Important Changes To The English Law Rule On Penalty Clauses - What Does It Mean For Franchising?

In a recent landmark decision, the highest court in England and Wales, the Supreme Court, considered the long established principles underlying the law relating to contractual penalty clauses (the penalty rule). The Supreme Court issued a joint judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi (El Makdessi) and ParkingEye Ltd v Beavis [2015] UKSC 67 (ParkingEye), which is one of the most important decisions in English common law for the last 100 years.

The Supreme Court judgment sets out a new, progressive test for determining whether or not a contractual provision will be considered penal and therefore unenforceable. The judgment is relevant to all franchise systems which operate under English law agreements, as it re-calibrates the application of the penalty rule and potentially gives franchisors greater scope to deter certain types of behaviour and impose contractual penalties for certain types of breaches.

What was the penalty rule?

The origins of the penalty rule can be traced back as far as the 16th century, and originates in the concern of the Courts to prevent exploitation in an age when credit was scarce and borrowers were particularly vulnerable. Essentially, a penalty is a payment of money stipulated in the contract and is unenforceable against the offending party if it is an exorbitant alternative to common law damages.

At the beginning of the 20th century, the judgment in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 (Dunlop) sought to restate the law on the penalty rule by providing four tests which were designed to be "helpful, or even conclusive" in determining whether or not a clause was an unenforceable penalty. The Dunlop judgment distinguished between penalty clauses (which are unenforceable) and "liquidated damages" clauses, which are enforceable provided that the specified sum is "a genuine pre-estimate of loss" - wording which has since appeared in many English law commercial contracts over the last 100 years.

However, in El Makdessi and ParkingEye the Supreme Court noted that the Dunlop tests had taken on the status of a "quasi-statutory code", which was never the intention, and the Dunlop test has been applied too rigidly, particularly in cases where there is a clear commercial justification for including a penalty clause, or where there may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial...