Penalty Clauses

Parties in commercial agreements may sometimes look to agree upon certain sums or other ‘payments’ that are to be paid by one party to the other following a breach of certain provisions of the agreement by the first party.


Whether such clauses are enforceable or not will depend upon whether a court would construe the provision as being a penalty clause or not (where it does so, the provision would be unenforceable). Provisions of this nature that are not deemed to be penalty clauses and are therefore enforceable are sometimes referred to as ‘liquidated damages’ clauses.

The test for whether a provision would be a ‘penalty clause’or a ‘liquidated damages clause’ was previously whether the provision was a genuine pre-estimate of the loss that would be suffered by the non-infringing party and came from the case of Dunlop v New Garage [1915] AC 847 and the ruling of Lord Dunedin: “the essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted preestimate of damage”.