Supreme Court Confirms the Test for Penalty Clauses


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Supreme Court Confirms the Test for Penalty Clauses

 

Last year we wrote to you about the Court of Appeal decision in the Honey Bees case.  This decision was appealed and the Supreme Court has now issued its judgment (attached).

Background

A Landlord claimed that a liquidated damages clause in its commercial lease was an unenforceable penalty because of the onerous obligations imposed under the clause.

The Supreme Court Decision

The Court has confirmed that the test for establishing a penalty clause is the disproportionality test and has clarified the applicable considerations for when applying the test.   This is a departure from the earlier test, which was that the amounts claimed must be a genuine pre-estimate of a party’s loss. 

  • The test is whether the consequences from the clause are out of all proportion to the legitimate interests of the party seeking to rely on the clause.  This is an objective assessment, as at the time of the contract formation,
  • This will be determined by considering:
    • What are the legitimate interests of the party relying on the clause, including those which may extend beyond the loss caused by the breach (as measured by a conventional assessment of contractual damages),
    • The context and circumstances in which the contract was entered into,
    • The bargaining power between the parties when entering into the contract, including whether a party had legal advice.

This decision is significant because it allows for a wide assessment of legitimate interests which may go beyond the loss caused by the breach.   This means particularly demanding clauses might be enforceable if the remedy is not out of all proportion to a party’s legitimate interests, which is a high threshold to meet.  

What does this Decision mean for you?

If you intend to include a liquidated damages clause in a contract, you must be careful to ensure that it is drafted to reflect a clear compensatory purpose, proportionate to the legitimate interests you are seeking to protect.  You should be clear in negotiations and in your drafting about the reasons why the remedy is required, to ensure that the clause will stand up to challenge in the future.

 

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