if the test for a penalty is now ultimately "commercial
justification" (a clause that is a genuine pre-estimate may be
regarded as justified on that basis), it is a rather curious test since the courts will not ask of any other type of provision: was it commercially justified? Alternatively, in a fully negotiated contract between sophisticated commercial parties advised by their lawyers, is not the commercial justification simply that they agreed to the clause? And if so, do we really need a rule against penalties? Write an essay responding to this quotation, considering both whether the points made by the author are justified in respect of the laws approach to penalty clauses, and whether they could also be fairly made in respect of other agreed remedies. The classic test for establishing the existence of a penalty clause set out in the case of Dunlop Pneumatic Tyre Company v New Garage and Motor Company Limited[1915] is now almost 100 years old. Since then the Courts have frequently looked at whether clauses are meant as deterrents and therefore punish the offending party or whether they are there to compensate the innocent party by way of liquidated damages. The more modern approach to penalty clauses has shifted away from this old formula and now considers the following questions: Is there commercial justification for the provision? Is it the extravagant or oppressive? Is this predominantly a deterrent? What happened at the time of negotiation? The commercial justification test was first suggested by the High Court in the case of Lordsvale Finance Plc v Bank of Zambia [1996] QB 752, where Colman J said:"There would therefore seem to be no reason in principle why a contractual provision the effect of which was to increase the consideration payable under an executory contract upon the happening of a default should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided always that its dominant purpose was not to deter the other party from breach." The Court of Appeal affirmed the position in the 2013 case of El Makdessi v Cavendish Square Holdings [2013] EWCA Civ 1539 where it was held at paragraph 117 that:- "For these reasons I am satisfied that the clauses, taken in the context of the Agreement as a whole, are not genuine preestimates of loss. On the contrary they are extravagant and unreasonable. That is not necessarily conclusive. A commercial justification may mean that a clause which is not a genuine preestimate is not penal." Taken together, these cases show that the key consideration is now whether the liquidated damages provision is considered oppressive and having the dominant purpose of deterring a breach. Also, even where a provision is not a "genuine
pre-estimate" of loss, the provision may yet survive if there is a
commercial justification for it. In other words, if you can justify your position commercially, if for example there is a specific commercial rationale for the provision, then a provision which may otherwise have failed as a penalty could still be upheld. Agreed remedies are previously negotiated measure of compensation upon breach of contract aiming to frustrate attempts to secure greater compensation from judicial remedies (Ian Macneil, Power of Contract and Agreed Remedies) and reduce uncertainty. They are extensively useful to the parties in a contract to maintain commercial certainty. This is especially so in transactions where there are inherent unpredictable risks. Liquidated damages, for example, promise a quicker court procedure for debt collection and avoid difficulties in proving losses for common law remedy. Upholding the principles of freedom of contract would seem to mean that parties can insure themselves against breaches with liquidated damages clauses (liquidated damages clauses) and deposits and foresee the consequences and hence protect their interests adequately with such a means. While an liquidated damages clauses may incentivise parties to complete obligations, the court would nevertheless not enforce it if the terms are deemed unconscionable, extravagant and not a genuine preestimate of loss, but a penalty stipulated in terrorem (Lord Dunedin). The courts approach to determine the validity, described as risk averaging by Collins, is illustrated in Dunlop v New Garage where the 5 per type charge was not considered extravagant but a genuine prediction of the average potential loss resulting from breaches. To add on that, in Philips Hong Kong the court concede that disparity in some circumstances would not automatically invalidate an liquidated damages clauses. Similarly, there are judicial control on deposits and other types of agreed remedies. These are rather strict control and one that attracts fierce criticisms. The strongest arguments against the equitable jurisdiction are the compromise of freedom and certainty and the lack of coherent principles in the decisions. Penalty clauses can certainly intrude on freedom because an over the top compensation is likely to compel or even coerce a party to perform its obligations. However, same can be said for the judicial control of penalty clauses. Contracts in a commercial context are negotiated mindfully with all parties aware of their rights and obligations. It is difficult to say that parties have not taken precautions and assessed risks before entering into an contract. It is very reasonable and indeed common practice that a more riskaverse party buy insurance from the less risk-averse party (Samuel Rea, Efficiency Implication of Penalties and Liquidated Damages). There are efficiency reasons to raise the compensation levels by a considerable amount. Rea argues that the courts jurisdiction to invalidate penalty clause would effectively compel
parties to charge higher contract prices for risking the agreed
remedy clauses being deemed unenforceable. From a commercial perspective, the courts intervention in effect does nothing but to force parties to reflect the risks in the price rather than in the agreed remedies as a functional form of insurance the parties interests are still protected, but the courts interference has only disrupted the balance of benefits obtained by the parties and made transactions economically inefficient. In defence of the courts interference, Collins contends that such is to maintain fairness and uphold corrective justice. The remedy should be qualified by foreseeability of probable losses and the main aim of remedies is to adequately compensate and not over compensate the injured party. In terms of procedural fairness, Fuller and Eisenberg suggest that the courts invalidation of extravagant liquidated damages clausess is a response to the possibility that the importance of the clauses are not fully appreciated by the parties (Hugh Collins, Fairness in Agreed Remedies). This argument seems a little contrived as contract terms are expected to negotiated and agreed carefully. A more satisfying explanation would be that the courts approach is to protect the weaker party from unconscionability. This however invites scepticism as the jurisdiction is limited to agreed remedies there are other doctrines to remedy the imbalance of bargaining powers. Similar to extravagant liquidated damages clausess, the court is prepared to strike down unreasonable deposit. Reasonableness is determined with reference to the trade; for example, usual deposit for sale of land would be capped at ten percent of the price save for special circumstances. However, in terms of the approach, deposits are treated different from liquidated damages clausess, as the court would uphold even if they are not genuine pre-estimate of loss. In other words, the deposit does not have to reflect the actual loss suffered by the innocent party as long as it is set at a reasonable proportion with reference to the industry. In this sense, rather than reflecting the loss suffered by the innocent party, the court seems to be more concerned with commercial reasonableness. The idea of corrective justice does not apply. Such inconsistency in terms of treatment of different types of remedies induces great uncertainty in commercial contracts. If fairness is truly an aim of the English treatment to agreed remedies, the same level of judicial control of penalty clauses should probably extend to other remedies like deposits because, in essence, a deposit is a penalty paid in advance. For example, references to the potential loss suffered by the innocent party may be put into consideration when determining the validity of the deposit. Lastly, it must be said that the concept of fairness is unclear and the lack of justification for the different standards in determining the validity of liquidated damages clausess and deposits suggest that the law was developed in an ad hoc and arbitrary manner. The absence of an overarching and coherent principles is frustrating for
contracting parties for there are no clear standards in testing the
fairness. Ultimately, the distinction of a deposit and LIQUIDATED DAMAGES CLAUSE may appear to be an elusive one in some instances. It is noteworthy that the courts approach, therefore, may encourage the use of deposit to ensure certainty in case of breach, eventually changing the picture of commercial contracts. In conclusion, the extensive commercial advantages of enforcing agreed remedies seem to overwhelm the jurisdiction aiming to maintain fairness. The courts interference would hardly prevent parties from protecting their interests adequately because the commercial market would inevitably adapt to the law. While the English jurisdiction may induce uncertainty and hence undermines commercial efficiency, the court never claims a general power not to enforce any agreement which the court regards as unconscionable and extravagant (Jobson v Johnson, per Dillon LJ). The law has come to shape and the instances where the court does intervene become traditional authority. While it is still unsatisfactory in terms of fairness and certainty, the trade off is necessary and inevitable. In addition, the lack of coherent principles attracts attention towards civil law jurisdictions like France where all liquidated damages clauses are valid, but the court reserves a power of control to reduce but not invalidate the level of compensation to reflect the loss suffered by the innocent party; certainly, the parties would be able to see for themselves the validity of liquidated damages clauses under this approach. Nonetheless, it is quite improbable that the English system would go towards the French direction since the Law Commission rejected the Unidriot proposal to adopt a model similar to the French system on the basis that it would induce even more uncertainty (Law Commission Working Paper No.61). After all, the English jurisdiction still provides for a certain latitude in testing the validity of liquidated damages clauses. In the meantime, it remains a challenge for the court to strike the balance between maintaining fairness and certainty without over compromising autonomy and commercial efficiency.