Penalty clauses in employment contracts

The Supreme Court has recently issued a judgment in the joined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis which has clarified the position on penalty clauses in employment contracts.

The case determined that the key test in determining whether the clause is a “penalty clause” (i.e. unenforceable) is whether the sum or remedy stipulated is exorbitant or unconscionable with regard to the employer’s interest in the performance of the contract.

Background

Employers often use contractual ‘claw back’ provisions to protect their position where an employee might renege on an agreement. By way of example: an employment contract may provide that the employer can recoup the cost of training or relocating an employee if the employment is terminated as a result of the employee’s breach. Settlement agreements commonly stipulate that the exiting employee is required to pay back any compensation if they subsequently take legal action against the employer. Service Agreements can provide that an existing employee forfeits any shares awarded during the course of his employment, in the event that the employee acts in breach of anti-competitive provisions.

Each of the above examples could be argued to constitute ‘penalty clauses’ which, under English law, are unenforceable. In order to avoid a clause being deemed a penalty clause, an employer must demonstrate that it is compensatory in nature, a genuine pre-estimate of loss and not simply a deterrent i.e. is a “liquidated damages” clause.

Supreme Court guidance

The Supreme Court recently issued a judgment in the joined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis which has further clarified the position. In effect, the Court concluded that the key test for penalty clauses is to determine whether the sum or remedy stipulated is exorbitant or unconscionable with regard to the innocent party’s (i.e. the employer’s) interest in the performance of the contract. Thus, the requirement that the sum must be a “legitimate pre-estimate” appears to have fallen away.

Under the revised position therefore, if an employer has a substantial and legitimate interest in the performance of the contract and the sum payable for breach is not wildly disproportionate or excessive, then the clause is unlikely to be considered a penalty. The practical effect of this decision is that clauses which previously might have been deemed penalties, and therefore unenforceable, might now be enforceable.

Comment

Employers should be clear what legitimate interest they are seeking to protect and how the sum payable is in line with the loss likely to be suffered in the event of a breach. This will be construed as at the time the contract was entered into and not at the time of the breach. If multiple breaches could potentially occur, different sums should apply to different types of breach. Ultimately, employers should continue to ensure that the purpose of such clauses is compensatory rather than to act purely as a deterrent. 

 

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