The parties to a contract often agree that in the event of a breach or non-performance, a certain sum should be payable by one party to the other. These clauses generally fall into one of two categories:-

  • Penalty clauses, which are unenforceable; or
  • Liquidated damages, which are enforceable.

In essence, the distinction between the two is that the former seeks to punish (and on a traditional analysis, deter) a party from breaching his obligations, whereas the latter seeks to quantify in advance how much loss the innocent party would suffer.

Parties often provide for such clauses in their contracts to avoid the difficulties in showing loss and assessing damages, which may include:-

  • Establishing loss – for instance, what the appropriate measure of damages would be and whether the type of loss is recoverable at all;
  • Remoteness – for instance, where loss suffered by one party would not be anticipated as being in the ordinary course of things;
  • Causation – for instance, showing the dominant cause of loss in situations involving multiple contracting parties (such as construction contracts);

The purpose of liquidated damages is to provide commercial certainty and to save time and expense in the event of a breach. These clauses can also benefit the parties by providing a deterrent effect and by protecting interests not ordinarily recoverable through damages. Whether this is permissible has been the subject of recent case law.

The conventional analysis

The conventional position is that there is a rule against penalty clauses. This was set out by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, who set out the conventional test for whether a clause was a penalty clause:-

  • Although the parties may describe a clause as a penalty clause or as a liquidated damages clause, the court will look beyond the label at the substance and effect of the clause;
  • The essence of a penalty clause is that it seeks to deter the party in breach, whereas as liquidated damages are a genuine pre-estimate of damage or loss;
  • In deciding whether a clause seeks to deter a party from breach or genuinely pre-estimates loss, the court will look at the contract and the surrounding facts and circumstances at the date of entering into the contract;
  • The following factors would indicate a clause is a penalty:-
    • If the sum payable is extravagant and unconscionable in comparison to the greatest loss that could have been foreseen;
    • In contracts concerning the payment of money, if the clause provides that a greater amount should be owed in the event of non-payment;
    • If the same clause covers multiple types of breaches, some of which may cause serious loss and some of which would not;
    • However, the difficulty in assessing loss in advance does not make a clause penal, rather, this is when its use is likely to be legitimate.

Therefore, the emphasis under the conventional approach is on whether the purpose of a clause is to deter a party from breaching the contract or provide for a genuine pre-estimate of loss.

A shift in approach

There has always been a degree of difficulty in applying the tests set out in Dunlop Pneumatic Tyre, which can be seen even in that case itself.

In Dunlop Pneumatic Tyre the facts were that a manufacturer (Dunlop) supplied tyres and other similar products into the market via a network of agents. The agreements between Dunlop and the agents included a “Price Maintenance Agreement” which set out minimum prices (these days such a clause may fall foul of competition law) and for a payment of £5 for every article, regardless of its value, sold below this minimum price.

The House of Lords paid considerable attention to the fact that Dunlop would have faced great difficulty in assessing in advance how much loss would be caused to it through its agents undercutting each other in this manner. Ultimately, they accepted that £5 was not extravagant and unconscionable and was designed to compensate rather than punish. However, this clause would clearly have had a deterrent effect, which the courts nonetheless were prepared to allow.

More recently, in Murray v Leisureplay plc [2005] EWCA Civ 963, Lady Justice Arden put the test for a genuine pre-estimate of loss slightly differently: “The real question is whether the sums for which the parties have provided to be paid on breach differ substantially from the sums that would be recoverable at common law”. Moreover, even if the sum did substantially differ it would be permissible if it was “commercially justifiable, provided always that its dominant purpose was not to deter the other party from breach”.

Penalty clauses were again an issue in Cavendish v Makdessi [2015] UKSC 67 in which Lord Mance said, “What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable”.

Moreover, the Supreme Court shifted away the test from deterrence – deterrence can now be a legitimate business interest: “A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected. It is no different in this respect from a contractual inducement. Neither is it inherently penal or contrary to the policy of the law,” said Lord Neuberger; “Many contractual provisions are coercive in nature, encouraging a contracting party to perform his or her obligations; the prospect of liability in common law damages itself is a spur to performance”, said Lord Hodge.

Indeed, this accords with the tension earlier identified in Pneumatic Tyre – often a clause will both deter and compensate, and if loss is hard to assess then the deterrent effect will be more pronounced. Following Cavendish the test has shifted somewhat in form and now focuses on whether the deterrent effect is unconscionable when compared to damages or the innocent party’s interest in performance.

The appeal in ParkingEye Ltd v Beavis was heard by the Supreme Court at the same time as Cavendish. It was significant in that it provided for an innocent party to have an interest in performance other than that which would normally give rise to compensation in damages. In effect, the court allowed the parties to agree a sum that takes into account factors that would not normally fall under a recoverable head of loss.  Lord Mance said, “commercial interests may justify the imposition on a breach of contract of a financial burden which cannot either be related directly to loss caused by the breach or justified by reference to the impossibility of assessing such a loss… There may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden”.

In ParkingEye a parking enforcement company (ParkingEye) operated a scheme whereby customers at a retail park had two hours’ free parking before they would be charged a fine of £85. ParkingEye could establish no direct loss in that the overstaying did not cost it anything. The Supreme Court held that whilst deterrence was the main purpose of the clause, it was justifiable by reference to its goals – namely ensuring the provision of free parking to customers, the efficient management of the car park and to make reasonable amounts to fund the operation of the scheme. Moreover, the amount charged, £85, was not disproportionate in comparison to these goals and was broadly in line with that charged by local authorities.

Conclusion

Penalty clauses and liquidated damages are often thought of as dichotomous – one is penal and the other a genuine pre-estimate of loss. However, there has always been an overlap between the two and accordingly there has always been a certain degree of tension.

However, the courts are shifting in their approach: clauses can still be ineffective for imposing a penalty, but in assessing what is a penalty regard will be had to a wider range of factors and deterrence is now recognised as being a legitimate objective. The crucial factor in ensuring the validity of such a clause will be the proportionality of the deterrence in the context of the legitimate objective.

Edward Ng-Cordell | Trainee Solicitor