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Penalty clauses and their implications

Napthens - February 8th 2016

It is a well known fact that the English are terrible at penalties. My theory is that this all stems from the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd back in 1915 whereby it became a fundamental part of English contract law that penalties were unenforceable.

Following Dunlop, clauses whose effects were “extravagant and unconscionable” would be regarded as penalties. This lead to any clauses designed to have a primarily deterrent effect, rather than just providing damages for pre-estimated loss, being automatically seen as unenforceable.

In November the Supreme Court published its judgement in two cases on this point, ParkingEye v Beavis and Cavendish v Tal Makdessi, and it would appear that the judgement is a fundamental change to the way we look at penalty clauses.

In the ParkingEye case, Mr Beavis overstayed the free two-hour parking at his local retail park by 56 minutes and was sent an £85 charge (as per the signs on display in the car park). Mr Beavis claimed that the charge was far greater than any loss suffered by ParkingEye and was therefore a penalty and unenforceable. Unfortunately for Mr Beavis the Supreme Court decided that the tests developed in Dunlop were out of date, and they decided to look whether the charge could be justified by a combination of social and commercial factors.

The Supreme Court refined the test so that the question is now whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.

Whilst the charge was clearly designed to be a deterrent, this should not mean that it is automatically unenforceable. In this case they found that the clause could be justified. ParkingEye did not charge the supermarket to manage the parking, and its sole source of revenue was from overstay charges. The court considered that the social benefits from having free parking available to the community, together with the fact that they considered the charge to be reasonable and proportionate (even though it was greater than any loss or damage suffered by ParkingEye), outweighed any claim that the charge was extravagant and unconscionable. Of course they made it clear that a charge could still be unenforceable if it was disproportionate, but it will be determined on a case by case basis.

In looking at Cavendish, where the parties had entered into a contract for the sale of shares and Cavendish had used a breach of restrictive covenants to avoid paying instalments of the purchase price, the Supreme Court went further and the judgement implies that it will be difficult to argue that a negotiated clause is extravagant and unconscionable if a party agreed to it at the time: “in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach”.

All this means two things:

  • You may have been advised not to worry about certain clauses in historic documents because they were unenforceable penalties – this may no longer be the case!
  • The levels of liquidated damages or penalties included in new documentation may be set to increase as parties realise that they can use the deterrent effect of a clause provided that it is justifiable to do so.