In this article we look at the importance of ensuring, where possible, that both parties take appropriately specialist legal advice when entering into the contract, and that onerous clauses are proportionate to the interests they are included to protect. 

Those who regularly enter into contracts with third party service providers in relation to their property interests may well be familiar with the concept of the penalty clause: a clause that puts an onerous obligation on a party in the event it breaches the contract, with the aim of deterring breach, can be held to be an unenforceable penalty clause. Typically, these would arise where the clause provided for payment of a fixed sum of money on breach, akin to a fine, that did not constitute a genuine pre-estimate of the damages likely to flow from the breach. The Supreme Court has now reconsidered the test for what constitutes a penalty clause. In the in the joined appeals of Cavendish Square Holding CV v Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, it described the law relating to penalty clauses as “an ancient haphazardly constructed edifice which has not weathered well”. They expressed the view that, had the law not already existed, it would not have been invented today.

Rather than abolishing the law of penalties, the Supreme Court has revised the test for what constitutes a penalty, and provided a strong indication that, in circumstances where there is equality of bargaining power and the parties have both been advised professionally, the courts should be reluctant to decline to enforce a clause on the ground that it is as penalty. As a result of the decision, there will also be more scope for arguing the wider commercial justifications for clauses that previously would have been considered to be penalties because they were primarily a deterrent to breach, rather than a genuine pre-estimate of damages.

THE PENALTY PRINCIPLE

Broadly speaking, as the law stood prior to the Cavendish decision, a clause in a contract designed more to deter a party from breaching the contract than to act as a genuine pre-estimate of damages likely to flow from a breach would be held to be a penalty clause and unenforceable. The construction of the clause depended on the terms of the contract and the circumstances at the time it was entered into. Clauses providing for extravagantly large payments in comparison with the greatest loss that could arise, or clauses that could operate on a number of different breaches of varying severity, were liable to be considered penalties. The principles were laid down in the House of Lords case of Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Limited [1915] AC 79, and prior to the Cavendish decision they had altered little since that time. The emphasis was very much on the purpose of the clause. Though parties sought to persuade the courts that certain clauses were justifiable on grounds that they protected legitimate commercial interests in the contractual relationship, if the overriding purpose of the clauses was to deter breach the courts tended to rule that they were penalties.

THE TWO APPEALS

The recent decision of the Supreme Court relates to appeals in two distinct cases, very different in their facts but joined together to allow a long-overdue consideration at Supreme Court level of the law of penalties in both the consumer and commercial contexts.

The ParkingEye case related to an £85 charge for exceeding the maximum two hour stay at a car park in Chelmsford. The case is outside the focus of this article, as it concerned the law of penalties in a consumer context. Suffice to say that Mr Beavis, who must have found it a somewhat surreal experience to hear his challenge to an £85 parking charge contested in the Supreme Court in front of no fewer than 7 Justices, lost because the Court ruled that the car park operator was protecting a legitimate interest by charging people a flat rate of £85 for over-staying the two hour limit by an indeterminate period of time, and there was no evidence that the charge was excessive by reference to other UK car parks. The Court also ruled that the charge did not infringe the Unfair Terms in Consumer Contracts Regulations 1999.

The Cavendish case concerned a share purchase agreement, whereby Cavendish purchased a 60 per cent stake in the largest media and advertising business in the Middle East from its founders, Messrs Makdessi and Ghoussoub, who retained the remaining 40 per cent. The agreement provided for staged payments of amounts that were to be calculated by reference to the ongoing profitability of the business. The amount of these payments was to a large extent dependent on goodwill, which in turn relied on the pivotal role played by Mr Makdessi in developing client and employee relationships. The agreement therefore contained a clause prohibiting him from competing with the business. If he did so, he would become a ‘Defaulting Shareholder’. It was two of the clauses dealing with the consequences of becoming a Defaulting Shareholder that gave rise to the penalty dispute. The first of these, clause 5.1 of the agreement, provided that a Defaulting Shareholder should not be entitled to receive the goodwill-dependent payments. The second, clause 5.6, allowed Cavendish to require the Defaulting Shareholder to sell all of his shares at a price calculated on the basis of a net asset valuation only, with no account taken of goodwill.

Mr Makdessi became a Defaulting Shareholder. He challenged clauses 5.1 and 5.6 on the basis that they were unenforceable penalty clauses that deprived him of his shares and his right to payments without any of the value attributed to the business goodwill that he was largely responsible for. Neither clause was a ‘classic’ penalty candidate, in that it provided for the payment of a fixed sum upon the occurrence of a breach, or breaches of the contract. The Court of Appeal nevertheless ruled that both clauses were penal, and Cavendish challenged this decision on three grounds: either (1) that the law of penalties should be abolished as an outdated restriction on the freedom of contract; (2) that it should not apply to clauses such as these; or (3) that, on the facts, neither of the clauses was penal. 

The Supreme Court ruled that Cavendish succeeded on ground (3). Given the circumstances, the clauses were not penal. The following factors were relevant to the Court’s decision:

  • The clauses had been negotiated between welladvised, commercial parties, and this raised a presumption that they were to be taken to have understood what they were agreeing to as regards the consequences of breach.
  • Too much emphasis has been placed on the principles set out in the Dunlop case. These were intended to be guidelines, not hard and fast rules.
  • A clause that seeks to deter breach so as to protect a legitimate interest will not necessarily be a penalty clause, as long as its effect is not punitive.
  • The effect will be punitive if it is grossly disproportionate and/or unconscionable in comparison to the innocent party’s interest in enforcing the contract.
  • Compensation for breach is not the only legitimate interest. Wider commercial concerns can be taken into account.

The Court reaffirmed that the law of penalties should only apply to ‘secondary’ obligations in contracts. Typically, these are obligations that only take effect to provide for a remedy in the event of breach of a primary obligation, but the distinction between primary and secondary obligations is not always clear.

CONCLUSION

The old question of whether a clause requiring the payment of a specified sum in the event of breach constitutes a genuine pre-estimate of damages will now only be relevant if the sole interest the clause is seeking to protect is a right to payment in the event of breach. To determine whether or not a clause constitutes an unenforceable penalty, the courts will now carry out a balancing exercise, considering the innocent party’s legitimate commercial interests in the wider contractual context and setting them against the impact of the clause in question on the party in breach. If the legitimate interests are not outweighed, the clause will not be a penalty. It will weigh substantially in favour of the innocent party if the clause was negotiated between well-advised, commercially sophisticated parties.

A number of questions arise. One relates to the distinction between primary and secondary obligations. Of equal interest will be how the courts weigh up what constitutes the legitimate interest of the innocent party, and how they balance that with the detriment to the party in breach. No doubt these will be considered by the courts in due course.