The Scope of the Penalty Clause Rule

The Court of Appeal in Houssein v London Credit Ltd [2024] EWCA Civ 721 reaffirmed the principles to be applied when deciding whether or not an agreed damages clause is a penalty clause and is therefore unenforceable. In doing so, the Court of Appeal confirmed that a three-stage approach should be applied when considering whether a clause is, or is not, a penalty clause. First, the court should ask whether the clause imposes a secondary obligation on the party required to make payment. Second, the court should focus on the extent and nature, if any, of the legitimate interest sought to be protected by the party seeking payment. Third, the court must ask whether the sum payable is extortionate, exorbitant or unconscionable. In the present case, the judge at first instance had not adopted this tri-partite approach and he was held to have erred in failing to do so.