For the first time in a century, the Supreme Court has considered the “penalty rule” which, in short, regulates the enforceability of defined contractual remedies for breach of primary contractual obligations. The Supreme Court commented that the rule is “an ancient, haphazardly constructed edifice which has not weathered well”. On 4 November 2015, the Supreme Court handed down its judgment in relation to two conjoined appeals that turned on the penalty rule, which are summarised below.
Background to the Supreme Court appeals
In Cavendish Square Holding BV v Talal El Makdessi, Mr Makdessi entered into an agreement to sell Cavendish a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. Two clauses of the agreement provided that if he breached certain restrictive covenants, Mr Makdessi (a) would not be entitled to receive the final two instalments of the sale price (clause 5.1); and (b) may be obliged to sell his remaining shares to Cavendish at a price that excluded the value of the goodwill of the business (clause 5.6). When Mr Makdessi breached those covenants, he argued that the two clauses were penalty clauses, which were unenforceable. At first instance, the Court disagreed with Mr Makdessi and held that the clauses were enforceable. However, the Court of Appeal held that the clauses were unenforceable penalties under the penalty rule as traditionally understood, and overturned the first instance decision. Cavendish appealed that decision.
In ParkingEye Ltd v Beavis, ParkingEye Ltd and the owners of the Riverside Retail Park in Chelmsford agreed to manage a car park together. ParkingEye put up several notices around the car park stating that any failure to comply with a two hour parking time limit would “result in a Parking Charge of £85”. When Mr Beavis overstayed that two hour limit by almost an hour, he argued that the £85 charge was a penalty at common law and therefore unenforceable, and/or that the charge was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (SI 1999/2083) (“the 1999 Regulations”). At first instance, the Court disagreed with Mr Beavis and held that the charge was enforceable. The Court of Appeal upheld that first instance decision. Mr Beavis appealed to the Supreme Court. Lord Neuberger and Lord Sumption gave a joint leading Supreme Court judgment on these appeals, in both cases upholding the enforceability of the clauses in question. In both appeals this outcome was attributable to the facts of each case. The Supreme Court declined to overturn the penalty rule as a matter of principle. Lord Clarke, Lord Carnwath, Lord Mance and Lord Hodge all agreed. Whilst Lord Toulson agreed that the appeal in Cavendish v El Makdessi should be allowed, he dissented in ParkingEye v Beavis. This was on the ground that it was not reasonable to assume that the burden was on the supplier (ParkingEye) to show that the consumer (Mr Beavis) would have agreed to the terms in individual negotiations on level terms (applying the 1999 Regulations).
What makes a contractual provision a penalty?
The traditional approach taken by the Courts was that a penalty clause is one which penalised a party for breach of a contract by obliging it to pay a sum specified in the relevant clause, which sum was not a genuine pre-estimate of the other party’s loss. That stemmed from the judgment of Lord Dunedin in Dunlop Pneumatic Tyre Company Ltd. v New Garage and Motor Company Ltd.  AC 79. Penalty clauses may appear in various forms, such as clauses withholding payment on breach, clauses requiring the transfer of property, and clauses requiring payment of a non-refundable deposit.
The Makdessi/ParkingEye judgment alters the appropriate test to be applied when deciding whether a clause is a penalty. The Supreme Court considered the key precedent cases such as Dunlop but, after discussion, concluded that asking whether the clause is a genuine pre-estimate of loss or a deterrent is unhelpful. Instead, the real test to determine whether the clause is a penalty is whether the provision goes beyond the innocent party’s “legitimate interest”. The Court stated that, “the question of whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm”. The Court went on to state that “the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter”. The Court also emphasised that the penalty must be a secondary obligation flowing from a primary obligation, rather than a primary obligation itself, stating: “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.”
Application of the test to the instant cases
In Cavendish Square Holding BV v Talal El Makdessi, the Court held that both clauses 5.1 and 5.6 were primary obligations and therefore not subject to the penalty rule. The Court held that clauses 5.1 and 5.6 were price adjustment clauses, which sat with other clauses in the contract which determined Cavendish’s primary obligations, including fixing the price payable by Cavendish for the shares. In addition, the clauses in question had a legitimate function that related to achieving Cavendish’s commercial objective in acquiring the business and protecting its goodwill, which was critical to Cavendish. The loyalty of Mr Makdessi was critical to that goodwill. Had the restrictive covenants not been in place, the Court felt it would not have had a basis on which to assess the precise value of that obligation or determine how much less Cavendish would have paid for the business. Whilst clause 5.6 excluded goodwill from the calculation of the payment price and therefore did not represent the estimated loss attributable to the breach, it did reflect the reduced purchase price which Cavendish would have been prepared to pay on the basis that they could not count on the loyalty of Mr Makdessi.
In ParkingEye Ltd v Beavis, the Supreme Court held that Mr Beavis had a contractual licence to park in the car park on the terms of the notices put up around the car park, including the two hour limit. The £85 was a charge for breaching the terms of that contractual licence. This is a common scheme, subject to indirect regulation by statute and the British Parking Association’s Code of Practice. The Court held that, whilst the penalty rule was engaged in this case, the £85 charge was not a penalty. The charge protected two legitimate business interests: (a) the efficient use of the car park, which benefited the Retail Park’s shops and customers by deterring long-stay or commuter traffic; and (b) the generation of income in order to run the scheme, which benefited ParkingEye. These interests extended beyond the recovery of any loss; and the charge was no higher than was necessary to fulfil those interests.
What implications do these decisions have?
The penalty rule is long established, and may appear less important in light of statutory regulation, such as the 1999 Regulations. However, in these two cases, the Supreme Court observed that the rule is also common to many developed systems of law and covers some key types of contracts not regulated by statute, such as non-consumer contracts. Further the rule is consistent with other, well established principles developed by judges that involve the Court declining to give full force to contractual provisions such as relief from forfeiture, equity of redemption and refusal to grant specific performance.
The Court concluded that extending the penalty rule could hinder freedom of contract. If the rule extended to other types of penalty, such as the ability to terminate a contract upon the occurrence of an insolvency event, that could represent an expansion of the Courts’ jurisdiction into new, uncertain territories. On that basis, the Court felt the penalty rule should neither be abolished nor extended. This followed Lord Hoffmann’s judgment in the case of Else (1982) Ltd v Parkland Holdings Ltd -  1 BCLC 130, where he stated “I would answer that the penalty doctrine, being an inroad upon freedom of contract which is inflexible compared with the equitable rules of relief against forfeiture, ought not to be extended.”
If a contractual remedy is enforceable, its inclusion benefits contractually wronged parties in the event of breach. However, if the clause does not relate to any legitimate business interest, and the remedy for any breach of it would be disproportionate considering the innocent party’s interest in the performance of the contract, then the remedy is likely to be unenforceable.
As accepted by the Court in this judgment, the application of the penalty rule still turns on the facts surrounding the particular contract and the drafting of the clause in question. Therefore, when negotiating or drafting the terms of a contract it is advisable for parties to:
- Consider what each party’s aim is in drafting the contract
- Bear in mind their own, and each other’s, legitimate business interests
- Agree what the primary obligations under the contract should be
- Indicate with clear drafting which clauses relate to the contract’s primary obligations
- Clearly understand what remedies are available, or being imposed, in the event of breach
- Ensure that the remedies are commercially practical
- Ensure that proper notice of the remedies is given (as applicable – such as the charge notices in ParkingEye)