UK: Important Changes To The English Law Rule On Penalty Clauses - What Does It Mean For Franchising?

Last Updated: 4 March 2016
Article by Gordon Drakes and Tim Rickard

In a recent landmark decision, the highest court in England and Wales, the Supreme Court, considered the long established principles underlying the law relating to contractual penalty clauses (the penalty rule). The Supreme Court issued a joint judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi (El Makdessi) and ParkingEye Ltd v Beavis [2015] UKSC 67 (ParkingEye), which is one of the most important decisions in English common law for the last 100 years.

The Supreme Court judgment sets out a new, progressive test for determining whether or not a contractual provision will be considered penal and therefore unenforceable. The judgment is relevant to all franchise systems which operate under English law agreements, as it re-calibrates the application of the penalty rule and potentially gives franchisors greater scope to deter certain types of behaviour and impose contractual penalties for certain types of breaches.

What was the penalty rule?

The origins of the penalty rule can be traced back as far as the 16th century, and originates in the concern of the Courts to prevent exploitation in an age when credit was scarce and borrowers were particularly vulnerable. Essentially, a penalty is a payment of money stipulated in the contract and is unenforceable against the offending party if it is an exorbitant alternative to common law damages.

At the beginning of the 20th century, the judgment in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 (Dunlop) sought to restate the law on the penalty rule by providing four tests which were designed to be "helpful, or even conclusive" in determining whether or not a clause was an unenforceable penalty. The Dunlop judgment distinguished between penalty clauses (which are unenforceable) and "liquidated damages" clauses, which are enforceable provided that the specified sum is "a genuine pre-estimate of loss" – wording which has since appeared in many English law commercial contracts over the last 100 years.

However, in El Makdessi and ParkingEye the Supreme Court noted that the Dunlop tests had taken on the status of a "quasi-statutory code", which was never the intention, and the Dunlop test has been applied too rigidly, particularly in cases where there is a clear commercial justification for including a penalty clause, or where there may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden.

What were the cases about?

The El Makdessi case related to the sale of a Middle Eastern media business and the provisions of a share purchase and shareholders' agreement.  The agreements provided that if the seller was in breach of certain non-compete restrictions, then he lost his entitlement to deferred consideration that would otherwise have been payable, and he must sell his remaining shares at a price that excluded the value of the goodwill (which would have been diminished by his breach of the covenants). The Court of Appeal held that these provisions were penal, as their purpose was to deter an act rather than to compensate the loss suffered by the innocent party.

The ParkingEye case related to a parking fine of £85 imposed after a driver overstayed the two-hour limit in a privately-run car park. The driver, Mr Beavis, attempted to argue that this was a penalty (as the owner of the car park had not suffered any clear loss) and therefore unenforceable. The Court of Appeal disagreed but granted Mr Beavis permission to appeal, and it is testament to the integrity and impartiality of the English court system that the Supreme Court gave such a detailed judgment on a case involving a £85 fine.

The new test

The Supreme Court's judgment has moved the law on contractual penalties away from the narrowly applied tests in Dunlop and has re-cast the test as follows: "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 [32]".

Lord Hodge expanded on this, stating 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 [255]".

In El Makdessi, the Court concluded that the provisions in the agreements protected the buyer's legitimate interest in enforcing the non-compete restrictions so that the goodwill of the business was protected.   The goodwill of the business was critical to its value to the buyer.  The provisions therefore did not go beyond protecting the buyer's legitimate interests.

In ParkingEye, it was clear that whilst the £85 charge may have been perceived understandably by users of the car park as a deterrent from over-staying the two-hour limit, there were also clear legitimate commercial interests that it was seeking to protect by imposing the charge. These included preserving the traffic management system and efficient use of parking space in the surrounding outlets and their users by deterring long-stay parking.  The charge was also relied upon to generate the income needed to run the scheme.  As a result, the charge was held not to be "out of all proportion" to those interests and therefore not penal.

In addition to the principles of primary versus secondary obligations, proportionality and the legitimacy of a deterrent, the Supreme Court judgment in respect of El Makdessi also referred to the importance of considering the circumstances in which the parties entered into the contract – "in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach [35]". This is relevant to franchise agreements, which can appear across this spectrum depending on whether it is an international deal, a domestic multi-unit or high value deal or a domestic business format unit franchise deal. 

What's changed? Some practical implications

The Supreme Court has set a new test which recognises that a contractual party will often have a legitimate interest which can be protected by a contractual penalty which does not have to be a genuine pre-estimate of loss.

Provided that a contracting party can demonstrate that it is using a penalty clause to protect a legitimate interest and the penalty is not exorbitant or unconscionable, the following principles now apply:

  • It is no longer necessary for the penalty to be a genuine pre-estimate of loss.
  • A party relying on the penalty clause does not have to suffer a loss.
  • The predominant purpose of a clause can be to act as a deterrent against a certain breach of contract.
  • The penalty does not just have to be a specified financial amount. A party can, for example, withhold deferred consideration or require the transfer of certain property as the consequence for breach.
  • Generally, parties have a greater freedom to contract for the consequences for breach.

It is also worth noting that the penalty rule only operates on and regulates against breaches of "primary obligations". For example, if the contract provides that Party A shall perform an act (the primary obligation) and goes on to state that if Party A does not perform that act, Party A is obliged to pay Party B a specified sum of money, the obligation to pay is a "secondary obligation" and is capable of being a penalty. If an obligation to pay a penalty can be expressed as a primary obligation, this would circumvent the application of the penalty rule. However, the Supreme Court judges had differing views on what constituted a primary and a secondary obligation, so clever drafting will not always guarantee that the penalty rule can be avoided by framing a penalty as a primary obligation.

What does this mean for English law franchise agreements?

Franchise agreements typically fall into two categories:

  • those which are issued on a "take it or leave it" basis, which is common in domestic business format franchising, when the parties are not of comparable bargaining position and the franchisee may not even take proper legal advice; or
  • those which are negotiated freely between well-advised parties of comparable bargaining positions, which is common in larger scale, often multi-unit domestic franchising and international franchising.

It therefore seems like a fair assumption that the greater freedoms conferred by the Supreme Court will have most impact on English law large scale domestic and international franchise agreements, as opposed to smaller scale domestic agreements.

Nevertheless, all franchisors have a number of legitimate interests to protect and contractual penalties can therefore play an important role in focussing the mind of the franchisee on the franchisor's key interests and the types of behaviours and breaches which cannot be tolerated. For example:

  • Franchisors must protect the goodwill and reputation of the brand and the system, both for themselves and their other franchisees. The goodwill and reputation is essential to maintaining and attracting franchisees and customers to the business.
  • Franchisors are vulnerable when a franchisee decides to leave the network, as each franchisee has the potential to become a direct competitor of the franchisor, having benefitted from training, support and access to know-how.
  • Franchisors have a legitimate interest in maintaining a high degree of contractual power and discretion so that they can effectively monitor and police their franchise networks and introduce innovations into the system.

This judgment is welcome news for franchisors, who may have previously hesitated from including deterrents and specified financial consequences for certain breaches. There may be more scope now to charge penalties for repeated operational breaches, breaches of audit protocols and breaches of in-term and post-term covenants. The approach to franchise sales could also be revised in light of El Makadessi.

However, the new test does raise a number of queries which will no doubt be tested in the Courts in the years to come. At what point does a specified sum become exorbitant? In Parkingeye, £85 was proportional, but would the court take the same view to a fine of £250? There is a degree of uncertainty over what constitutes a primary and secondary obligation and the extent to which it is therefore possible to "draft around" the whole issue of contractual penalties.

In terms of practical steps, franchisors should consider taking legal advice and reviewing carefully the terms of their template agreements with a view to:

  • weaving in the thread of "legitimate interests" and linking it to certain standards of performance
  • including more financial consequences for certain breaches
  • reviewing restrictive covenants and franchise sale provisions in light of El Makadessi
  • replacing references to "genuine pre-estimates of loss"
  • framing certain clauses as primary obligations

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

Gordon Drakes
Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of

To Use you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions