Earthquakes occur in the natural world all the time. They happen less frequently in the otherwise stable terrain of contract law. Earthquakes are relatively short in duration but the after-shocks go on for a long time. The same can be said of judgments and their impact.

There was a very deep tectonic slip in England recently. The degree of change and impact on the legal landscape will only be clear once the dust has fully settled and a few follow-on cases are determined. In the meantime we can already be sure that some of the boilerplate in English commercial contracts may never quite look the same again. But before we survey the new horizons we must ask what caused the spectacular seismic activity.

One of the major differences between the civil and common law approaches to contractual obligations has always been the concepts related to penalties. This may have changed dramatically by the judgment of the UK Supreme Court on 4 November last year in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis.

Let’s accept a basic definition that a contract penalty is a fixed or calculable amount of money (based, for example, on contract value or period of delay) expressly agreed in advance in a contract by the parties and intended to be paid by the defaulting party to the other party in case of breach. I have encountered such clauses often in commercial agreements in Germany and other civil law jurisdictions. However, these types of provisions have been widely rejected by the courts in common law countries such as England and the United States as being inequitable and therefore unenforceable. 

This basic principle has not been changed by the decision in November. But the dividing line between what is a penalty and what constitutes liquidated damages in English common has been moved considerably. Liquidated damages (LDs) in contracts are generally permissible in common law (and civil law) contracts as agreed pre-estimates of the expected damage arising from a specific breach event.

In a nutshell the test is: LDs are reasonable amounts intended to compensate and are permissible; penalties are excessive because they are intended to deter and punish and are not enforceable in common law systems.

Well, at least that was the assumed understanding until 4 November 2015. The Supreme Court seems to have moved the goal posts to make it even harder for English lawyers to get a penalty. In other words, the definitions of unenforceable penalties and enforceable liquidated damages appear to have been substantially revised (or should we say,”restated”).

The Supreme Court has rejected the traditional test and stated that the true principle is whether the clause is out of all proportion to the innocent party’s legitimate interest in enforcing the counterparty’s obligations under the contract. A clause will no longer be regarded as a true (and therefore unenforceable) “penalty” under English if it punishes but this can be regarded as being in pursuit of a party’s legitimate interests.

In the ParkingEye case, the Supreme Court held that a £85 charge imposed on a visitor to a car park was not penal because it was justified by ParkingEye’s legitimate commercial interest in imposing the charge, and such interest went beyond the mere recovery of any loss. The court found that the contractual charge had two main objects: to manage the efficient use of the car park by deterring motorists occupying spaces for long periods, and providing an income stream to enable ParkingEye to meet the costs of the scheme and make a profit from its services. Both objectives were perfectly reasonable, and the imposition of a charge to deter overstayers was a reasonable mode of achieving such targets. Thus, the court held the amount of £85 was not out of all proportion to ParkingEye’s legitimate interest in imposing the charge, and so it was not penal.

What exactly constitutes a “legitimate interest”? Let’s brace ourselves for more after-shocks.