A case was heard last month by the Supreme Court (ParkingEye Ltd v Beavis ) which may effectively change the law on penalty clauses and liquidated damages. For 100 years, ever since the landmark case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, it has been established law that a contractual clause which is intended to apply undue force to the other party to perform his side of the contract and is not a genuine pre-estimate of the loss which the innocent party will suffer will be regarded as a penalty and will be unenforceable.

In commercial contracts it is common to find liquidated damages provisions which provide for payments by one party to the other if there is a breach. For example, payments for late deliveries under a supply contract or, in the rail industry, payments for every minute by which a contractor overruns the agreed period during which a track is closed for works to take place. They can be called a variety of things such as service credits, railway costs or simply liquidated damages. Their key common feature, however, is that they are intended to be a realistic pre-estimate of a party’s financial loss. Of course, it is often difficult to determine exactly what that financial loss might be, but provided the contracting parties have attempted to make a reasonable calculation and have both entered into the contract with their eyes open, then the courts will usually not interfere by ruling such a provision invalid.

Where the courts have so far been very reluctant to change the position established in the Dunlop case is if the contractual payment is designed to have a deterrent effect. One of the principles established in that case was that if the sum stipulated is “extravagant and unconscionable” in amount, when compared with the greatest loss that could conceivably have followed from the breach, then it will be a penalty and unenforceable.

In the ParkingEye case, Mr Beavis overstayed the two hour free parking limit in the car park which ParkingEye managed. The car park had clear signs saying a charge of £85 would be payable by anyone who didn’t comply with the limit. The notices formed the basis of a contract between Mr Beavis and ParkingEye, so was the parking charge a penalty? It was clear that ParkingEye did not suffer a direct financial loss because if Mr Beavis had left on time there would either have been a vacant bay or another car parking for free for two hours.

The courts that have reviewed this case so far, up to and including the Court of Appeal, have decided this was not a penalty clause. While acknowledging that it was clearly designed to have a deterrent effect, they have concluded that a modern approach to this issue meant that in all the circumstances, this was not necessarily extravagant and unconscionable (to use one of the key phrases from the Dunlop case). In the Court of Appeal, it was said that the charges were justified by a combination of social and commercial factors. Historically, in commercial contracts, a primary purpose of deterrence has been directly linked with extravagance and unconscionability.   But today, that need not be the case.

We expect to receive the definitive judgment from the Supreme Court in the next few weeks. Whatever their ruling, it is clear that the courts are prepared to modify established legal tests to ensure that the law relating to penalties and liquidated damages reflects current commercial and social trends. That is one of the great virtues of the English system of common law – that it can adapt with the times. But the dynamic nature of our laws means that everyone entering into commercial contracts must be careful to ensure they are drafted in a way which reflects the law as it has evolved. If you commonly use liquidated damages or other forms of service credits in your contracts we would recommend you take specialist legal advice to ensure those contracts remain effective and enforceable.