A significant case determined by the UK’s top court, the Supreme Court, has taken the opportunity (the ‘first in a century’) to review the law relating to contractual penalty clauses. This case is likely to have an impact on the enforcement of clawbacks in the UK and in other common law jurisdictions (such as New Zealand and Bermuda) which have ties to the UK judicial system. The decision relates to whether a contract can specify an amount to be paid (repaid) if there is a breach of contract.

The Court did not abolish or extend the penalty rule but did significantly change the test as to what would amount to an unenforceable “penalty clause”. This ruling was a joint judgment delivered earlier this month (ParkingEye v Beavis and Cavendish Square Holding BV v El Makdessi).

This change could impact both employment and incentive related contracts, particularly clawbacks.

What is a penalty clause?

It is common for a commercial contract to include a provision specifying that a particular remedy (such as payment or forfeiture of an amount of money), will apply if there is a breach of contract. If the party in breach disputes the application of the provision, and it is a found to be excessive or imposed merely as a deterrent, then it could be held to be a penalty and be unenforceable. In the UK the test applied by the court in the past was whether the provision represents a ‘genuine pre-estimate of the loss’ caused by the breach.  A similar approach is followed in many other jurisdictions.

When this is considered in the context of clawbacks, there is a concern that if a company seeks to enforce a clawback and ask for the award or its value to be returned the employee could argue that the clawback was a penalty because it was excessive or was imposed as a deterrent.

What has changed?

Previously, to enforce this type of clause you had to show that the amount to be paid was a ‘genuine pre-estimate of loss’. The Court has rejected this test and held that the true test for establishing whether a provision is a penalty is whether the provision imposes a detriment on the defaulting party which  is out of all proportion to the innocent party's legitimate interest in enforcing the defaulting party’s obligations under the contract. 

This more flexible test should mean that parties have greater freedom in setting out the consequences of a breach of contract without the need to calculate whether the remedy constitutes a genuine pre-estimate of loss. The key factors are that the innocent party must have a legitimate interest in the performance of the contact and the remedy must not be out of proportion or ‘extravagant, exorbitant or unconscionable’. The wider commercial context of a transaction will be of greater relevance. Even if the remedy set out in the provision bears no relationship to the loss actually attributable to the breach, it will not necessarily be a penalty if the employer can show that there is a legitimate reason why compensation for the actual loss suffered would not be sufficient, for example where the breach damages the employer’s reputation.

The Cases

In ParkingEye, the Court held that while the penalty rule was relevant, a charge imposed for parking in a private car park beyond the free two-hour period was not a penalty. It found that there were legitimate interests for the car park manager in charging overstaying motorists, both to control the use of the car park by shoppers and to make a profit. The Court also found that the £85 excess parking charge was commercially justifiable and not out of proportion.

The amount at stake in Cavendish Square Holding BV v El Makdessi was considerably higher than the £85 in ParkingEye.  The case concerned a breach of restrictive covenants in a contract for the sale and purchase of an advertising business.  The Court held that the penalty rule did not apply or, if it did, the terms did not amount to a penalty. The purchaser had a legitimate interest in enforcing the restrictive covenants and the terms of the agreement, although harsh, were not exorbitant or unconscionable. The Court emphasised that the penalty rule was not intended to make a better bargain for the defaulting party. It was relevant that the contract was negotiated in detail by parties of equal bargaining power and with skilled legal advice. 

Tapestry comment: is this relevant to incentives?

This could be highly relevant – for example in the context of Clawback and also in the context of bad leaver provisions. In the past the employee could argue that these provisions did not amount to a ‘genuine pre-estimate’ of the loss suffered by the employer - and it may have been hard for the employer to prove loss, for example where the employee has breached a restrictive covenant. 

Now these provisions should be enforceable unless the financial cost to the employee is out of all proportion to the employer’s legitimate interest in enforcing the obligations. Careful drafting remains crucial and it may be helpful specifically to identify the legitimate interest that the provision is protecting.