In its decision in the Makdessi case, the Supreme Court considered the historical origins of the rule against penalty clauses in contracts. [5] The law emerged in the fifteenth century with respect to “defensible obligations” (sometimes called punitive obligations), which were a contractual promise to pay money that could be fulfilled when certain obligations were fulfilled (and if the obligations were not met, then the terms of payment could be enforced under the bond). [6] However, the fair courts considered that they were what they really were – a guarantee for the performance of the underlying obligation – and were prepared to restrict the performance of those obligations if the defaulting party paid damages due under customary law. [7] Over time, common law courts began to reflect this approach and to stay all proceedings involving such bonds in which the defendant agreed to pay damages plus interest and costs. The position of the common law courts was adopted and codified in the Administration of Justice Act 1696 and later in the Administration of Justice Act 1705. As a result, the procedural remedy for these bonds was then administered in its entirety by the common law courts without the intervention of the fair courts. However, fair courts began to develop remedies for revocation at the same time. With the decline in the use of enforceable clauses, procedural mechanics have been increasingly applied to lump-sum damages clauses. The judges described the penalty clause rule as “an old randomly constructed building that is not well patinated,” but strongly noted that the rule should not be abolished. This is because the rule is a “long-standing principle of English law” that plays a “useful role in protecting people from certain oppressive corporate categories”; in particular, if the parts of “unequal . Bargaining power” and there is a “danger of oppression.” The Supreme Court, which ruled in two interrelated cases, strengthened the common law concept of freedom of contract between duly advised and demanding parties. Lord Mance made it clear that if both parties are “well-informed and sophisticated parties” who have “carefully negotiated [a] deal”. under normal market conditions”, there is a “strong presumption that the clause will not be interpreted as a penalty”.

Therefore, in the case of commercial contracts, the parties should have more confidence that their contracts are not considered unenforceable. The Court distinguishes between a term classified as a principal obligation and an ancillary obligation. The Court will not review the main obligations, as this would amount to a review of the fairness of the Treaty and is unlikely to take this into account. This means that the Court will only review clauses that fall within the category of ancillary obligations. As a general rule, in commercial contracts, the parties strive to agree on terms that determine the financial extent of the liability of one of the parties in the event of default. These clauses are called contractual penalty clauses and are often used in oil and gas, manufacturing and manufacturing contracts when the performance of the parties` obligations is often determined within tight deadlines and the non-compliance can affect the current contract. For example, parties to a construction contract may agree that if a party does not deliver the materials on time, which delays the project, it will pay a fixed amount per day until delivery takes place. It may be advantageous to use set-off clauses for a variety of reasons. The Supreme Court also confirmed that the sanction rule applies only to secondary obligations, i.e. for obligations arising from a breach of a primary obligation.

[23] A clause that sets out onerous provisions in a contract may be onerous, but if it is not triggered by a breach, it is not a penalty under the law. Their lordships also noted that a penalty clause can often be a simple payment of money, but can also include other things, such as source payments, requirements for the transfer of assets, or (based on the facts they have) a request for reimbursement of a non-refundable deposit. In Dunlop, the Court departed from the “genuine due diligence” rule. Rather, they recognized that if an innocent party could prove that it was using a clause in a contract to protect a legitimate interest and that the penalty was not exorbitant or unscrupulous, it did not have to be a true prediction of loss. The Court held that the real test is “whether the impugned provision is a secondary obligation imposing on the infringer harm that is disproportionate to the innocent party`s legitimate interest in enforcing the primary obligation.” Therefore, the correct analysis should now be applied as follows: however, regardless of any contractual provision, the courts have made it clear that they will comprehensively consider the actual nature and content of the transaction when deciding to impose a primary or secondary obligation. Therefore, in order to ensure that the provisions do not fall within the scope of the sanction clause, the parties should structure the provisions as principal obligations while formulating reasonable provisions to ensure that they are not considered a “disguised” sanction clause and are therefore unenforceable. It is not always possible or economically desirable to draft a contractual provision as a “principal” obligation – for example, because a party wants to retain the ability to obtain common law damages for breach of contract. If this is the case and the penalty clause rule is applied, the courts will consider whether the provision is criminal in nature. Where the term is a secondary obligation, the author should endeavour to demonstrate that the other elements of the penalty clause test are not met. The Supreme Court then reformulated the common law test to determine what constitutes an unenforceable penalty clause.

They considered that the validity of such a clause depended on whether the party seeking to enforce the clause could assert a legitimate interest in enforcing the clause:[23] Overall, a penalty clause is a contractual provision that imposes an excessive amount of money unrelated to the actual damage, against a defaulting party. Penalty clauses are generally unenforceable under English law. You must therefore review your contractual provisions to ensure that they do not fall within the scope of the penalty rule and amend the necessary provisions to take account of the change in the law. The Supreme Court`s decision establishes a new progressive test for determining whether a contractual provision is considered punishable and therefore unenforceable. The decision is relevant to all franchise regimes that operate under English law agreements, as it has recalibrated the application of the sanction rule and may give franchisors more leeway to deter certain conduct and impose contractual penalties for certain types of violations. For example, Vivienne Westwood Limited v. Conduit Street Development Limited[2017] EWHC 350 (Ch) concerned a lease and a letter incidental between the plaintiff and the defendant for a clothing and fashion store. The consequence of the secondary letter was that the defendant agreed to accept the annual rent at a lower rate, regardless of the rental conditions.

The parties agreed that in the event of a breach of any of the terms of the cover letter and/or lease, the defendant was able to terminate the cover letter and retroactively calculate the higher rent in the lease. Applying the Cavendish Principles, it was concluded that the plaintiff`s obligation to pay the higher rent in the lease was a secondary obligation entered into as soon as the primary obligation in the subsidiary letter to pay the lower rent had been breached. As a result, the criminal rule was applied. Finally, it should be noted that, in the context of oil and gas, the doctrine of English criminal law is also often used with respect to “confiscation” provisions in joint exploitation agreements. .