Contractual penalties

“An ancient, haphazardly constructed edifice which has not weathered well and which, in the opinion of some, should simply be demolished and, in the opinion of others, should be reconstructed or extended.”

This sounds like a description of a redundant mediaeval building in the town centre. In fact, it is a quote from the decision in a recent Supreme Court appeal describing what is known in English contract law as the “penalty rule”.

It is quite common for parties to a commercial contract to agree that, in the event of a breach of a contractual provision, the defaulting party should pay a specified sum. The general rule is that, if the specified sum equates to liquidated damages for the breach, it is enforceable whereas, if it is a penalty, it will not be enforced beyond the actual loss of the claimant.

The traditional test for establishing whether a penalty clause can be enforced is to determine whether the stipulated sum is “extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach of contract”.

The recent Supreme Court appeal involved two very different breaches of contract. In the first case, Mr M. had sold his company with payment to be made in three stages. The second and third instalments were conditional on him not competing with the buyer. Mr M. admitted being in breach of the non-competition clause but argued that the buyer’s refusal to pay the two final instalments was an unenforceable penalty.

In the second case, Mr B. parked his car in a city centre car park which allowed a maximum stay of 2 hours and incurred a penalty of £85, payable to the company who managed the car park, when he overstayed by 56 minutes. He refused to pay the penalty claiming it was unenforceable and that the car park company had not actually suffered any loss.

In both cases, the Supreme Court judges decided that the contractual penalty was enforceable. In the case of Mr M. his refusal not to compete with the buyer of his business had effectively undermined the value of the goodwill he had sold which was fundamental to the deal. In the case of Mr B. the judges found that the car park managers had a legitimate interest in charging a sum which extended beyond the recovery of any loss.

The detailed judgment helpfully clarifies the law in this area and provides guidance as to how the penalty rule should be applied to modern commercial contracts.

Article published previously in Business East, 23rd November 2015

Toby Pound is a partner and head of the Property department at Barker Gotelee.

Suffolk Property Solicitors – for more information on our range of legal services, please call the team on 01473 611211 or email [email protected]