Supreme Court rewrites English law rule on penalties

In a judgment handed down this morning, the Supreme Court has in effect re-written the rule on penalties, saying that the underlying rationale of the rule in English law has been misunderstood and that as a result the rule has been applied in many situations where it is both unnecessary and unjust: Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67.

The Supreme Court has rejected the traditional test of whether a clause that takes effect on breach is a “genuine pre-estimate of loss” and therefore compensatory, or whether it is aimed at deterring a breach and therefore penal. The true principle, as established in the judgment, is whether the clause is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations under the contract. If so it will be penal and therefore unenforceable.

The decision helpfully recognises that a party can, in some circumstances, have a legitimate interest in enforcing performance which goes beyond simply being compensated for losses. On this basis, the Supreme Court has overturned the Court of Appeal's judgment in Makdessi (outlined here) which found that provisions in a share purchase agreement which took effect if the seller breached certain restrictive covenants were unenforceable penalties. The Supreme Court concluded that the buyer had a legitimate interest in enforcing the covenants, in order to protect the goodwill of the business, and the parties themselves were the best judges of how that interest should be reflected in the agreement.

The Supreme Court's decision therefore introduces a more flexible test as to whether or not a clause will be found to be penal, and therefore unenforceable, than the traditional question of whether a clause was aimed at deterrence rather than compensation. Of course, the question of precisely what will amount to a legitimate interest, and whether a clause is out of proportion to that interest, may be open to debate in many cases. But the decision provides a much more helpful starting point, and is likely to mean less interference in contracts freely negotiated between commercial parties of similar bargaining power.

The decision is also helpful in confirming that a clause may fall outside the rule against penalties altogether if takes effect in circumstances other than a breach of contract, for example a payment which is conditional on performance rather than an entitlement to liquidated damages in the event of breach. It may therefore be possible to avoid the application of the rule with careful drafting, though the judgment does make it clear that classification of the term will depend on substance rather than mere form. David Nitek and Maura McIntosh, a partner and professional support consultant in the disputes team, consider the decision further below.

Background / Court of Appeal decision

The Supreme Court heard two appeals relating to whether certain sums payable on breach of contract were penal and therefore unenforceable. The appeals arose in very different contexts, and with different conclusions by the Court of Appeal on the enforceability of the relevant terms.

The underlying dispute in Makdessi concerned provisions of a share purchase and shareholders’ agreement. These provided that if the seller (Mr Makdessi) was in breach of certain non-compete restrictions, he lost his entitlement to deferred consideration that would otherwise be payable, as well as the benefit of a put option to sell his remaining shares at a price determined by reference to goodwill; instead a call option was triggered, which allowed the purchaser (Cavendish) to buy his remaining shares at a price based on net asset value, with no provision for goodwill. The Court of Appeal (overturning the High Court decision) held that the provisions were penalties and therefore unenforceable. The provisions were not a genuine pre-estimate of loss, but were extravagant and unreasonable compared to the likely damage resulting from a breach, and they had no sufficient commercial justification. That meant they were unconscionable, as their purpose was deterrence rather than compensation, and they were therefore penal. Cavendish was granted permission to appeal to the Supreme Court.

ParkingEye related to a charge of £85 imposed on an individual, Mr Beavis, for overstaying a two-hour permitted period of free parking at a retail park in Chelmsford. The Court of Appeal (in agreement with the High Court decision) rejected an argument that the charge was penal. Although it was not a genuine pre-estimate of loss, and was aimed at deterring motorists staying beyond the permitted period, it was not extravagant or unconscionable and was justifiable both commercially and by other factors. The court commented that in the commercial context a "dominant purpose of deterrence" has been equated to extravagance and unconscionability, but in another context (as here) that need not be the case. Mr Beavis was granted permission to appeal to the Supreme Court.

Supreme Court decision

The Supreme Court has unanimously allowed the appeal in Makdessi and (by a six to one majority) dismissed the appeal in ParkingEye, in each case finding that the provisions in question were not penal. The leading judgment is given jointly by Lord Neuberger and Lord Sumption, with whom Lord Clarke and Lord Carnwath agree. Lord Mance and Lord Hodge give concurring judgments. Lord Toulson also concurs in Makdessi, but would have allowed the appeal in ParkingEye on the basis that the clause infringes the Unfair Terms in Consumer Contracts Regulations 1999 (a point which is not considered in this post).

In its judgment, the Supreme Court has taken the opportunity for a fundamental re-examination of the underlying justification of the rule against penalties. The court declined to abolish the rule altogether, but also held that the rule should not be extended (at least by judicial, rather than legislative, decision-making) so that it could apply to provisions that take effect other than on a breach of contract. The court confirmed that the rule is engaged only where a clause sets out a remedy for breach. Its application may therefore depend on how the relevant obligation is framed in the contract. The judgment explains:

"Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty."

However, the court emphasised that the classification of terms for the purposes of the penalty rule depends on the substance of the term and not mere form. Further, although the payment of money is the classic obligation under a penalty clause, the Supreme Court says there is no reason the rule should not apply to an obligation to transfer assets (either for nothing or at an undervalue). Lord Mance and Lord Hodge also consider that the rule applies equally to clauses withholding payments on breach, and could apply alongside relief against forfeiture. Lord Neuberger and Lord Sumption leave that latter question open.

As for what makes a clause penal, the Supreme Court has rejected the traditional test of whether the provision is aimed at deterring the breach, rather than providing compensation for losses suffered as a result of the breach. Instead, the court has set out a new test of whether the clause imposes a detriment on the contract breaker which is out of all proportion to the innocent party's legitimate interest in enforcing the relevant contractual obligation. If so, the clause will be penal and therefore unenforceable.

The fact that a clause is not a pre-estimate of loss will not, without more, mean that it is penal. The court comments that, in a straightforward damages clause, the innocent party's interest will rarely extend beyond compensation for breach, and so the traditional test will usually be adequate to determine the validity of the clause. However, the judgment recognises that a party may have a legitimate interest in the enforcement of the contract which extends beyond the recovery of compensation for breach, in which case the clause will be upheld unless it is out of all proportion to that interest.

The Supreme Court also helpfully recognises that the circumstances in which a contract was made and the nature of the parties are relevant in considering the application of the penalty rule. The judgment states:

"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."

Makdessi

Applying the test to the facts of the case, the Supreme Court concluded that the relevant provisions were not penalties, essentially for two reasons.

First, in substance, they were not secondary obligations but rather primary obligations under the contract. They were not contractual alternatives to damages. The clause depriving Mr Makdessi of his entitlement to deferred consideration was, in reality, a price adjustment clause. Although the occasion for its operation was a breach of contract, it was in no sense a secondary provision. Similarly, the clause requiring Mr Makdessi to sell his remaining shares, at a price which excluded the value of goodwill, reflected the reduced price which Cavendish was prepared to pay for the business in circumstances where it could not count on the loyalty of Mr Makdessi.

Second, the clauses were justified by Cavendish's legitimate interest in the observance of the restrictive covenants in order to protect the goodwill of the business. The court could not assess the precise value of compliance with the relevant obligations. The parties, who were "sophisticated, successful and experienced commercial people bargaining on equal terms over a long period with expert legal advice", were the best judges of how their proper commercial interests should be reflected in the agreement.

Although to some extent the provisions could be described as deterrent, that was only objectionable if they were penal, ie if the object was to punish. Here, the provisions had a legitimate function which, the court said, "had nothing to do with punishment and everything to do with achieving Cavendish's commercial objective in acquiring the business".

ParkingEye

In this case, the Supreme Court held that the £85 charge was not penal because it was justified by ParkingEye's legitimate interest in imposing the charge, which went beyond recovery of any loss.

The court found that the charge had two main objects: managing the efficient use of the car park, by deterring motorists occupying spaces for long periods, and providing an income stream to enable ParkingEye to meet the costs of the scheme and make a profit from its services. Both objectives were perfectly reasonable, and the imposition of a charge to deter overstayers was a reasonable mode of achieving them. The charge of £85 was not out of all proportion to ParkingEye's interest in imposing the charge, and so it was not penal.

The recognition that a clause will not necessarily be penal, and therefore unenforceable, simply because it is aimed at deterrence rather than compensation could prove significant in a number of sectors, including construction, where, for example, liquidated damages for delay might be set by government entities which do not necessarily suffer financial losses in the same way as commercial parties.