New test for whether penalties clauses in contracts should be given a red card

Inflated damages in tyres case

In the 1915 landmark case of Dunlop Pneumatic Tyre Company, the House of Lords said that it was legitimate for a contract to specify (“liquidate”) the amount of damages payable following a breach of contract, as long as the amount specified to be payable was not a penalty. In order to be valid, the amount had to be a “genuine pre-estimate” of the maximum possible financial loss of the “innocent” party.

Parking charges

Recent court decisions have been moving away from concept of a “genuine pre-estimate of loss”, as being the test for the validity of liquidated damages clauses, towards a concept of “commercial reasonableness”.

In ParkingEye, 100 years after Dunlop, the Supreme Court (the successor to the House of Lords) has finally shown the red card to the “genuine pre-estimate” test. In that case the court said that the test is now whether the amount specified as being payable following a breach, “is out of all proportion to the innocent party’s legitimate interest in the performance of the contract”.

The court therefore upheld a charge of £85 for staying 53 minutes after the 2 hours permitted on the basis that “ParkingEye had a legitimate interest in charging overstaying motorists which extended beyond the recovery of any financial loss”.

Payment forfeit for competing

ParkingEye was heard at the same time as another case on penalties, Cavendish Square v Makdessi. This concerned the enforceability of a clause forfeiting certain payments for the sale of an advertising business if the seller competed with the business they had just sold. Although the seller forfeited millions of pounds, the court upheld the clause. The court said that there is a strong presumption that sophisticated commercial parties, with similar bargaining power and the ability to take legal advice, should be able to agree an appropriate remedy for a breach of contract without the court overturning this.

Implications for payment mechanisms

Recent good practice has involved drafting performance incentives in contracts so as to give the contractor additional payments for meeting specific performance targets. Quite often the amount to be used to pay these incentives was first “top slice” deducted from the total amount payable to the contractor.

These were drafted as “incentives”, rather than performance deductions, so as not to fall foul of the law against penalties. In most cases the employer would not suffer any financial loss from the contractor’s failure to meet those performance targets, so the amounts deducted could not properly be regarded as “genuine pre-estimates of loss.”

ParkingEye now enables employers to draft these as deductions for not achieving specified performance targets. Reasonable deductions are likely to be upheld on the basis that they are proportionate to the employer’s legitimate interest in the performance targets being achieved. This is preferable to having to deduct money from the payments to the contractor that is “handed back” as “incentives” for meeting the performance targets. This could lead to a much simpler way of drafting the performance incentive/performance deduction provisions in maintenance, construction and ICT contracts and any other contracts where poor performance is to be penalised financially.

If you would like advice on drafting payment mechanisms, performance incentive/deduction provisions or any aspects of the ParkingEye decision, please contact Andrew Millross .

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