The Supreme Court has upheld previous decisions in finding that when it comes to penalty clauses, the measure is no longer whether the penalty is a “genuine pre-estimate of loss”.

A penalty clause will now be enforceable unless it is “out of proportion” with the innocent party’s legitimate interests in having the contract performed.

What happened?

In this case Honey Bees Preschool Limited (“Honey Bees”) leased its premises from 127 Hobson Street Limited (“Hobson”). Within the lease agreement, Hobson was required to install a second lift in the building in which the preschool was situated by a specific date. It was agreed that if Hobson failed to install the lift by that date, it would indemnify Honey Bees for all obligations under the lease. The deadline was missed and Honey Bees invoked the indemnity clause and halted all rent payments. Hobson argued that the indemnity was unenforceable, and Honey Bees was liable for all rent due.

The High Court and the Court of Appeal agreed with Honey Bees and held that the indemnity was enforceable.

The Supreme Court upheld the Court of Appeal’s decision, finding that indemnifying Honey Bees was not out of all proportion in the context of what the clause was trying to protect Honey Bees against. Honey Bees required a second lift by the deadline for the sake of their business. One lift was insufficient to service a childcare centre with up to 45 children being picked up or dropped off at the same time. The Supreme Court concluded that “the indemnity clause does not offend the rules against penalties”.

The test:

The Supreme Court articulated a useful test for enforceability of penalty clauses as summarised below:

• The relevant legitimate interest is determined on an objective basis at the time the contract was formed, by reference to the terms and circumstances of the contract. Those circumstances can include the broader commercial context within which the contract sits.
• A party’s legitimate interests may extend beyond the loss caused by the breach and extend to the impact of non-performance on broader commercial interests, which may extend beyond the contract in question.
• Liquidated damages will be unenforceable if they seek to “punish” the other party, however it is legitimate for them to be at a level which would ensure/encourage performance.
• Where there is evidence of unequal bargaining power, or where one party is not legally advised, a court will scrutinise more closely the innocent party’s claims as to the interests protected, and also the issue of proportionality. However, whatever the bargaining positions of the parties, the issue for the court remains whether the consequences for breach are out of all proportion to the innocent party’s legitimate interests in performance.
• Where the clause purports to be a pre-estimate of damages, the courts may consider what damages would have been available at common law (ie direct, foreseeable loss flowing form the breach) in determining proportionality.

How do I ensure my penalty clause is enforceable?

This decision has followed the United Kingdom’s trend away from a “genuine pre-estimate of loss” being the guiding principle of what constitutes an enforceable clause. Rather, as set out above, the focus is on whether the consequence is at an appropriate level of harshness, in the context of what the other party would suffer due to the breach. The decision means that penalty clauses are now harder to enforce provided they relate to a legitimate interest.

The Court determined that Honey Bees’ legitimate interest that needed protecting was securing the second lift, as it was necessary for the Ministry of Education’s licence it needed to be granted in order to operate. The court found that this interest was proportionally protected by the indemnity clause.

The Supreme Court’s decision emphasises the need to set out the legitimate interest which a liquidated damages, or penalty clause is trying to protect. If you are negotiating a contract or otherwise relying on these types of clauses, our contract experts can advise on what is enforceable in your specific context.

You can find the case here.