Are Penalty Clauses Enforceable?

From time to time a business may become involved in a contractual dispute whereby a large monetary penalty is sought. These disputes relate to penalty clauses and there are certain circumstances where such penalties may or may not be enforceable.

What is a penalty clause?

A penalty clause is an express provision in a contract. It places an obligation upon the party who has breached the contract to provide compensation to the aggrieved party affected by the breach.

Receiving compensation is not as straightforward as it may seem and it may be very complex and difficult in certain situations.

Is a penalty clause enforceable?

In the case of Cavendish Square Holdings BV v Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67, the Court found that a penalty clause can be enforced if:

  • There is a legitimate purpose;
  • It is proportionate; and
  • The clause is not a primary obligation.

Otherwise, a penalty clause may not be deemed enforceable.

The Court distinguishes between a clause that is classified as a primary obligation or a secondary obligation. The Court will not review primary obligations, as this would amount to reviewing the fairness of the contract and it is not something the Court will likely consider. This means that the Court will only review clauses which fall into the category of secondary obligations.

Primary Obligation

This is a condition that is imposed upon a party which states that it is a requirement that the party performs the condition since it is a main condition of the contract that it is contained within the agreement.

Secondary Obligation

This is an obligation which is incidental to the main/primary obligation or arises when the main/primary obligation cannot be satisfied.

ParkingEye

Background

A car park was owned by British Airways Pension Fund, who contracted with ParkingEye to act on their behalf. Users were allowed to park for free, for up to 2 hours. Any time spent beyond the 2 hour time limit could attract a charge of £85.00.

Beavis used the car park, stayed beyond the 2 hour limit and was charged £85.00. Beavis argued the charge was a penalty clause and was unenforceable.

The Court found that the penalty rule was activated, but ParkingEye had a legitimate interest and in the circumstances it was proportionate to the aims in charging an individual who had overstayed £85.00.

Cavendish

Background

Cavendish and Makdessi entered into an agreement that Makdessi would sell to Cavendish a position in a company. A provision in the agreement entered into was that Makdessi would receive the final payments of the purchase price, from Cavendish, via instalments.

However, if Makdessi breached certain restrictive covenants that were in place, he would not receive his final instalments. Furthermore, he would have to sell his shares to Cavendish at a significantly discounted rate.

Makdessi breached the covenants and argued that the clauses (there were two clauses that were disputed) were penalty clauses and therefore unenforceable in the circumstances.

It was held by the Court that the first clause was a primary obligation and was therefore enforceable. The second clause was found to be a secondary obligation as it was reliant on the performance of the primary obligations contained within the agreement.

However, when analysing if it was enforceable, it was found by the Court that the second clause was enforceable as it served a legitimate interest and the remedy provided was proportional to the aims.

The test

Therefore, the test on enforceability as set out by Court in the above cases is:

Step 1) Can the clause in dispute be classified as a primary or secondary obligation?

  • If it is a primary obligation then the clause is enforceable.
  • If it is a secondary obligation then go to step 2).

Step 2) Can the clause in dispute be classed as penal?

  • Are there legitimate interests/aims behind the party benefiting? If no, then it is a penalty clause and unenforceable. If yes, then can it also be said that the remedy provided is proportionate to the interests/aims? If no, then it is a penalty clause and unenforceable. If yes, then it is not a penalty clause.

How can Nelsons help?

Matthew Clarke is a Trainee Solicitor in our expert Dispute Resolution team.

If your business has an on-going contractual dispute or any related questions, please contact our team in Derby, Leicester or Nottingham for advice on 0800 024 1976 or via our online form.