It is not unusual for business contracts to include a provision which requires compensation to be paid, by one party to another, in the event that certain terms are not complied with.  But are you obliged to make payment under such a provision where a breach has arguably caused no discernable harm or where the amount being sought appears to be excessive? 

As Richard Shears a commercial dispute resolution lawyer and founder of Shears Law explains, ‘The answer will depend on the circumstances, and specifically on whether the provision has been imposed to safeguard the legitimate business interests of your opponent and, if so, whether it can be said to do this in a fair and reasonable way.’ 

In some cases, it may be possible to have disproportionate compensation provisions declared unenforceable, particularly where they have been effectively imposed on you because of a lack of bargaining power at the time the contract was agreed.

Where a contractual provision is held to be void you may still find yourself liable to pay compensation under common law rules, but you will have the comfort of knowing that in this case the amount you have to pay will reflect the losses that your breach has actually caused. 

Compensatory provisions

The most common type of provision requiring the payment of compensation upon a breach of contract is known as a ‘liquidated damages’ clause.  Here, there is a requirement that where a party fails to do something that they have contractually agreed to do, they must pay the other party a pre-agreed sum which may or may not be based on a pre-estimate of the losses that a particular breach is likely to cause. 

Liquidated damages clauses are routinely included in business contracts to provide certainty about what the consequences of a breach of contract will be, with the intention that this should reduce the likelihood of a disagreement arising.  

However, what many business owners do not realise is that a liquidated damages clause (or indeed any other clause which seeks to impose sanctions on a party where a breach of contract has occurred) will only be enforceable where it can be shown that it does not amount to a penalty clause, as defined in a test developed by the Supreme Court in the case of Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis. 

Penalty clause test

There are three questions that need to be answered to determine whether a clause ought to be categorised as being penal in nature and therefore declared unenforceable. 

Question 1 - Can the clause be classed as a secondary obligation as opposed to a primary one?  In other words, is it an incidental clause or, alternatively, a clause that is triggered only where there has been a failure to comply with a principal contractual obligation?  This has to be the starting point because it is only secondary obligations (which are contingent on a breach of contract having occurred) that can be challenged under the penalty clause rule.

Question 2 - What is the rationale behind the clause? Is there evidence to suggest that it has been included in order to protect the legitimate business interests of your opponent, or does it simply appear to have been inserted to inflict punishment where a breach of contract occurs? 

Recent examples of clauses upheld as protecting legitimate business interests include: 

A clause which provided that, if restrictive covenants in a business share sale agreement were not observed the seller would lose the right to payments of £44 million and the buyer could purchase the remaining shares at a reduced price.  This was deemed justified on the basis that the clause had been included to protect the buyer’s legitimate interest in ensuring that the terms of the restrictive covenants were observed because a large part of the price paid for the business related to goodwill, the value of which would be significantly diminished if the non-compete provisions were ignored.

A clause which provided that, if the users of a private car park exceeded the two-hour maximum stay limit, the operators of the car park would become entitled to a payment of £85.  This was deemed justified on the basis that the clause had been included to protect the legitimate interest of the operator in ensuring that spaces at the car park became regularly available and that, to facilitate this, people were actively discouraged from overstaying.

Note that liquidated damages clauses which demand compensation which has been set at a level that is likely to be commensurate with the actual losses that a breach of contract will cause (known as genuine pre-estimate of loss provisions) are also likely to be upheld. 

If it is there to provide genuine protection, then the provision is likely to be enforceable, provided the answer to the third question is ‘yes’.  However, if it is just there as a punishment then there is a chance that it could be declared invalid.  

Question 3 - Given the nature of any business interests that the clause appears to seek to protect, can the requirements imposed be said to be proportionate or are they plainly extravagant, exorbitant, or unconscionable? If they are proportionate, then the clause is likely to be enforceable. However, if they are disproportionate then there is a chance that the clause will be disallowed. 

A recent example of a provision that was found to be disproportionate arose in the context of an employment contract which required an employee to repay recruitment costs related to their appointment because they had elected to leave their role within 12 months of being hired.  The repayment sought was in excess of £5,000, which equated to 21 per cent of the employee’s annual salary and took no account of the income they had generated or the fact that they had remained in their role for 11 months before choosing to leave.  

While the provision was not declared to be a penalty in this case, given that the trigger for the repayment was not a breach of contract but rather the employee’s own decision to depart, the Employment Tribunal made it clear that had this not been the case the clause would have been unenforceable due to its penal nature. This was because the clause attempted to pass on normal recruitment costs, restrict the employee’s ability to leave within a year of joining, and require them to pay a sum that was out of all proportion when compared with their salary and the income they had generated during the time they were in their role. 

How we can help

This is a complex area to navigate, so it is essential that legal advice is taken to find out where you stand and so you can devise a strategy that enables you to push back against a punitive contractual claim, but in a constructive and commercially sensible way. 

Our litigation lawyers are skilled in supporting clients through the resolution of commercial contract disputes and in finding ways to address breach of contract claims that are fair and proportionate, and where possible avoid the need for you to go to court. Many of the cases we deal with can be resolved through informal negotiation or by enlisting the help of an independent mediator who will work collaboratively with everyone involved to find a commercially acceptable way to move forward.

To find out more about the enforceability of contractual compensation provisions, and how we can help to de-escalate any dispute that may arise where a breach of contract has occurred, please contact Richard Shears on 0800 020 9495 or rds@shearslaw.co.uk.

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.