You are on page 1of 4

if the test for a penalty is now ultimately "commercial

justification" (a clause that is a genuine pre-estimate may be


regarded as justified on that basis), it is a rather curious
test since the courts will not ask of any other type of
provision: was it commercially justified? Alternatively, in a
fully negotiated contract between sophisticated commercial
parties advised by their lawyers, is not the commercial
justification simply that they agreed to the clause? And if so,
do we really need a rule against penalties?
Write an essay responding to this quotation, considering
both whether the points made by the author are justified in
respect of the laws approach to penalty clauses, and
whether they could also be fairly made in respect of other
agreed remedies.
The classic test for establishing the existence of a penalty clause set
out in the case of Dunlop Pneumatic Tyre Company v New Garage
and Motor Company Limited[1915] is now almost 100 years old.
Since then the Courts have frequently looked at whether clauses are
meant as deterrents and therefore punish the offending party or
whether they are there to compensate the innocent party by way of
liquidated damages. The more modern approach to penalty clauses
has shifted away from this old formula and now considers the
following questions: Is there commercial justification for the
provision? Is it the extravagant or oppressive? Is this predominantly
a deterrent? What happened at the time of negotiation?
The commercial justification test was first suggested by the High
Court in the case of Lordsvale Finance Plc v Bank of Zambia [1996]
QB 752, where Colman J said:"There would therefore seem to be no reason in principle why a
contractual provision the effect of which was to increase the
consideration payable under an executory contract upon the
happening of a default should be struck down as a penalty if the
increase could in the circumstances be explained as commercially
justifiable, provided always that its dominant purpose was not to
deter the other party from breach." The Court of Appeal affirmed the
position in the 2013 case of El Makdessi v Cavendish Square
Holdings [2013] EWCA Civ 1539 where it was held at paragraph 117
that:- "For these reasons I am satisfied that the clauses, taken in
the context of the Agreement as a whole, are not genuine preestimates of loss. On the contrary they are extravagant and
unreasonable. That is not necessarily conclusive. A commercial
justification may mean that a clause which is not a genuine preestimate is not penal." Taken together, these cases show that the
key consideration is now whether the liquidated damages provision
is considered oppressive and having the dominant purpose of
deterring a breach. Also, even where a provision is not a "genuine

pre-estimate" of loss, the provision may yet survive if there is a


commercial justification for it. In other words, if you can justify your
position commercially, if for example there is a specific commercial
rationale for the provision, then a provision which may otherwise
have failed as a penalty could still be upheld.
Agreed remedies are previously negotiated measure of
compensation upon breach of contract aiming to frustrate attempts
to secure greater compensation from judicial remedies (Ian
Macneil, Power of Contract and Agreed Remedies) and reduce
uncertainty. They are extensively useful to the parties in a
contract to maintain commercial certainty. This is especially so in
transactions where there are inherent unpredictable
risks. Liquidated damages, for example, promise a quicker court
procedure for debt collection and avoid difficulties in proving losses
for common law remedy. Upholding the principles of freedom of
contract would seem to mean that parties can insure themselves
against breaches with liquidated damages clauses (liquidated
damages clauses) and deposits and foresee the consequences and
hence protect their interests adequately with such a means. While
an liquidated damages clauses may incentivise parties to complete
obligations, the court would nevertheless not enforce it if the terms
are deemed unconscionable, extravagant and not a genuine preestimate of loss, but a penalty stipulated in terrorem (Lord
Dunedin). The courts approach to determine the validity, described
as risk averaging by Collins, is illustrated in Dunlop v New
Garage where the 5 per type charge was not considered
extravagant but a genuine prediction of the average potential loss
resulting from breaches. To add on that, in Philips Hong Kong the
court concede that disparity in some circumstances would not
automatically invalidate an liquidated damages clauses. Similarly,
there are judicial control on deposits and other types of agreed
remedies. These are rather strict control and one that attracts
fierce criticisms. The strongest arguments against the equitable
jurisdiction are the compromise of freedom and certainty and the
lack of coherent principles in the decisions.
Penalty clauses can certainly intrude on freedom because an over
the top compensation is likely to compel or even coerce a party to
perform its obligations. However, same can be said for the judicial
control of penalty clauses. Contracts in a commercial context are
negotiated mindfully with all parties aware of their rights and
obligations. It is difficult to say that parties have not taken
precautions and assessed risks before entering into an contract. It
is very reasonable and indeed common practice that a more riskaverse party buy insurance from the less risk-averse party (Samuel
Rea, Efficiency Implication of Penalties and Liquidated
Damages). There are efficiency reasons to raise the compensation
levels by a considerable amount. Rea argues that the courts
jurisdiction to invalidate penalty clause would effectively compel

parties to charge higher contract prices for risking the agreed


remedy clauses being deemed unenforceable. From a commercial
perspective, the courts intervention in effect does nothing but to
force parties to reflect the risks in the price rather than in the
agreed remedies as a functional form of insurance the parties
interests are still protected, but the courts interference has only
disrupted the balance of benefits obtained by the parties and made
transactions economically inefficient.
In defence of the courts interference, Collins contends that such is
to maintain fairness and uphold corrective justice. The remedy
should be qualified by foreseeability of probable losses and the main
aim of remedies is to adequately compensate and not over
compensate the injured party. In terms of procedural fairness, Fuller
and Eisenberg suggest that the courts invalidation of extravagant
liquidated damages clausess is a response to the possibility that the
importance of the clauses are not fully appreciated by the parties
(Hugh Collins, Fairness in Agreed Remedies). This argument seems
a little contrived as contract terms are expected to negotiated and
agreed carefully. A more satisfying explanation would be that the
courts approach is to protect the weaker party from
unconscionability. This however invites scepticism as the
jurisdiction is limited to agreed remedies there are other doctrines
to remedy the imbalance of bargaining powers.
Similar to extravagant liquidated damages clausess, the court is
prepared to strike down unreasonable deposit. Reasonableness is
determined with reference to the trade; for example, usual deposit
for sale of land would be capped at ten percent of the price save for
special circumstances. However, in terms of the approach, deposits
are treated different from liquidated damages clausess, as the court
would uphold even if they are not genuine pre-estimate of loss. In
other words, the deposit does not have to reflect the actual loss
suffered by the innocent party as long as it is set at a reasonable
proportion with reference to the industry. In this sense, rather than
reflecting the loss suffered by the innocent party, the court seems to
be more concerned with commercial reasonableness. The idea of
corrective justice does not apply. Such inconsistency in terms of
treatment of different types of remedies induces great uncertainty
in commercial contracts. If fairness is truly an aim of the English
treatment to agreed remedies, the same level of judicial control of
penalty clauses should probably extend to other remedies like
deposits because, in essence, a deposit is a penalty paid in
advance. For example, references to the potential loss suffered by
the innocent party may be put into consideration when determining
the validity of the deposit.
Lastly, it must be said that the concept of fairness is unclear and the
lack of justification for the different standards in determining the
validity of liquidated damages clausess and deposits suggest that
the law was developed in an ad hoc and arbitrary manner. The
absence of an overarching and coherent principles is frustrating for

contracting parties for there are no clear standards in testing the


fairness. Ultimately, the distinction of a deposit and LIQUIDATED
DAMAGES CLAUSE may appear to be an elusive one in some
instances. It is noteworthy that the courts approach, therefore,
may encourage the use of deposit to ensure certainty in case of
breach, eventually changing the picture of commercial contracts.
In conclusion, the extensive commercial advantages of enforcing
agreed remedies seem to overwhelm the jurisdiction aiming to
maintain fairness. The courts interference would hardly prevent
parties from protecting their interests adequately because the
commercial market would inevitably adapt to the law. While the
English jurisdiction may induce uncertainty and hence undermines
commercial efficiency, the court never claims a general power not
to enforce any agreement which the court regards as
unconscionable and extravagant (Jobson v Johnson, per Dillon
LJ). The law has come to shape and the instances where the court
does intervene become traditional authority. While it is still
unsatisfactory in terms of fairness and certainty, the trade off is
necessary and inevitable. In addition, the lack of coherent principles
attracts attention towards civil law jurisdictions like France where all
liquidated damages clauses are valid, but the court reserves a
power of control to reduce but not invalidate the level of
compensation to reflect the loss suffered by the innocent party;
certainly, the parties would be able to see for themselves the
validity of liquidated damages clauses under this
approach. Nonetheless, it is quite improbable that the English
system would go towards the French direction since the Law
Commission rejected the Unidriot proposal to adopt a model similar
to the French system on the basis that it would induce even more
uncertainty (Law Commission Working Paper No.61). After all, the
English jurisdiction still provides for a certain latitude in testing the
validity of liquidated damages clauses. In the meantime, it remains
a challenge for the court to strike the balance between maintaining
fairness and certainty without over compromising autonomy and
commercial efficiency.