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Legal challenges may get harder on penalties for breach of contract

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A recent ruling by the Supreme Court means business owners facing ‘penalties’ for breaching a contract may find it harder to challenge these, says John Moore

You may have read about an attempt to challenge the validity of a parking charge  for overstaying the motorist’s welcome. It was challenged on the basis that it was a ‘penalty’ clause because the parking charge was seen as ‘excessive and unfair’ after the motorist had gone over his allotted two free hours. Recently this case was heard by the Supreme Court with another, similar case, to consider the whole question of ‘penalty’ clauses.

What’s the problem?

For years, under English law, any clause that attempted to set an arbitrary amount that a party to a contract must pay that seemed excessive was considered to be a ‘penalty’ clause and open to challenge. If it was successfully challenged, then any payment due under the contract would be unenforceable.

What’s been the way of getting round them?

  1. Inserting in the contract what’s called a ‘liquidated damages’ clause – which effectively attempts to insert an amount that’s deemed to be a genuine pre-estimate of loss
  2. Changing the structure of the contract so that any payment due is triggered not by the breach but by an alternative option
  3. Inserting appropriate wording to provide that the clause is ‘commercially justified’ because it serves an important purpose that the parties to the contract have agreed on

What has the Supreme Court had to say?

Both cases before the Supreme Court explored whether clauses setting an amount to be paid by one party to the other in the event of a breach were penalty clauses, and so unenforceable. For example, in the parking case, because the motorist overstayed a couple of hours, the argument was that the £85 was a ‘penalty’ charge.

The Supreme Court reviewed both cases and upheld both clauses, saying they weren’t penalties. They decided the old concepts of ‘deterrence’ and ‘genuine pre-estimate of loss’ weren’t helpful, but decided against scrapping the old law.

Instead, they held that the ‘legitimate interest’ of the party relying on the clause justified its enforcement. They also confirmed that, in future, parties could try to avoid getting into any discussion over whether something is or isn’t a penalty clause if they structured the contract in such a way that any payment due wasn’t triggered by the breach.

This means that now a clause will probably be enforceable even if it’s not a genuine pre-estimate of the innocent party’s loss, or if it’s designed to deter a breach of contract. What matters is whether or not the innocent party is protecting a ‘legitimate interest’. In the parking case, the court found that, although on the face of it the £85 charge appeared to be a penalty, it wasn’t, because the landowner had a ‘legitimate interest’ in the efficient management of the car park.

What this means

The courts are effectively saying that they’re less inclined to interfere in contracts that are freely entered into, particularly when it comes to commercial contracts, where the parties have access to legal advice.

Challenging a clause that, on the face of it, is a penalty clause will be increasingly difficult because the other party is likely to say the clause is there to protect a legitimate interest. It will now be possible to challenge such clauses only if its impact significantly exceeds the innocent party’s legitimate interest.

So if you’re given a contract, look carefully at any clauses that require a payment if the contract is broken. Don’t think that, just because any figure inserted looks to be on the high side, it can automatically be challenged later. Any attempt to do this might be met by the other party arguing that the amount reflects their legitimate interest in having such a clause in the contract. Of course, you’re free to ask them what this interest is.

JOHN MOORE is Commercial and Technical Advice Services Manager at LHS Solicitors, FSB’s legal services provider. If you have a legal query, call 03450 727 727 or visit www.fsb.org.uk/benefits/legalbenefits