The common law penalty rule is poorly understood but can have disastrous consequences for contracting parties who do not consider it when setting out remedies for contractual breach. The UK Supreme Court recently brought some much needed clarity to the rule and articulated a revised test in a pair of decisions: Cavendish v Talal and ParkingEye v Beavis. The two decisions consider the rule in very different contexts: Cavendish in the valuation of assets in a share sale and ParkingEye in the imposition of a charges for violating parking lot time limits.
The Legal Principles
By way of background, the commonly understood application of the rule in modern times has been to invalidate clauses which require a payment of money that was in significant excess of a genuine pre-estimation of damages in the event of contractual default. With limited exceptions, it has been applied most often to payments of money and not transfers of assets or the withholding of payments (to which the doctrine of relief from forfeiture may apply).
In the decision, the UK Supreme Court reviewed the history of the rule and its development through the common law in order to consider whether to abolish the rule or expand it. Ultimately, it did neither. Abolishing the rule was inappropriate because it is common to all major systems of law, it addresses important circumstances that are not covered by statute, and it is consistent with other contractual principles developed by judges. Expanding it was inappropriate because it would represent “the expansion of the courts’ supervisory jurisdiction into a new territory of uncertain boundaries, which has hitherto been treated as wholly governed by mutual agreement.” (para 42)
Instead, the Court reformulated and clarified the rule by setting down the following principles:
- The rule applies only to secondary obligations, i.e. remedies for breach of contract. It does not apply to or consider the fairness of primary obligations. (para 13)
- The rule can apply to any secondary obligation including a payment of money, a payment of assets, a withholding of payment, or a forfeiture of a deposit. (para 16)
- The clause does not need to be a genuine pre-estimation of damages. Rather, the “true test” according to the Court is whether the clause 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.“ (para 32)
Background and Application to Cavendish
Cavendish concerned a commercial agreement for the sale of an advertising and marketing communications group in the Middle East. A large portion of the business’ value was goodwill and there were, apparently, concerns about the vendor’s loyalty. As such, two covenants were built into the agreement to provide protection in the event the vendor was disloyal (e.g. competed with the company or solicited its employees). First, the agreement was to be paid in four parts, with the last two forfeitable in the event of disloyalty. Second, the agreement contained a call option exercisable in the event of disloyalty with an exercise price formula that excluded goodwill from the value of the shares. The vendor breached the covenants but argued that they were unenforceable penalty clauses. He lost at trial but won at the Court of Appeal.
The Court unanimously held that neither clause engaged the penalty rule as neither was a secondary obligation. They were primary obligations and could be enforced. The first was, in effect, a price adjustment clause. (para 74) The second simply determined the price of a call option. (para 81) In both cases, the clauses reflected a legitimate interest of the purchaser as “the goodwill of” the “business was critical to its value.” (para 75)
Background and Application to ParkingEye
Many commercial parking lots in the UK allow for free parking for two hours with a charge to be paid for longer stays. The purpose is to encourage shopping while making efficient use of the available parking. The appellant, Beavis, overstayed at a parking lot managed by ParkingEye for roughly an hour. He then challenged the subsequent charge in court, arguing that it was a penalty. He lost at trial and at the Court of Appeal.
The Supreme Court disagreed with Beavis as well and held that, although the penalty rule was engaged, the £85 charge was not a penalty as it reflected a legitimate interest of the landowners (managing their parking lot in a manner to attract shoppers) and of ParkingEye (whose income is entirely derived from penalty charges). As well, the charge was not extravagant nor unconscionable as it was within a range commonly charged in the UK and was prominently and clearly advertised.
Impact in Canada
The penalty doctrine applies in Canada and usually follows the four factor test articled by Lord Dunedin in Dunlop Pneumatic Tyre v. New Garage. In the case of a straightforward damages clause, the UK Supreme Court held that those four factors will remain “perfectly adequate”. (para 32)
Interestingly, the UK Supreme Court expressly declined to follow the approach set out the broader approach set out by the Australian Supreme Court’s in Andrews and Ors v. Australia and New Zealand Banking Group Limited,  HCA 30. In Andrews, the Australian Supreme Court expanded the penalty doctrine to address any “sufficiently onerous provision which was conditional upon a failure to observe some other provisions, whether or not that failure was a breach of contract.” (see Cavendish at para 41) As a result, the law in this area is diverging in Australia and the United Kingdom. It remains to be seen what path Canadian courts will follow.
Docket: UKSC 2013/0280
Date: November 4, 2015