Penalty clauses and public policy

Tuesday 9 June, 2020

Sometimes when parties enter into a contract, they anticipate that one of them might not fulfil their contractual obligations. Instead of seeking a remedy from the courts, they choose to agree in advance what the consequences of breaching the contract will be and insert those consequences into a clause in the contract. However, these clauses are not enforceable if their purpose is to punish the breach rather than compensate the innocent party who did not breach the contract.

The Supreme Court recently considered the principles that courts should apply in determining whether to enforce a clause containing a consequence for breaching the contract.[1] If the consequences are vastly disproportionate to the innocent party’s legitimate interests, then the clause will not be enforceable. Legitimate interests are the innocent party’s interests in the performance of the contract. They can extend beyond the loss caused by the breach to encompass the broader commercial and business interests that the parties want to achieve, or protect, through the contract. Deterring either party from breaching the contract can be a legitimate interest.

In determining whether the clause protects legitimate interests, the courts will look objectively at the terms of contract at the time it was entered into, and the circumstances in which it was entered into. The relative strength of each party’s bargaining position is also relevant, as is whether the parties had legal advice prior to entering into the contract. If commercial parties are contracting on equal terms or are legally advised, the courts will normally assume that the parties can decide what the appropriate consequences should be to protect legitimate interests in the performance of the contract.

However, if the parties are not bargaining from a position of equal strength, or one of the parties did not have legal advice, the courts will look more closely at the innocent party’s claims that the interests protected are legitimate, and also at whether the consequences are proportionate to the need to protect those interests. Ultimately, the key question for the court is whether the consequences for the breach are disproportionate to the legitimate interests of the innocent party in ensuring performance of the contract.

The Supreme Court considered that amount of damages that a court would have awarded for the breach will not usually be relevant, unless the clause claims to provide a pre-breach estimate of damages, or if the only legitimate interests in having the contract performed are the monetary losses which would arise from breach of the contract.

Conclusion

When entering into a contract, parties are entitled to anticipate the consequences for a potential breach of the contractual terms. However, the consequences for breaching the contract must not be totally disproportionate to the legitimate interests that innocent party is trying to protect, otherwise the clause will be unenforceable.

If you have any concerns about the enforceability of your contracts, contact Mark Renner or Kate Cornege.