Penalty clauses are unenforceable by courts.
If the sum agreed is meant as a threat to the other party to force them to perform, such a sum is said to be a penalty and the claimant can only recover their actual loss.
In Law v Redditch Local Board [1892] 1 QB 127 the court held that whether a sum is liquidated damages or a penalty depends on the intention of the parties. If the sum agreed was meant to secure performance by imposing a fine or penalty, then it is a penalty. If, however, it is a sum meant to compensate for breach of contract, it is classified as a liquidated damages clause. The burden of proving that the agreed sum is a penalty is on the party who is sued for the sum agreed (Robophone Facilities Ltd v Blank [1966] 1 WLR 1428).
In 2015, the Supreme Court, in the cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, introduced a more flexible approach to determining whether a contractual provision constitutes a penalty. The court criticized the previous rigid categorization of penalties and emphasized the need to consider the broader commercial context of the transaction.
According to Lord Neuberger’s judgment in Cavendish, the key test for determining whether a clause is a penalty is whether it imposes a disproportionate detriment on the party breaching the contract compared to the legitimate interest of the innocent party in enforcing the primary obligation. This approach shifts away from the traditional focus solely on whether the clause represents a genuine pre-estimate of loss.
Under this new framework, courts will examine whether the clause’s effect is unreasonably harsh relative to the innocent party’s interests. This involves considering factors beyond just the direct financial loss, such as reputational concerns or other non-quantifiable damages. Therefore, even if the specified amount does not directly correspond to the actual loss suffered, it may not be considered a penalty if there are legitimate reasons for the discrepancy, as seen in the Cavendish case.