New penalty test
15 December 2015
The Supreme Court has provided a new test on penalties, which replaces the old test of whether a clause was a "genuine pre-estimate of loss". The court ruled in Cavendish v Makdessi; ParkingEye v Beavis  UKSC 67 that the new test is whether the clause is a secondary obligation which imposes a detriment which is out of all proportion to the legitimate interest of the innocent party. If so it will be penal and therefore unenforceable. The ruling helpfully acknowledges that a party can, in some circumstances, have a legitimate interest in enforcing performance which goes beyond simply being compensated for losses.
- The difficult distinction as to whether a provision is a primary or secondary obligation. The members of the court did not agree on this point on the facts.
- In what circumstances, even where one is concerned with a primary obligation, it can nevertheless be viewed as a disguised punishment? It is hoped that this will only operate as a safety valve in exceptional circumstances.
- What legitimate interests can be protected? This itself may by intertwined with whether the clause is a primary obligation and parties are advised to consider this aspect of the test in any event.
- How the courts are going to apply the test of whether or not a clause is "out of all proportion" to that legitimate interest. It is hoped that they will be loath to second-guess the parties' own judgment on that issue, especially in a heavily negotiated commercial contract.
- Try to identify precisely what the legitimate interests in a clause that operates on breach may be and even consider setting those interests out the recitals.
- Try to ensure that, where possible, key clauses operating on breach are drafted so as to highlight their importance to the overall package. The idea is to maximise the chances of such a clause being identified as primary obligations. An alternative would be to draft in a way which makes the obligation conditional.
- Where appropriate include within an agreement that that each side was of comparable bargaining power and each side had been fully advised by solicitors.
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