Guidance on law relating to “penalty” clauses

Summary

The UK Supreme Court has recently clarified the legal test under English common law for determining if a contractual provision is a penalty clause and, therefore, unenforceable. In short, the emphasis is no longer on whether the provision is a “genuine pre-estimate of loss” and compensatory (and enforceable) as opposed to being penal and deterrent (and unenforceable). Rather, the English courts will focus on whether the nature of the contractual provision comes within the “penalty rule” at all and, if so, whether the provision protects a legitimate interest and is proportionate.

The UK Supreme Court’s ruling marks a shift towards the supremacy of contractual relations between commercial parties dealing with each other at arm’s length. This should herald a less interventionist approach by the English courts as regards penalty clauses. For Hong Kong readers, we would expect the UK Supreme Court’s judgment to be of considerable persuasive force.

In the meantime, we set out some brief background to the case and some points to note.

Background

In Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis, the UK Supreme Court upheld the validity of the two disputed clauses, being two appeals rolled into one judgment1. The seven judges are unanimous in their declaration of the common law test for determining whether a contractual provision is a penalty clause or not2.

Cavendish Square Holding BV v El Makdessi concerned (among other things) the withholding of payment instalments under a deferred consideration type clause in a commercial agreement for the sale of a controlling stake in a holding company. ParkingEye Ltd v Beavis concerned the enforceability of an excess parking charge of some £85.

It is important to note that the UK Supreme Court has not abolished the rule against contractual penalties; rather, it has reinterpreted the rule. The reinterpretation is best summed-up in paragraph 32 of the judgment:

“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.”3

Hong Kong

In Hong Kong, the Court of Final Appeal has applied the test of “genuine pre-estimate of loss” in the leading case of Polyset Ltd v Panhandat Ltd4. Therefore, that still represents the common law position in Hong Kong. However, in light of the UK Supreme Court’s judgment in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis, we would expect further appellate court clarification in Hong Kong. The Hong Kong courts traditionally favour contractual supremacy between commercial parties dealing with each other at arm’s length; the Hong Kong courts also lean towards a more literal interpretation of commercial contracts between parties on an equal footing.

On the face of it, it is difficult to see why  the reasoning of the UK Supreme Court in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis should not apply to agreements that are subject to Hong Kong law and between commercial parties dealing with each other at arm’s length. That said, the local courts are not bound to follow English authority and for now Polyset Ltd v Panhandat Ltd is still binding. It should also be noted that (for now) the Australian courts have preferred the “genuine pre-estimate of loss” test in considering whether a contractual provision is a penalty and Australian cases (in this context) carry equal weight to English cases5.

Some points to note

  • Contractual provisions providing for remedies (secondary obligations) in the event of a breach of a primary obligation by a party to a contract can come in all different shapes and sizes. Essentially, they provide for remedies against a contract breaker. A common example is a liquidated damages clause or a “variation payments” clause. These are common in construction and outsourcing contracts.
  • In considering whether a contractual provision amounts to a penalty, ask: is the rule against penalty clauses triggered at all? If so, does the contractual provision protect the enforcing party’s legitimate commercial interests?
  • The common law rule against penalty clauses is only engaged with respect to secondary obligations. The rule does not apply with respect to the fairness of parties’ primary obligations under a contract. For example, in Cavendish Square Holding BV v El Makdessi the deferred consideration clause was not triggered by reference to a secondary obligation; rather, it was triggered with respect to a primary obligation and was, in effect, a price adjustment mechanism. Therefore, the first thing to do is to consider whether the rule against penalty clauses is engaged at all.
  • In deciding whether the “penalty rule” is engaged or not, the courts look at the substance of the clause; not only its form. However, going forward, we would expect some commercial parties to attempt to frame provisions for contractual remedies by reference to primary obligations in contrast with (for example) payment of liquidated damages as a secondary obligation in the event of a breach.
  • If the rule against penalty clauses is engaged under English common law, in deciding whether a contractual provision is enforceable or not it is legitimate to consider the enforcing party’s wider interests, rather than a narrow assessment of whether the provision is a “genuine pre-estimate of loss”. While a “genuine pre-estimate of loss” test applies in Hong Kong, we would expect further appellate court clarification on point. This is a good time to review your standard terms of business.
  • In the meantime in Hong Kong, the more exorbitant or unconscionable a contractual remedy (in the event of a party’s breach) the more likely it is to be unenforceable. This is a key commercial consideration when negotiating contractual provisions providing for remedies in the event of a party’s breach of a primary obligation (for example, performance) in a commercial  agreement.