The Supreme Court has changed the law on penalties which may result in greater freedom being given to parties to decide the consequences of a breach of contract.

The law before the judgment

Previously, clauses which imposed an obligation to pay a set amount for a breach of contract were susceptible to being unenforceable as a penalty. In order to be able to enforce such an obligation, the innocent party would have to show that the sum to be paid represented a genuine estimate of its losses and was not simply being used as a deterrent against breach.

The change resulting from the judgment

The Supreme Court has stated that whether or not the sum reflects a genuine pre estimate of the losses of the innocent party is not the determining factor in deciding whether an obligation to pay a fixed sum for breach of contract is enforceable.

Whether such an obligation is enforceable actually depends on whether it is out of all proportion to the legitimate interest that the innocent party holds. A legitimate interest can include an interest in ensuring that the contract is performed and is not just confined to compensation.

Practical effect on your contracts

Companies may impose higher financial consequences for breaches of contract as a method of deterring the other party from committing a breach. This means that the inclusion in your contract of things such as early termination charges and fixed payments for late delivery are more likely to be effective and may be set at a higher amount than was previously the case, in order to deter a breach.

We can help

If you would like advice on ways to take advantage of the new law when drafting and negotiating your legal contracts please get in touch.