes a payment of money or other remedy which goes beyond a pre-estimate of loss. The key factor in deciding whether a clause should be deemed a penalty was instead whether it was unconscionable or extravagant in reprimanding the party in breach.

This new approach was clearly demonstrated in the Parking Eye Ltd v Beavis branch of this case, which concerned an individual (Mr Beavis) who was charged £85 for overstaying beyond the maximum stay in a car park. Mr Beavis contested this charge on the basis that this was a penalty which extended beyond the loss suffered as a result of his actions. It was decided, however, that this £85 charge did not amount to a penalty. Despite going beyond a pre-estimate of the loss caused by Mr Beavis overstaying at the car park, it was held that the charge was not disproportionate to the claimant’s interests and was therefore not unconscionable or extravagant. The decisions of Makdessi and ParkingEye therefore largely relaxed the rule on penalties, which now appears to be reserved for penal clauses of unacceptable severity.

Liquidated Damages Clauses

As a result of the rule against penalties, modern commercial contracts should avoid the inclusion of any clauses which could be deemed penal. As explained, penalty clauses are unenforceable, thereby preventing a potential claimant from relying on its protection, and the courts’ approach to damages in circumstances where a penalty clause has arisen have been inconsistent. Certainty can therefore be achieved by including a clear liquidated damages clause which states the damages payable should a breach of contract arise. Some key considerations when including a liquidated damages clause include:

• whether the damages figure provided would be deemed an unconscionable or extravagant punishment of the breaching party. This accusation can be easily avoided if the figure represents a genuine estimate of potential loss, however it is possible to stipulate a higher amount as long as the chosen figure is commercially justifiable; and
• whether the chosen damages figure would need to be adjusted should the contract be amended- for example, where a purchase price is reduced, would the chosen figure still constitute a potential estimate of loss deriving from breach of contract?

Default Interest Clauses

Another form of liquidated damages clause is a default interest clause. These clauses are commonly included in loan agreements and other financial instruments, stipulating that any sums of money due under the contract which are not paid on time will be subject to an agreed higher rate of interest until payment is made in full.

Default interest clauses can, however, be deemed to be a penalty where the repercussions on the defaulting party are considered to be overwhelmingly punitive rather than simply encouraging prompt payment. This occurred in Ahuja Investments Ltd v Victorygame Ltd and another, where a default interest rate of 12% per month (a 400% increase on the pre-default interest rate) was deemed unconscionably extravagant, and the lender could not enforce this clause as a result.

Default interest clauses should therefore be drafted with the same care and with the same considerations in mind as a liquidated damages clause. Any party seeking to include a default interest clause should do so in accordance with the commercial acceptability of the imposed default interest rate, and whether they are able to justify this. Notably, the judge in Ahuja commented that he would have accepted a default interest rate which was double the usual rate charged without the need for supporting evidence, as an appropriate reflection of a defaulting borrower’s credit risk- the need to be mindful of each commercial circumstance is therefore undoubtedly a leading consideration when incorporating enforceable default interest clauses in contractual agreements.

Conclusion

Following Makdessi and ParkingEye, the rule against penalties has been undoubtedly relaxed, therefore allowing greater freedom when stipulating damages clauses in modern commercial relations. This should not, however, be taken as a blanket approval of any and all damages clauses regardless of their severity, as courts have demonstrated a clear willingness to prevent reliance on unconscionable and extravagant clauses aiming to punish parties in breach beyond all commercial sensibilities. Where damages clauses are used, they should therefore be drafted carefully and incorporate a justifiable damages figure to ensure that the contracting parties can safely rely on these in cases of breach.

Further advice on Penalty Clauses

If you have any queries relating to penalty clauses, please contact one of our experienced Corporate, Commercial and Finance lawyers who will be able to advise you further.

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