Penalty Clause in UK Law

Nevertheless the Courts would be doing an ill-turn to those whom the rule about "penalty clauses" is designed to protect if they were to apply it so as to make it impracticable for parties to agree at the time when they enter into a contract upon a fair and easily ascertainable sum to become payable by me party to another as compensation for the loss which the latter will sustain as a consequence of its breach.

The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. These are not natural opposites or mutually exclusive categories. The question whether it is enforceable should depend on whether the means by which the contracting party's conduct is to be influenced are "unconscionable" or (which will usually amount to the same thing) "extravagant" by reference to some norm.

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.

I therefore conclude that the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract.

My Lords, one purpose, perhaps the main purpose, of the law relating to penalty clauses is to prevent a plaintiff recovering a sum of money in respect of a breach of contract committed by a defendant which bears little or no relationship to the loss actually suffered by the plaintiff as a result of the breach by the defendant.

It has been held to apply to a clause entitling the innocent party to the retransfer of property which had previously been transferred to the contract breaker ( Jobson v Johnson [1989] 1 WLR 1026), and (see Workers Trust and Merchant Bank Ltd v Dojap Investments Ltd [1993] AC 573) to a clause which requires a contract breaker to forfeit a deposit or sum of money due or to become due to the other party in the event of breach.

In principle, a transaction must be just as objectionable and unconscionable in the eyes of equity if it requires a transfer of property by way of penalty on a default in paying money as if it requires a payment of an extra, or excessive, sum of money. In each case the clause ought to be unenforceable in equity in so far as it is a penalty clause.