The Rule Against Penal Contracts

Whether in the commercial sphere or when dealing with consumers, the ancient and haphazard rule that contract terms must not be penal in nature has not weathered well and is often a source of confusion. However, the Supreme Court’s ruling in two test cases serves to bring it up to date.

The first case concerned a contract by which a businessman sold his controlling stake in a company. The contract included restrictive covenants against competing activities and provided that, if he breached them, he would not receive the final two instalments of the purchase price. He would also be required to sell his remaining shares to the purchaser at a price which excluded the value of the goodwill of the business. However, after a dispute arose, the businessman successfully argued that the covenants were unenforceable penalty clauses.

The second case involved a motorist who was charged £85 after leaving his vehicle in a car park for more than the two hours permitted. Numerous notices had warned drivers of the charges and the motorist’s arguments that they were unacceptably penal fell on fallow ground. His plea that the charges were unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 was also rejected.

In allowing the appeal in the first case, and dismissing it in the second, the Court found that the relevant clauses in both cases were enforceable. In the first case, the goodwill of the company, which depended upon the businessman’s loyalty, was crucial to the purchaser. In the second, the motorist was fully on notice that his contractual licence to park was subject to the two-hour time limit and that he would be charged if that was exceeded.

The Court acknowledged that the state of the law in relation to the rule against penal contract clauses was highly unsatisfactory. However, in refusing to abolish the rule, it noted that similar provisions exist in all other developed legal systems. Clarifying the law on the issue, the Court ruled that the true test to be applied is to ask whether an impugned clause amounts to a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligations under the contract.