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Supreme Court Offers Clarity on Penalty Clauses in Contracts

11 Nov 2015

What does a parking ticket and a multimillion pound share purchase have in common?

Not very much, was the answer until recently. However in a combined appeal to the Supreme Court, the parties on the wrong end of two arguably harsh clauses sought clarity on whether the following were unenforceable penalties:
1)    A clause in a share purchase agreement, that effectively reduced the purchase price payable for shares in the event the seller breached the non-compete provisions in the share sale agreement; and
2)    A term that allowed a parking company to charge consumers £85 for staying longer than 2 hours in a city centre car park.
It was held that neither clause was an unenforceable penalty. The Supreme Court emphasised that a clause will only be a penalty if (i) it creates a secondary obligation on the contract breaker (i.e. perform the contract or pay £100) and (ii) the secondary obligation on the contract breaker is ‘out of all proportion to the legitimate interests of the innocent party’.

Share purchase
In the case of the share purchase, the Court held that the clause in question was a price adjustment clause rather than a secondary obligation on the contract breaker. The penalty rule was therefore not engaged at all.

Parking ticket
Whilst the penalty rule was engaged, the Court held that the £85 charge was not out of all proportion to the parking company’s legitimate interests. It was accepted that the purpose of the clause was to enable to the car park to be managed efficiently as well as providing an income stream to enable the company to operate the parking scheme at a profit.

Whilst the cases were said to offer clarity, the rule is clearly still open to interpretation and professional advice should be sought if in doubt.

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