The Supreme Court clarified the contractual penalty rule in a decision on appeals, Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis.
The Supreme Court held that the underlying rationale for the rule had been misunderstood and the established test was applied over-literally and poorly adapted to modern commerce. The Supreme Court rejected the old test of whether a clause was a “genuine pre-estimate of loss”. Lord Neuberger held that a clause will be penal where it is:
“a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”.
The innocent party’s legitimate interest is usually in the performance of the primary contractual obligation. However, the Supreme Court noted the wider commercial context of the contract may be relevant and a party might have an interest which goes beyond compensation for default of a primary obligation.
Despite an invitation to do so, the Supreme Court declined to abolish the penalty rule, noting that it was a longstanding principle of English law which also existed across the commonwealth and in most Western European legal systems. The court also refused to extend the rule to apply to clauses which operate in situations other than breach.
For further information, please contact Steven Mash, Partner, Fladgate LLP (firstname.lastname@example.org)