The rule against penalty clauses

The test is whether the clause in question imposes a liability on the breaching party which is disproportionate to any legitimate interest of the innocent party in the commercial context of the contract. When drafting such a clause it is advisable to consider the following:

• The purpose and context of the contract as a whole, in particular what its primary purpose is.
• The mischief or harm which may be caused by a breach of the clause (i.e. what you would be trying to correct). For example, if the other party is a seller of a particular item which you need to manufacture your product, what would happen if it was not delivered on time? What would that cost you?
• Whether there any other remedies already available to you if such a breach were to occur.

We take a look at some examples of how the court has approached this:

Vivienne Westwood Ltd v Conduit Street Development Ltd [2017] EWHC 350 (Ch)

This matter was a landlord and tenant dispute. The lease provided for rent at a certain rate but a separate agreement stated that the tenant could pay a lower rent so long as they did not breach any of the terms of the lease. If they did breach, they would be liable under the agreement to pay the higher rent contained in the lease both going forward and with retrospective effect (i.e. back-dating the additional rent to the commencement date of the lease).

The High Court found that paying this higher rent was extravagant, especially given other remedies were already available to the landlord, such as damages, costs and interest. These usual remedies were sufficient and the additional obligation of paying a higher rate, particularly one applied retrospectively, was disproportionate in the circumstances. The clause was deemed to be a penalty and was not upheld.

Makdessi v Cavendish Square Holdings [2015] UKSC 67

Mr Makdessi agreed to sell a controlling stake in a company to Cavendish. There was a non-compete covenant in the agreement which, if breached, meant Mr Makdessi would not receive the two final payment instalments and could be forced to sell the remaining shares at a reduced price.

The Court held:

The court will look at what a genuine pre-estimate of loss would be, and the wider commercial interest in performance by the innocent party. Even where the clause protects a legitimate interest of the innocent party, it still cannot be extravagant or unconscionable, so the court will also consider proportionality.

In Makdessi the Court found that although the clause had no relationship to the loss attributable to the breach, Cavendish had a legitimate interest in the observance of the covenant which extended beyond the recovery of that loss: ensuring that Mr Makdessi did not compete with his old business. Cavendish were therefore able to enforce the clause. It was not found to be a penalty.

Penalty clauses summary

The Court will intervene even where an agreement has been carefully negotiated between two informed parties in good faith.

It is a fine line between deterring a breach and punishing a party. This means that drafting clauses that deal with breach of contract can be difficult, and is something that requires careful thought if the clause is to be upheld. The commercial circumstances in which the agreement was made will be the key consideration in determining on which side of the line the clause likely falls.

Our Commercial Team can provide advice in relation to sector specific commercial considerations and how best to draft agreements that contain these types of clauses. Similarly, our Commercial Disputes Team can assist where a dispute has already arisen. Please contact us for more information.