The old test and the new
Until 2015 the question was whether an LD clause was a genuine pre-estimate of loss (Dunlop Pneumatic Tyre v New Garage [1915] AC 79) - anything else was a penalty. Cavendish Square Holding BV v Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67 replaced that with a more permissive test: a clause is penal only if it imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in performance.
Out of all proportion is a high bar - approaching the exorbitant or unconscionable - not merely more than a pre-estimate of loss. For arm's-length commercial parties, penalty challenges are now hard to win, and the burden is on the party trying to escape the clause.
Legitimate interest can exceed financial loss
The first big shift is that the innocent party's legitimate interest is no longer limited to its quantifiable financial loss. In ParkingEye Ltd v Beavis, a GBP 85 charge for overstaying was upheld even though ParkingEye suffered no financial loss from a single overstay, because it had legitimate interests in efficient car-park management and in the revenue that funded the scheme.
For commercial drafters, that means LD clauses protecting brand integrity, exclusivity, supply-chain reliability, or business continuity can be justified even where the monetary loss from a specific breach is modest or hard to measure - exactly the situations LD clauses are for.
Primary obligations sit outside the rule
The penalty doctrine only applies to secondary obligations - those triggered by a breach. A clause structured as a primary obligation falls outside it entirely. In Holyoake v Candy [2017] EWHC 3397 (Ch), a redemption charge payable on early repayment was held to be the price of borrowing, a primary obligation not triggered by breach, so the penalty rule did not apply.
So take-or-pay clauses, service credits framed as price reductions, and conditional payment obligations can often be drafted to avoid the doctrine. But courts look at substance over form - a penalty dressed up as a primary obligation will still be caught.
What survives, and what fails
A decade of case law shows the pattern. Clauses upheld tend to be proportionate, documented, and negotiated between sophisticated parties: in GPP Big Field LLP v Solar EPC Solutions [2018] EWHC 2866 (Comm), delay LDs of a round GBP 500 per day per MWp were enforceable despite being a round sum, despite appearing unchanged across five contracts, and despite the clause using the word penalty - round-sum LDs are acceptable where precise prediction is hard.
Clauses struck down tend to be blunt instruments. In Vivienne Westwood Ltd v Conduit Street Development Ltd [2017] EWHC 350 (Ch), a side-letter clause reverting to full rent (retrospectively and prospectively) on any breach was a penalty, because the same consequence applied whether the breach was trivial or serious. That single-consequence-for-different-breaches problem is the recurring reason clauses fail; the case also set the three-stage test now widely used (primary or secondary? what legitimate interest? exorbitant or unconscionable?).
Default interest, amendments, and review
Two further lessons. Enhanced default interest is assessed the same way: in Houssein v London Credit Ltd [2024] EWCA Civ 721, the Court of Appeal applied the Cavendish test to a default rate, confirming a high rate is judged for whether it is exorbitant, not automatically penal. And a clause valid at the outset can become penal after amendment: in Unaoil v Leighton Offshore [2014] EWHC 2965 (Comm), a fixed LD figure became unconscionable once the contract price was reduced without recalibrating it.
So review LD quantum whenever you change the price or scope, and do not assume that if an enhanced rate is struck down the standard rate automatically revives - provide an express fallback (see the architecture guide).
Use at the desk
Practical checklist
- Apply the Cavendish test: penal only if out of all proportion to a legitimate interest (Cavendish [2015] UKSC 67).
- Document a legitimate interest beyond financial loss where relevant (brand, exclusivity, continuity) (ParkingEye).
- Consider structuring payments as primary obligations to sit outside the penalty rule (Holyoake v Candy [2017] EWHC 3397 (Ch)) - but watch substance over form.
- Avoid a single blunt sum for trivial and serious breaches alike - use graduated or tiered structures (Vivienne Westwood [2017] EWHC 350 (Ch)).
- Round-sum LDs are acceptable where precise prediction is hard (GPP Big Field [2018] EWHC 2866 (Comm)).
- Recalibrate LD quantum whenever the price or scope is amended (Unaoil v Leighton Offshore [2014] EWHC 2965 (Comm)).
This guide is informational only and is not legal advice. It does not replace advice from licensed counsel on the facts of a specific transaction.
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