Penalty clause disputes commonly arise in settlement agreements, shareholder agreements, restrictive covenants, deferred consideration clauses, commercial supply agreements, financing arrangements, and wider breach of contract claims.
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When Will a Penalty Clause Be Unenforceable?
A contractual clause may be unenforceable as a penalty where it is triggered by breach and imposes a consequence that is disproportionate to the innocent party’s legitimate interest in performance of the contract.
The penalty rule does not apply to every harsh or commercially unfavourable clause. English courts generally respect freedom of contract, particularly where sophisticated commercial parties have negotiated the agreement. However, a clause may still be vulnerable if it operates mainly to punish the defaulting party rather than protect a genuine commercial interest.
The Supreme Court Test in Makdessi
In Cavendish Square Holding BV v Talal El Makdessi, the Supreme Court restated the law on penalty clauses. A clause will generally be penal if:
- it is a secondary obligation triggered by breach of a primary obligation; and
- it imposes a detriment on the defaulting party that is out of all proportion to any legitimate interest of the innocent party in enforcing the primary obligation.
This replaced the older and narrower focus on whether the clause was a “genuine pre-estimate of loss”. While that concept may still be relevant in straightforward damages clauses, the modern test is broader and allows the court to consider legitimate commercial interests beyond simple compensation.
Primary Obligations and Secondary Obligations
A primary obligation is a core contractual promise. For example, a party may agree to pay a purchase price, comply with a restrictive covenant, deliver goods, provide services, or refrain from competing with a business after a sale.
A secondary obligation is a consequence that arises if a primary obligation is breached. This may include an obligation to pay a specified sum, forfeit a payment, transfer shares, accelerate a debt, or lose a contractual benefit.
The distinction matters because the penalty rule usually applies only to secondary obligations. If the clause is properly characterised as part of the primary bargain between the parties, it may fall outside the penalty rule altogether.
Legitimate Commercial Interest Explained
The innocent party may have a legitimate interest in enforcing performance that goes beyond recovering financial loss. In commercial contracts, this may include protecting goodwill, preserving the value of a business, maintaining confidentiality, preventing unfair competition, securing payment discipline, or protecting the commercial structure of a transaction.
However, the innocent party cannot rely on a clause whose main purpose is simply to punish the defaulting party. The court will consider whether the consequence is commercially justifiable or whether it is excessive when compared with the interest being protected.
Penalty Clauses in Settlement Agreements
Penalty clause issues often arise in settlement agreements where a party agrees to pay a reduced sum by instalments, but the agreement states that the full original amount becomes payable if there is a default.
These clauses require careful drafting. A creditor may have a legitimate interest in ensuring prompt payment and avoiding further enforcement costs. However, if a minor default exposes the debtor to a vastly greater liability, the clause may be open to challenge as a penalty, depending on the facts and commercial context.
Parties entering into settlement agreements should consider whether default provisions are proportionate, clearly drafted, and commercially defensible. This is particularly important where there is unequal bargaining power or where the default consequence is significantly greater than the missed payment.
Penalty Clauses in Shareholder and M&A Transactions
Penalty clause disputes may also arise in shareholder agreements, business sale agreements, and M&A transactions. Common examples include deferred consideration clauses, share transfer provisions, earn-out mechanisms, non-compete covenants, and clauses that remove or reduce payment rights following breach.
In Makdessi, the Supreme Court held that the relevant provisions were not unenforceable penalties. The clauses formed part of the commercial structure of the transaction and protected the buyer’s legitimate interest in preserving the goodwill of the business.
This does not mean that all similar clauses will be enforceable. Each case depends on the wording of the contract, the commercial background, the nature of the breach, and the proportionality of the consequence imposed.
Liquidated Damages vs Penalty Clauses
A liquidated damages clause sets out an agreed sum payable following breach. These clauses can be enforceable where they are commercially justified and not out of proportion to the innocent party’s legitimate interest.
A penalty clause, by contrast, is vulnerable because it imposes a punitive or excessive consequence. The fact that a clause requires payment of a fixed sum does not automatically make it a penalty. The key question is whether the clause protects a legitimate interest or whether it imposes an excessive detriment on the defaulting party.
Can You Challenge an Unfair Contractual Clause?
A party facing enforcement of a severe contractual clause may be able to challenge it if the clause operates as a penalty under English law. This may arise where the amount claimed is far greater than the loss suffered, where a minor breach triggers a severe financial consequence, or where the clause appears designed to punish rather than protect a legitimate commercial interest.
Before challenging a clause, it is important to review the full contract, the circumstances in which it was agreed, the commercial purpose of the clause, the nature of the breach, and the financial consequences of enforcement.
Penalty Clause Case Study
We recently acted for a client who had been ordered to pay the entire sum due under a settlement agreement.
The client’s liability under the settlement agreement represented approximately 5% of the total settlement sum, but he was jointly and severally liable. When he failed to make payment, the creditor obtained judgment ordering him to pay the entire sum due under the settlement agreement, less any payment already made.
In practical terms, the client became exposed to a sum almost ten times greater than the amount he was originally liable to pay. We appealed, arguing that the provision imposed a secondary obligation and operated as an unenforceable penalty.
Permission to appeal was obtained. Shortly before the hearing, the matter settled on favourable terms.
This example shows why default provisions in settlement agreements and commercial contracts should be reviewed carefully before enforcement action is taken or before liability is accepted.
Commercial Litigation Over Penalty Clauses
Penalty clause arguments often arise as part of wider commercial litigation. They may be relevant where a party is seeking to enforce a settlement agreement, recover liquidated damages, accelerate a debt, enforce restrictive covenants, or impose severe financial consequences following breach.
For businesses, the practical question is not only whether the clause is enforceable, but also how it affects negotiation strategy, settlement leverage, litigation risk, and the prospects of defending or reducing the claim.
Our commercial litigation solicitors advise on contractual disputes, settlement agreements, shareholder disputes, enforcement issues, and cross-border commercial claims. We also advise on disputes involving parties and assets across multiple jurisdictions. You can learn more about our international disputes work on our jurisdictions page.
Frequently Asked Questions
What is a penalty clause under English law?
A penalty clause is a contractual provision that imposes a disproportionate consequence on a party following breach of contract. Under English law, a clause may be unenforceable if it operates mainly as a punishment rather than protecting a legitimate commercial interest.
What is the test for whether a clause is a penalty?
The modern test comes from Cavendish Square Holding BV v Talal El Makdessi [2016] AC 1172. The court considers whether the clause is a secondary obligation triggered by breach and whether it imposes a detriment that is out of proportion to the innocent party’s legitimate interest in enforcing the contract.
What is the difference between a primary obligation and a secondary obligation?
A primary obligation is a core promise under the contract, such as an obligation to pay, deliver goods, provide services, or comply with a restrictive covenant. A secondary obligation arises when a primary obligation is breached and imposes a consequence, such as payment of a specified sum, forfeiture, or accelerated liability.
Are liquidated damages clauses enforceable?
Liquidated damages clauses can be enforceable if they protect a legitimate commercial interest and are not disproportionate. A fixed payment clause is not automatically a penalty, but it may be challenged if the amount or consequence is excessive in the commercial context.
Can a settlement agreement default clause be challenged as a penalty?
Yes. A default clause in a settlement agreement may be challenged if a missed or late payment triggers a financial consequence that is disproportionate to the creditor’s legitimate interest in securing payment and enforcement.
Do penalty clauses arise in shareholder or business sale disputes?
Yes. Penalty clause arguments can arise in shareholder agreements, business sale agreements, deferred consideration clauses, earn-out provisions, restrictive covenants, and other commercial arrangements where breach triggers a severe contractual consequence.
Can a business challenge an unfair contractual penalty after judgment has been entered?
In some circumstances, a party may be able to appeal or challenge the enforcement of a contractual provision if there are proper legal grounds. The available options will depend on the wording of the agreement, the procedural history, the timing of the challenge, and the nature of the order or judgment.
Why should businesses review penalty clauses before signing a contract?
Businesses should review penalty clauses carefully because default provisions can create significant financial exposure. Proper drafting and early legal advice can reduce the risk of later disputes over enforceability, proportionality, and commercial justification.
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