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Practical considerations arising from the Supreme Court’s restatement of the rule against contractual penalties

Contract Document Print publication

17/11/2015

Anyone involved in the negotiation of commercial contracts will note the Supreme Court’s recent restatement of the law on penalty clauses with interest. Gwendoline Davies and Malcolm Simpson explain one of the most anticipated and important judgments of the year and offer some practical advice.

Rule against penalties

Contracting parties frequently wish to pre-emptively protect themselves against the breach of their counterparty. Parties therefore often agree what are known as liquidated damages clauses, which specify in advance the consequences that will flow from a party’s breach. Liquidated damages clauses usually provide for the breaching party to pay a pre-determined sum of money to the innocent party. However the common law rule against penalties provides that, to the extent that such a clause is a penalty, it will be unenforceable. So, how do you determine what is a penalty?

In the recent landmark legal decision following the appeals, heard together, of Cavendish v Makdessi and ParkingEye v Beavis [1], the Supreme Court has undertaken a wholesale review of the guiding principles of the rule against penalties and it has restated the law for the modern day, providing a more flexible test for determining penalties.

A century ago [2] Lord Dunedin identified a number of tests which could prove helpful or conclusive in deciding whether or not a contractual provision amounted to an unenforceable penalty. The Supreme Court has now found that those tests had, over time, been applied more rigidly than was ever intended, and had effectively been distilled into an unhelpful, over-simplified distinction between a genuine pre-estimate of loss which is compensatory, and therefore enforceable; and a deterrent which is penal, and therefore not (the ‘old’ test).

Whether a contractual provision amounts to a penalty can now be determined by asking 3 questions (the ‘new, true’ test):

  1. Is the penalty rule engaged at all? The Supreme Court explained that whether the penalty rule applies may depend on how the relevant obligation is framed in the contract. 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 or some other benefit in kind (for example the transfer of shares or the forfeit of a sum otherwise due), the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty. However, where the clause in question refers instead to direct, or ‘primary’, obligations of a party, and therefore does not merely set out remedies for breach, the penalty rule may not be engaged and the clause may stand as enforceable without any further analysis. To give an example, in the event of a supplier failing to provide goods on time, a consequential ‘primary’ obligation might be that the customer could impose a new delivery deadline, specification and pricing structure for its purchase of goods. By comparison, a consequential ‘secondary’ obligation would be for the supplier merely to pay monetary compensation for late delivery.
  2. Does the clause serve to protect any legitimate interest? A justifying interest may well be (but does not necessarily have to be) a valid commercial interest in the observance of the relevant contractual provisions. The Supreme Court has now conclusively confirmed that the factual circumstances of a case and any commercial context will be relevant to the determination of whether a clause is a penalty.
  3. If so, is the provision out of proportion to the protection of that interest, by being extravagant or unconscionable?

Only if the answer following consideration of all 3 questions is ‘yes’ is the clause likely to be an unenforceable penalty.

To explain what that means in practice, we will briefly explain the facts and key issues arising out of Makdessi and ParkingEye.

Makdessi

The Makdessi case concerned a clause in a share purchase agreement which provided that, in the event of the seller’s breach of a restrictive covenant, the buyer would be released from its contractual obligation to pay certain monies and would be entitled to force the seller to transfer the remainder of its shares in the business to him at a reduced price.

Applying the new test and overturning the earlier decision of the Court of Appeal [3], the Supreme Court held that the rule against penalties was not even engaged, and that the clause was enforceable. It found that the clause in question concerned primary obligations, to which the penalty rule does not apply. The clause was drafted in such a way that it did not merely set out “secondary” remedies to be provided by the seller in the event of his breach.

The court also placed emphasis on the fact that the buyer had a legitimate commercial interest in the observance of the restrictive covenants in order to protect the goodwill (and, as such, the value) of the business he was purchasing. The function of the disputed clause was not simply to penalise a seller’s breach.

In addition, the court took account of the fact that both parties were sophisticated and experienced commercial people, bargaining on equal terms with expert legal advice. The court acknowledged that the parties were the best judges of their respective commercial interests and of what was legitimate in a contractual provision dealing with the consequences of breach.

ParkingEye

In this case Mr Beavis overstayed the permitted time in a car park and then challenged the £85 fine levied. He argued that £85 did not represent a genuine pre-estimate of the loss that ParkingEye would suffer in the event that a motorist exceeded the free parking period and that, as such, the clause imposing the fine was penal and unenforceable.

Applying the new test, the Supreme Court held that, while the rule against penalties was plainly engaged, nevertheless the clause levying the fine was not a penalty. There were reasonable, legitimate commercial and social interests protected by it, namely: the effective management of the car park, which included ensuring availability of time-limited free parking for the benefit of all consumers and retailers in the locality; and the provision of an income stream to enable ParkingEye to meet the costs of, and make a profit from, running the car parking scheme.

In addition, the fine was not extravagant or unconscionable having regard to nationwide industry practice and the clear wording of notices used in the car park. The fine was held to stand.

Practical advice

So what does this mean in practice, particularly for those responsible for negotiating contract terms?

  • The new approach embraces more flexibility, which is likely to mean that fewer clauses will be found to be unenforceable penalties.
  • More than ever before, careful drafting can help parties to pre-emptively protect themselves against certain breaches of contract:
    • parties should consider framing contractual obligations so as to ensure that they are primary obligations to which the penalty rule does not apply, as opposed to secondary provisions which merely set out consequences of breach; and
    • parties may wish to specify, in the contract itself, the commercial context and why the particular clause provides reasonable and proportionate protection of a legitimate interest.
  • Legitimate interests which can justify a particular provision may be commercial in nature, but they may also take into account wider social, economic or consumer considerations.
  • The courts should now be more reluctant to characterise a clause negotiated between commercial parties and/or parties that are legally advised as a penalty.
  • The new approach will be applied by the courts from now on, including to any disputes about existing contracts. Anyone who has received prior advice that an existing contractual provision may or may not be a penalty should now seek immediate expert advice in case the position has changed.
  • Businesses would be well advised to review their existing and standard contracts in light of this decision. It may be that standard terms can now be improved upon and any provisions which still fall foul of the rule against penalties should be identified.
  • If you have any queries arising from Makdessi and ParkingEye, or if you would like any advice or assistance in relation to your commercial contracts, please do not hesitate to contact any of the partners in Walker Morris’ Commercial Dispute Resolution team.

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[1] Cavendish Square Holding BV (Appellant) v Talal El Makdessi; and ParkingEye Limited v Beavis [2015] UKSC 67
[2] Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79
[3] The Court of Appeal had previously held that the provision was penal and unenforceable.

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