Commercial Contracts: When Will Penalty Clauses be Enforceable?

Commercial Contracts: When Will Penalty Clauses be Enforceable?

Businesses with commercial contracts imposing pre-determined financial or other penalties in the event of a breach may find they are unenforceable, following landmark rulings in two similar cases.  

The expert commercial lawyers at top Bahamas law firm ParrisWhittaker have many years’ experience advising clients on commercial contracts and the implications of breach of contract.

What is a penalty clause?

A penalty clause is a term in the contract requiring one party to pay or forfeit a sum of money if they breach the contract.  This will not usually be enforceable unless that sum is justifiable as being a genuine pre-estimate of the loss suffered, or on certain other grounds.

The UK’s Supreme Court recently handed down two important rulings in cases concerning penalty clauses and liquidated damages in commercial contracts.

In one case, a penalty charge of £85 was imposed on a motorist who overstayed the timed parking period for which he had paid the usual fee. The Court eventually found that the penalty charge was valid and neither extravagant nor unconscionable - or even unfair.  It was justified for both social and commercial reasons, and the company had a legitimate interest in attempting to prevent motorists overstaying.

In the other case, two clauses in a share purchase agreement required a shareholder who was selling his shares, to forfeit large sums of money for breaching restrictive covenants that prevented him from competing with the business of the company in which he had sold shares.   The penalty clauses were enforceable – but how did the court decide this?

The Supreme Court considered the law on penalty clauses.  It ruled that the true test to be applied is whether the provision is a ‘primary obligation’, or a ‘secondary obligation’ (which effectively imposes a disproportionate detriment on the person breaching the contract which is exorbitant and unconscionable) which is unenforceable.

The clauses in the second case were found by the Supreme Court not to be penalties because they were ‘primary’ obligations.

What does this mean?

The result of these rulings is not the complete abolishment of penalty charges – but a limitation imposed on when it will be allowed to stand. This means businesses who have contracts imposing pre-determined financial or other penalties in the event of a breach should review them to check whether they are enforceable.  The question is – are they linked to primary or secondary obligations?

Parties negotiating new contracts should take this test into account when considering/negotiating which penalties to include in their contract documentation.

How can we help?

For expert assistance on penalty clauses or any issue or dispute relating to your commercial contracts, contact the experienced commercial lawyers at ParrisWhittaker for urgent advice and representation.

1 Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67