← The hardest concepts in United Kingdom law
In one breath
A clause that fixes in advance what a party must pay on breach is enforceable if it protects a legitimate interest of the innocent party and is not out of all proportion to that interest. A clause that merely punishes the party in breach is a penalty and cannot be enforced.
The picture
The library late fee
A library charges a small fee for each day a book is late. The fee does not exactly measure what the library lost; it exists to keep books circulating, which is a legitimate interest, and the fee is modest beside it. If the library charged £500 a day, nobody could say it protected circulation, because it would simply punish the borrower. The old test asked whether the fee was a genuine pre-estimate of loss. The modern test asks a different question: does the fee protect a legitimate interest, and is it out of all proportion to it?
The modern law is in the decision on Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis. The rule applies only to a clause triggered by a breach, a secondary obligation, that makes the party in breach pay or give up more than ordinary damages would give. It does not apply to a price adjustment or fee that is triggered by something other than breach. A clause that fails the test is unenforceable as a penalty, and the innocent party recovers ordinary damages instead.
Where the picture stops working
The library has one borrower and one rule, whereas the courts look at the whole bargain, including the parties’ relative strength, their advice and the commercial purpose. Between businesses of equal strength the courts leave a good deal of room. A genuine pre-estimate of loss is still a strong sign of validity, but it is no longer the whole test, and the same sum may pass in one deal and fail in another.
How it really works
- 1Identify the clause: a term fixing a sum, or a transfer of property, payable when a party breaches the contract.
- 2Check that it is triggered by breach. A payment triggered by something other than breach, such as an option fee or a price adjustment, is outside the penalty rule.
- 3Identify the innocent party’s legitimate interest in the performance of the contract. It can be wider than compensation for loss.
- 4Ask whether the sum or remedy is out of all proportion to that interest. If so, the clause is penal and unenforceable, and the innocent party claims ordinary damages instead.
- 5Weigh the context: the parties’ bargaining power, whether they were advised, and whether the sum was a genuine pre-estimate of loss.
Why people get it wrong
- Thinking a clause is a penalty just because the sum exceeds the actual loss. A larger sum can be justified by a legitimate interest.
- Applying the rule to every payment clause. Only obligations that arise on breach are tested.
- Treating the old “genuine pre-estimate” test as the whole test. It remains a good sign, but the question is wider.
- Believing that the label settles the matter. Calling a clause “liquidated damages” does not save it, and calling it a penalty does not condemn it.
A worked example
The facts are invented
Dray Builders agrees to finish a village hall by 1 June, and the contract says it will pay two thousand pounds for every day of delay. Dray finishes ten days late. Dray argues that the hall committee’s real loss is only five hundred pounds a day, so the clause is a penalty.
The committee has a legitimate interest beyond lost hire fees, including the cost of alternative venues for events already booked and the community’s use of the building. The daily sum is not out of all proportion to that interest, and between two commercial parties it is likely to stand. Change the clause so that Dray forfeits the whole contract price for a single day’s delay, and it looks like punishment, out of all proportion to any interest in punctuality, and the court is likely to refuse to enforce it.
Try it
A contract between two businesses says that a customer who pays an invoice late must pay a fixed sum of £2,000, however short the delay. Is the clause unenforceable simply because the sum exceeds the supplier’s actual loss?
Landmark authorities
Read the sources themselves; this list is a starting point.
- Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd, [1915] AC 79
- Cavendish Square Holding BV v Makdessi; ParkingEye Ltd v Beavis, [2015] UKSC 67, [2016] AC 1172
Where to go next
Courses
Case briefs
More hard concepts in United Kingdom law
- Consideration and promissory estoppel (Contract law)
- Privity and third-party rights (Contract law)
- Mistake and misrepresentation (Contract law)
- Duty of care and the incremental approach (Tort law)
This page is an educational overview. It is not legal advice and not a substitute for the sources: the statute, the rule, the case itself. The United Kingdom has three legal systems: England and Wales, Scotland, and Northern Ireland. These pages mostly describe the law of England and Wales and say where Scots law differs when it clearly does; Northern Ireland law is often similar to English law but is not covered separately. Parliament is sovereign, but the devolved legislatures also make law within their powers. Each page states the usual formulation of the rule and names landmark decisions; check the primary sources before relying on any rule.