PT-2021-000393 - [2025] EWHC 2749 (Ch)

Fecha: 23-Oct-2025

The law on penalties

The law on penalties

113.

The parties did not agree on what the Court of Appeal Judgment required me to do in making that determination. In addressing their respective positions it will be necessary to consider what the legal test is, and so it makes sense to start with that.

114.

As I have noted, in my First Judgment I made reference to the Supreme Court decision in Makdessi, in particular the judgments of Lords Neuberger and Sumption. The Court of Appeal also referenced those paragraphs, but in light of the way matters have developed, and in particular in light of the significantly greater detail with which this judgment addresses the penalty issue, I feel it would be helpful to return to the question of approach de novo.

115.

In my view the starting point is paragraph [9] of Makdessi, which lays down some general propositions. I do not believe these to be controversial, but since I will return repeatedly to them it merits quoting that passage at length:

The distinction between a clause providing for a genuine pre-estimate of damages and a penalty clause has remained fundamental to the modern law, as it is currently understood. The question whether a damages clause is a penalty falls to be decided as a matter of construction, therefore as at the time that it is agreed: Public Works Comr v Hills [1906] AC 368, 376; Webster v Bosanquet [1912] AC 394; Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, at pp 86-87 (Lord Dunedin); and Cooden Engineering Co Ltd v Stanford [1953] 1 QB 86, 94 (Somervell LJ). This is because it depends on the character of the provision, not on the circumstances in which it falls to be enforced. It is a species of agreement which the common law considers to be by its nature contrary to the policy of the law. One consequence of this is that relief from the effects of a penalty is, as Hoffmann LJ put it in Else (1982) Ltd v Parkland Holdings Ltd [1994] 1 BCLC 130, 144, “mechanical in effect and involves no exercise of discretion at all.” Another is that the penalty clause is wholly unenforceable: Clydebank Engineering &Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo y Castaneda [1905] AC 6, 9, 10 (Lord Halsbury LC); Gilbert-Ash (Northern) Ltd v Modern Engineering (Bristol) Ltd [1974] AC 689, 698 (Lord Reid), 703 (Lord Morris of Borth-y-Gest) and 723-724 (Lord Salmon); Scandinavian Trading Tanker Co AB v Flota PetroleraEcuatoriana (The “Scaptrade”) [1983] 2 AC 694, 702 (Lord Diplock); AMEV-UDCFinance Ltd v Austin (1986) 162 CLR 170, 191-193 (Mason and Wilson JJ).

116.

Not all of those propositions survived Makdessi. In particular, the concept of genuine pre-estimate of loss is no longer the law. However, many did and, of particular relevance to this case, it remains the law that the assessment is to be carried out at the time the agreement is entered into and that the effect of a finding that a clause is penal is that the clause as a whole is unenforceable. I had not understood either proposition to be in issue at the trial; certainly, it did not seem to me controversial as between the parties at this hearing.

117.

Lords Neuberger and Sumption then turned to the circumstances in which the penalty rule was engaged. It applies only to secondary obligations, those which arise on breach. It does not apply to the primary obligations under the contract.

118.

They then turned to the various authorities. In particular, at paragraph [22] they expressed reservations about the status of “quasi statutory code” that had been accorded to Lord Dunedin’s four tests in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79. Of particular relevance here is the third of those tests: that there was a presumption that a sum would be penal if it was payable in a number of events of varying gravity.

119.

Lords Neuberger and Sumption returned to Dunlop at paragraph [31]:

In our opinion, the law relating to penalties has become the prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and a genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent. These distinctions originate in an over-literal reading of Lord Dunedin’s four tests and a tendency to treat them as almost immutable rules of general application which exhaust the field.

120.

The point on deterrence was especially clearly put when Lords Sumption and Neuberger came to apply the test at paragraph [99]: “As we have pointed out, deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract.”

121.

They returned to Dunlop at paragraph [32], where they also set out the test:

The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations. This was recognised in the early days of the penalty rule, when it was still the creature of equity, and is reflected in Lord Macclesfield’s observation in Peachy (quoted in para 5 above) about the application of the penalty rule to provisions which were “never intended by way of compensation”, for which equity would not relieve. It was reflected in the result in Dunlop. And it is recognised in the more recent decisions about commercial justification. And, as Lord Hodge shows, it is the principle underlying the Scottish authorities.

122.

Two related points, it seems to me, are worth highlighting from that. First, a contract may contain multiple relevant primary obligations and the legitimate interests in seeing each of them performed may be different. Secondly, Lord Dunedin’s four tests, including that a clause protecting multiple different interests in the same way gives rise to a presumption (but no more) of penalty, remain valid issues to be considered.

123.

Lords Sumption and Neuberger went on to reiterate at paragraph [33] that the penalty jurisdiction interferes with freedom of contract and that the courts “should not be astute to descry a penalty clause’”. They further observed, at paragraph [35]: “In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.”

124.

I will need to address Makdessi further in due course, obviously, and will there address what was said by Lord Hodge and Lord Mance. That is not necessary at this stage, however.

125.

In applying Makdessi, the Court of Appeal Judgment endorsed the three-stage approach adopted by Mr Fancourt QC, as he then was, in Vivienne Westwood v Conduit Street [2017] EWHC 350 (Ch). At paragraph [41] he said:

The Cavendish case shows clearly that, in considering whether a contractual stipulation is or is not a penalty, one must address first the threshold issue - is a stipulation in substance a secondary obligation engaged upon breach of a primary contractual obligation; then identify the extent and nature of the legitimate interest of the promisee in having the primary obligation performed, and then determine whether or not, having regard to that legitimate interest, the secondary obligation is exorbitant or unconscionable in amount or in its effect.

126.

The approach of Mr Fancourt QC was adopted in Cargill International Trading PTE Ltd v Uttam Galva Steels [2019] EWHC 476 (Comm), to which I will also need to return at some length, and Ahuja Investments Ltd v Victorygame Ltd [2021] EWHC 2382 (Ch).

127.

Finally, I note Mr Fancourt QC’s point at paragraph [53]:

It follows that, under the Side Letter, the same substantial financial adjustment applies whether a breach is one-off, minor, serious or repeated, and without regard to the nature of the obligation broken or any actual or likely consequences for the lessor. Although it is far from being conclusive, that has long been recognised as one of the hallmarks of a penalty.

128.

That follows from what he said at paragraph [41]: one identifies the primary obligation whose breach triggers the secondary obligation that is said to be penal, then one looks at the legitimate interest in the performance of that primary obligation. If there are multiple primary obligations that are subject to the same remedy, in this case the Default Rate, one must assess the legitimate interest in each of those primary obligations (or group of primary obligations if there is some common legitimate interest in their enforcement). The use of the same Default Rate for multiple different primary obligations was a concern I expressed in my First Judgment, and for the reasons I give above I agree with Mr Fancourt QC that it remains a proper question to ask when applying the Makdessi test.

129.

The question of whether a provision is extortionate, and so a penalty, turns on the facts of each case.