Most typically, they provide that, where a contractor fails to complete the contract works by the stipulated date, then it shall pay the employer, or allow the employer to deduct, LDs at the given rate per day or week for the period during which the contract works remain incomplete.  As such, the primary obligation, to complete the works on time, is replaced by a secondary obligation, to pay the LDs.  Such provisions may also be used where certain performance criteria are to be achieved. The advantage of this arrangement is that the contractor has certainty as to the financial exposure it faces for breach of contract, whilst the employer does not have to incur time and expense proving its loss.

LDs have been recognised as commercially desirable by the courts, always providing that they do not fall foul of the law on penalties, which provides that the LDs must represent a “genuine covenanted pre-estimate of damage”. This principle was established a century ago, in the case ofDunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co  which suggested that an LDs provision would be unenforceable  if the amount payable was "extravagant, exorbitant or unconscionable." This has led to a number of challenges to LDs clauses on the basis that they constituted a penalty.

More recently, the lower courts have refined their position in relation to the operation of LDs clauses, with an acknowledgement that in certain circumstances there may be a "commercial justification" for such provisions even where the amount to be paid appears penal. Now, for the first time in a century, the Supreme Court has considered the "penalty rule”.

Commenting 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 had 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), thus ostensibly well below value. When Mr Makdessi breached those covenants, he argued that the two clauses were penalty clauses, which were unenforceable. At first instance, the Court found against Mr Makdessi, holding that the clauses were not penalties, and were enforceable. Mr Makdessi then appealed, and the Court of Appeal overturned the first instance decision, holding that the clauses were unenforceable penalties.  This decision was then appealed to the Supreme Court by Cavendish.

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 GBP 85”. When Mr Beavis overstayed that two hour limit by almost an hour, he argued that the GBP 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 the clauses were found to be enforceable, with the outcome 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 grounds that it was not reasonable to assume in this case 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 (i.e. applying the 1999 Regulations).

What makes a contractual provision a penalty?

The Makdessi / ParkingEye judgment has brought a modest refinement to the understanding of penalties, as set out in the Dunlop case referred to above. The Supreme Court considered the key precedent cases such as Dunlop but, after discussion, concluded that these are 'considerations'  which may not apply to every case, and that asking whether the clause is a genuine pre-estimate of loss or a deterrent may be helpful for straightforward LDs clauses, but not necessarily for more complex provisions where a broader test is required.

Instead, the real test to determine whether the clause is a penalty is whether the provision goes beyond the relevant 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 LDs provisions must always be expressed as a secondary obligation flowing from the primary obligation, rather than a primary obligation itself: "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. The Court held that 5.1 was a price adjustment clause, which belonged with clauses 3 and 6 among the provisions that determined Cavendish's primary obligations, including price fixing. In the case of 5.6, the Court held that the clause could not sensibly be analysed as a mere security for the performance of the restrictive covenants. As the sale of the shareholding was both legitimate and commercially sensible, the price formula in 5.6 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, in turn, was critical to the 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 GBP 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 GBP 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 has perhaps diminished in importance 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 contracts not regulated by statute, such as non-consumer contracts. The rule is also 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 was of the view that the parties themselves are the best judge of what constitutes a legitimate consequence of a breach, and 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 - [1994] 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 the contractual remedy is enforceable, its inclusion benefits contractually wronged parties in the event of breach. However, if a contractual 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 can still turn on questions of drafting. As noted above, LDs clauses are generally upheld by the courts, providing they do not constitute a penalty; it is therefore worth remembering when inserting such provisions that the obligation to pay LDs must be expressed as a secondary obligation which only operates once the primary obligation has been breached, and it should not be out of all proportion to any legitimate interest the injured party had in performance of the primary obligation.  Most standard form construction contracts contain straightforward LDs provisions, but care should be taken when amending these provisions or producing bespoke versions.