Last week, the Supreme Court of England and Wales issued a judgment that gives some welcome clarification about when a contractual provision may be deemed an unenforceable “penalty clause”. This should help employers draft their employment and commercial contracts in a way that encourages compliance, and sets out consequences for breach, without becoming unlawful.

What is The Rule Against Penalty Clauses?

Parties to a contract often wish to agree that certain consequences will apply if one of them breaches the contract, or a particular contractual clause. For example, the defaulting party might be required to pay a set sum of money, or the innocent party might be entitled to withhold a payment that would otherwise be due. These provisions can feature in all sorts of contracts, whether employment or commercial (including, to give one everyday example, a venue charging a cancellation fee for bookings cancelled at short notice).

English law has developed to allow such clauses, provided that the sum or remedy in question is a genuine pre-estimate of the loss that might arise as a result of the breach. If, instead, the provision is really just intended as a deterrent to a breach, and/or is disproportionate to any loss that might realistically arise from any such breach, it risks being deemed a “penalty clause”, which is void and unenforceable.

So What’s The Problem?

At first glance, this might sound reasonable enough, and many legal systems operate this principle in some form. Its application in English law is not, however, always clear-cut. Indeed, the Courts have acknowledged that it can be difficult to tell where a genuine pre-estimate of loss ends, and a penalty clause begins, or even whether or not it’s possible to estimate loss at all in some circumstances. 

Such clauses, which are designed to create certainty about the consequences of a breach of contract, can therefore end up having the opposite effect and provoke the sort of disagreement and litigation they were intended to avoid. The Supreme Court’s recent judgment in the joined cases of Cavendish Square Holding BV v. Talal El Makdessi / ParkingEye Limited v. Beavis [2015] UKSC 67 therefore provides some welcome clarity.

What Did The Supreme Court Decide?

The Supreme Court’s lengthy judgment touches on a number of issues, but for these purposes the key message is

“The correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract”.

Essentially, this means that parties are free to agree set consequences for a breach of contract, provided that

• The innocent party has a legitimate interest in the clause in question being performed/not breached. For example, in Cavendish the Court decided that the buyer of a company had a “substantial and legitimate” interest in protecting the goodwill of its purchase by restricting a selling shareholder’s ability to compete with it for a set period after the sale.

• The sum or remedy for breach is not wildly disproportionate or excessive in the circumstances. For example, in ParkingEye a car park overstay charge of £85 was considered lawful, taking into account market practice and relevant national guidelines.

As long as contracting parties bear these two principles in mind, they will no longer need to agonise over whether the sum or remedy they want for a particular breach is a genuine pre-estimate of loss.

How Does This Affect an Employer When Drafting Contracts?

This updated test gives employers two clear, guiding principles to consider when drafting contracts. Applying these in a sensible, proportionate way can help to avoid falling foul of the rule against penalties when drafting any number of typical employment provisions, such as:

• Withholding, clawback or re-valuation of bonus if an employee breaches his contract

• Forced transfer of shares by an employee deemed to be a “bad leaver”, e.g. if he breaches a post-termination restriction

• Repayment of compensation paid under a settlement agreement if an employee attempts to renege on his waiver of claims and take action against the employer.

It should be possible to lawfully implement all these obligations, as long as you’re clearly protecting a legitimate interest, and doing so in a way that’s not “extravagant, exorbitant or unconscionable”. The same applies in other situations, e.g. when documenting arrangements with selling shareholders in an M&A context.

It’s also worth bearing in mind that a Court may consider the background and context to a contractual provision when assessing whether or not it might constitute a penalty clause. In some circumstances, it might therefore further help an employer to clearly identify in the relevant clause

• What legitimate interest(s) it seeks to protect

• Why the parties agree that it is an appropriate means of doing so

• That the employee has had the chance to take legal advice, if appropriate.

This can be particularly helpful in clauses relating to restrictive covenants, where this sort of drafting is generally good practice in any event.