20 The Commercial Litigation Journal May/June 2019
When is the law not the law?
David Cook is commercial
dispute resolution director
at Walker Morris LLP
It sounds like the beginning of a
bad joke, but it is no laughing
matter that a recent run of Supreme
Court cases serve to demonstrate that
conventional wisdom and common
practice concerning some of the
apparently established legal principles
underpinning many commercial
disputes may actually miss the mark.
Restatement of the
rule against penalties
Anyone practising in commercial
contract litigation in recent years
will be aware that, in considering
whether a provision amounts to a
penalty in Cavendish Square Holding
BV v Makdessi; ParkingEye v Beavis
[2015], the Supreme Court pointed
out that, over the century since
Lord Dunedin identified a number
of tests which could prove helpful or
conclusive in deciding that question
in Dunlop Pneumatic Tyre Co Ltd v
New Garage and Motor Co Ltd [1914],
those tests had been applied more
rigidly than was ever intended.
Conventional wisdom and
common practice over time had
effectively distilled Lord Dunedin’s
Dunlop tests into an unhelpful,
over-simplified distinction between
a genuine pre-estimate of loss which
is compensatory, and therefore
enforceable; and a deterrent which is
penal, and therefore not. The Supreme
Court in Cavendish stated that it was
‘unfortunate’ that Lord Dunedin’s
judgment ‘had achieved the status of
a quasi-statutory code in subsequent
case-law’. It therefore undertook
a wholesale review of the guiding
principles of the rule against penalties
and brought clarity by restating –
but not outright altering – the law
in this area.
The Supreme Court explained that
a penalty is a secondary contractual
obligation that imposes a detriment
on the party in breach of a primary
obligation which is out of all proportion
to any legitimate interest of the innocent
party in the performance of that primary
obligation. Breaking that down, there
are three questions which can help to
determine whether a provision amounts
to an unenforceable penalty:
• The ‘threshold test’: is the
penalty rule engaged at all? In
English law, the court will not
generally interfere with a party’s
‘primary’ contractual obligation
to do something, but it can
regulate the ‘secondary’ liability
that may be imposed when a
party breaches that obligation.
The penalty rule is only engaged
at all, therefore, if the provision
in question imposes a secondary
liability for breach of a primary
obligation.
• The ‘legitimate interest test’:
does the clause serve to protect
any legitimate interest? A clause
that is potentially penal in nature
may nevertheless be allowed if
it serves to protect a legitimate
interest of the innocent party in
the performance of the primary
obligation.
• The ‘exorbitance test’: if so, is the
provision out of proportion to the
protection of that interest, by being
extravagant or unconscionable? So
long as the provision in question is
not exorbitant or unconscionable
in amount or effect, by reference to
some norm, as against the legitimate
interest which it serves to protect,
then it may not amount to a penalty.
The Supreme Court has therefore
highlighted to contract drafters and
commercial litigators of the dangers
of complacency when it comes to our
Practice
‘Conventional wisdom and
common practice over time
had effectively distilled
Lord Dunedin’s
Dunlop
tests into an unhelpful,
over-simplified distinction.’
David Cook seeks certainty from the Supreme Court
