Punitive or a pre-estimate of loss: Clarity is shed on penalty clauses after a century of confusion

15th November 2015

The two recent cases of Cavendish and ParkingEye have clarified the position in relation to penalty clauses for breach of contract.

 

The issue in Cavendish related to a clause that prevented the seller from being engaged in any business that would compete with the business of the company that he had sold for a number of years after the sale. The contract stated that the consequences of such a breach were that he would not be entitled to further agreed payment instalments, and he could be required to sell his remaining shares in the company, without any consideration given for goodwill.

 

In this case it was decided that the clauses were not penalties: goodwill was deemed crucial when negotiating the deal, so it was not disproportionate for the clauses to focus on this in the event of a breach; and the clauses were ‘primary obligations’ in the contract and to remove them would fundamentally change the contract.

ParkingEye managed a car park which contained notices stating that if you overstayed the two hours of free parking this would result in an £85 charge. A customer who overstayed and was issued such a charge argued that the levying of the charge was unenforceable as a penalty. The court ruled, however, that this was not a penalty, as the charge deters overstaying which is important for the proper functioning of the car park. Although ParkingEye did not suffer a direct loss from people overstaying, it still had a legitimate interest in charging a sum which was greater than the recovery of the loss. This was due to ParkingEye’s interests to the landowner and the shops for which it ran the car park.

The crucial test for determining if a clause constitutes a penalty now focuses on whether the clause imposes a detriment that is disproportionate to the legitimate interest of the other party to enforce the primary objective of the contract. A clause can validly attempt to pre-estimate the loss that can be incurred if a breach occurs without constituting a penalty. The notion of proportionality is fundamental, as even if the sum is much greater than the financial loss resulting from a breach, if it can be demonstrated why compensation for the loss suffered would be inadequate, this will not necessarily be a penalty.

 

An important aspect of the judgement is that if the contract was properly negotiated by parties with similar bargaining power who have prior experience of negotiating such a contract, the court will assume that the parties themselves are best placed to assess what a legitimate consequence for a breach should be. Unless there is a clear reason to decide otherwise, the courts will be unlikely to intervene in such cases.

These judgments are a reminder that parties cannot necessarily ignore potential penalty clauses in contracts in the hope that they will be struck out by the courts.

If you wish to discuss any of the issues raised in this article or would like assistance with updating your terms of business please contact Chris Wills, Director and Head of Corporate, on 01872 226992 or chris@murrellassociates.co.uk or Melanie Brown, author of the article.

The information provided in this article is for general information purposes only and does not constitute legal or other professional advice and cannot be relied upon as such. Any law quoted in this article is correct as at27 November 2015. Appropriate legal advice should be sought for specific circumstances before any action is taken. Copyright © Murrell Associates Limited, November 2015.