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This briefing note is only intended as a general statement of the law and no action should be taken in reliance on it without specific legal advice.

The new penalties law: a more flexible test
 Briefing 
Author
Laurence Jacobson, Amy Last
Date
27 January 2016

The new penalties law: a more flexible test

In a landmark decision the Supreme Court has set out a new approach to the identification of penalty clauses. In two very different cases, Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67, it was argued that certain clauses were unenforceable as penalties, however the Supreme Court upheld the clauses and deemed them not to be penalties on the basis that they were "commercially justified". The decision of the Supreme Court is good news for those seeking to rely on such terms in commercial contracts as the courts should be more inclined to uphold the parties' freedom of contract where possible.

Previous position on penalties

Many contracts include provisions for a sum to be paid, or another sanction to apply, on breach of contract. Before the decision in Cavendish, the traditional analysis of whether clauses of this type were penalties was found in the judgment of Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] A.C.79. This case drew a distinction between a clause which provided for a genuine pre-estimate of the loss likely to be suffered as a result of a breach, which was compensatory and therefore enforceable, and a clause which aimed to deter a breach, which was penal and therefore unenforceable.

In his judgment, Lord Dunedin formulated the following four tests which he considered helpful in determining whether provisions were penal:

  1. the provision would be penal if the sum stipulated was extravagant and unconscionable in amount compared with the greatest loss that could flow from the breach; 
  2. the provision would be penal if the breach consisted only in the non-payment of money and it provided for payment of a larger sum;
  3. there was a presumption that a clause was penal if it specified payment of a single lump sum but the loss that could be suffered could vary in gravity;
  4. the provision would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.

The underlying disputes

In Cavendish, Mr Makdessi sold part of his advertising and marketing company to Cavendish. The share purchase agreement provided that if Mr Makdessi breached certain restrictive covenants which prohibited competing activities, he would lose his entitlement to deferred consideration payments and could be required to sell his remaining shares to Cavendish at a price excluding the value of goodwill. Mr Makdessi breached those covenants but argued that the clauses operated as penalty clauses and were unenforceable. The Court of Appeal agreed with him and overturned the first instance decision.

ParkingEye related to a charge of £85 imposed by the operator of a car park, ParkingEye Limited on an individual, Mr Beavis, for overstaying a two-hour permitted period of free parking at the car park. When ParkingEye sought payment, Mr Beavis' defence was that the charge was unenforceable as a penalty, or alternatively that it was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (UTCCR 1999). Both the High Court and the Court of Appeal rejected those arguments.

The true test

The Supreme Court justices were broadly in agreement as to the applicable legal principles underpinning the rule on penalties. It was felt that the concept of "genuine pre-estimate of loss" had been followed too slavishly since Dunlop.

The "true test" is whether the offending clause is a secondary obligation (an obligation which arises only once a primary obligation has been breached) which imposes a detriment on the party in breach, out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

A clause is not penal merely because it is not a genuine pre-estimate of loss, even if it operates as a deterrent. In a "straightforward" liquidated damages clause (i.e. simply quantifying the damages payable on a specified breach), compensation for breach is likely to be the only legitimate interest that the non-defaulting party has and in these cases the traditional test set out in Dunlop is likely to be adequate to determine the validity of the clause. The Supreme Court was also in agreement that the penalties rule is not restricted to clauses requiring payment of money. It will apply to obligations to transfer assets, either for nothing or at an undervalue, or clauses disentitling the party in breach from receiving a sum otherwise due.

The decision

Applying the reformulated test, the Supreme Court allowed the appeal in Cavendish and dismissed the appeal in ParkingEye, in each case finding that the provisions in question were not penal.

In Cavendish, there was disagreement as to whether the penalty doctrine even applied as some of the justices classified the provisions as price adjustment clauses and therefore primary obligations. Despite the differing approach, they all agreed that, even if the rule was engaged, the clauses were not penalties. Cavendish had a legitimate interest in the observance of the covenants, as the goodwill of the business was critical to its value, and a legitimate interest in matching the price to the value that Mr Makdessi was contributing to the business. Important to the decision was the fact that the agreement had been negotiated in detail, over a considerable period of time between two sophisticated parties dealing on equal terms with expert legal advice.

In ParkingEye, the justices considered that the £85 charge was justified by ParkingEye's legitimate interest in imposing the charge, which went beyond the recovery of any loss; namely the management of the efficient use of parking space and the generation of income to run the scheme. The charge was not deemed to be out of proportion to that interest. It was also held by the majority not to be unfair under the UTCCR 1999 (a discussion of the regulations is beyond the scope of this note).

In summary, a clause may not be penal even if its purpose is to deter a breach, however a court will look to see whether the clause is a genuine pre-estimate of loss or otherwise has commercial justification, taking into account the circumstances at the time the contract was made.

Practical implications

The test represents a new formulation in this area of the law and it is likely that case law relating to penalties will evolve. In the meantime, the following drafting tips may be helpful:

  • For a "straightforward" liquidated damages clause, consider building into your clause any information that helps show the sum stipulated is a genuine pre-estimate of loss. In cases where it is not possible to predict at what stage damages will be triggered, consider whether it is appropriate to provide for a daily rate of damages rather than a lump sum.
  • Try to draft more complex clauses as primary obligations to avoid engaging the rule on penalties or so that the remedy specified is not triggered by breach. For Cavendish-type clauses, the payment of deferred consideration could be made conditional on the observance of the restrictive covenants. However, the Supreme Court did stress that the proper interpretation of a clause is a matter of substance over form so "disguised" penalties could still be attacked.
  • Consider including an acknowledgement in the agreement that there is a "legitimate commercial interest" for the clause with an explanation of the background to that interest and avoid including remedies which are completely disproportionate to the interests of the party that is likely to want to rely on it.