Penalty Clauses in UK Contracts: Understanding Primary and Secondary Obligations

Penalty clauses are a common feature in commercial contracts, often inserted to deter breaches and motivate performance.

However, under English law, such clauses are subject to strict enforceability rules. The distinction between primary and secondary obligations, clarified in recent case law, plays an important role in determining whether a clause is a valid contractual term or an unenforceable penalty.

What is a Penalty Clause?

A penalty clause is a contractual provision that imposes a detriment, usually a financial payment, on a party who breaches the contract, where that detriment is out of proportion to the legitimate interest of the party enforcing the contract.

• Principle: English law does not allow a party to punish another for breach. The law only permits compensation for actual loss suffered, or the protection of a legitimate interest.
• Authority: Cavendish Square Holding BV -v- Makdessideveloped the test by moving away from the old “genuine pre‑estimate of loss” assessment to a wider “legitimate interest”

Primary and Secondary Obligations

Primary obligations

• These are the core obligations in the contract. For example, to deliver goods and pay the purchase price by a certain date.
• They exist regardless of any breach.

Secondary obligations

• These arise only upon breach of a primary obligation.
• They typically require the breaching party to pay damages. For example, a clause requiring the supplier to pay a specified sum if delivery is late.

Why the Distinction Matters

• The rule against penalties only applies to breach of secondary obligations.
• If a clause is part of the primary obligation (for example, a price reduction mechanism if the obligation is breached), then it is generally outside the scope of the rule against penalties.
• If the clause is triggered by breach of a secondary obligation, it will be analysed by the courts for proportionality and legitimate interest.

The Modern Test for Penalty Clauses

Following the case of Cavendish and Parking Eye Ltd -v- Beavis, the courts will analyse the following:

• Is the clause triggered by a breach of contract? If not, the rule against penalties does not apply.
• Does the clause impose a detriment which is disproportionate to any legitimate interest of the innocent party?
• Consider the context – the commerciality and respective bargaining power of the parties, and the extent of the interest being protected are all relevant.

Practical Drafting Considerations

• Link to a primary obligation: For example, use different payment terms rather than imposing a sanction for breach.
• Identify legitimate interests: Document the commercial reasoning for the clause. For example, protecting goodwill or ensuring timely performance of the contract.
• Avoid arbitrary sums: Link the amount to a reasonable assessment of potential loss.
• Consider alternatives: Consider the use of credit notes or termination rights instead of penal sums.

Conclusion

Penalty clauses are a high‑risk area in UK contract law. The enforceability of such provisions depends on whether they arise from the breach of a secondary obligation, and if so, whether they protect a legitimate interest in a proportionate way. Considered drafting, being mindful of the primary/secondary obligation distinction, can mean the difference between a clause that is enforceable and one that is not.

How Can We Help?

The Corporate and Commercial team at Wilson Browne Solicitors is ideally placed to advise on all aspects of drafting and negotiating commercial contracts, including ensuring that provisions do not fall foul of the rule against penalties.

For a confidential and no obligation initial discussion about how we may be able to help, please contact the Corporate and Commercial team or call 0800 088 6004.