The new test sets a higher threshold, which will make it harder for commercial parties to raise penalty arguments successfully, particularly in circumstances where the terms of a contract were negotiated between sophisticated commercial parties of roughly equal bargaining power, who have been legally advised.
There is a wide spectrum of types of clauses that potentially fall within the penalty rule which need to be considered. On the simpler end of the spectrum are straightforward liquidated damages clauses requiring payment of a sum, and on the more complex end sit, for example, restrictive covenants in sale agreements, take or pay provisions in long-term supply agreements and deposit and pre-payment forfeiture clauses.
When dealing with simple liquidated damages clauses, the innocent party’s legitimate interest will rarely extend beyond compensation for the breach, and therefore (as recognised by the Supreme Court) the Dunlop principles (as outlined above) are still ‘good law’ as to whether a clause is penal.
However, for the more complex provisions and non-straightforward liquidated damages clauses, Courts (and therefore parties) may now take into account ancillary commercial factors (such as reputational damage and loss of goodwill, back-to-back contractual obligations, and possibly even incentive payments) in determining the scope of the innocent party’s legitimate interest in performance of the primary obligation.
Interestingly, the Supreme Court specifically considered the application of the penalty rule to forfeiture clauses, and determined that in some circumstances a forfeiture clause could also be a penalty. However, it did not provide a conclusive or detailed reasoning for this, and instead stated that the application of the penalty rule to deposits and clauses forfeiting pre-payments will have to await future decisions.4
Whilst this judgment is significant (and many articles have and will be written discussing it), in practical terms it is likely to have a limited impact on how secondary obligation clauses in contracts governed by English law will be drafted.
However, parties negotiating contracts will still want to consider whether a particular clause is potentially a penalty, and in some instances may even consider stepping away from using a liquidated damages clause altogether, and instead rely on a right to claim damages at large (subject to that party’s bargaining power).