In November 2015, the Supreme Court handed down the long awaited judgment on the scope and application of the contractual penalty rule in England in the joined case of Cavendish Square Holding BV v Talal El Makdessi andParkingEye Ltd v Beavis [2015] UKSC 67. The Cavendish claim related to a substantial commercial contract and the ParkingEye claim, a consumer setting.

Prior to the judgment, the penalty rule in England had not been considered by the Supreme Court, or its predecessor, for a century. As a result, when considering the penalty rule, the Supreme Court found that "for many years, the courts have struggled to apply standard tests formulated more than a century ago for relatively simple transactions to altogether more complex situations. The application of the rule is often adventitious. The test for distinguishing penal from other principles is unclear".

Whilst accepting that the rule "is an ancient, haphazardly constructed edifice that has not weathered well", the Supreme Court declined to abolish the rule in relation to consumer or commercial contracts but it did take the opportunity to establish a new test and guidance for the application of that test. Having accepted that the penalty rule is here to stay, it is necessary to look at the following 2 questions: (1) when is the rule engaged? And (2) what makes a contractual provision penal?

The "Dunlop Test"

The leading authority on the law of penalties, for the last 100 years, has been Dunlop Pneumatic Tyre Company Ltd v New Garage & Motor Company Limited. The test derived from that case, and applied by the lower Courts, is that a clause providing for the payment of a sum of money on breach of contract is an unenforceable penalty if that sum does not represent a genuine pre-estimate of the loss likely to flow from that breach. To determine whether a clause is penal, it was necessary to consider:

  1. Whether a clause was extravagant and unconscionable with the predominant function of deterring a party from breaching the contract, as opposed to compensating the innocent party by way of genuine pre-estimate of loss; and
  2. If the clause was extravagant and unconscionable, whether there was a commercial justification for the clause, such that the law will still enforce the clause.

Whilst the test that has been derived from Dunlop was a "useful tool" for simple cases/liquidated damages clauses, its application to cases with more complex facts was limited. Nonetheless, the Courts sought to apply the Dunlop test to the facts of the case before them. The Supreme Court did confirm that in the case of a straightforward damages clause, the test in Dunlop will usually be adequate to determine the validity of the clause.

The Cavendish claim and the decision

In the Cavendish claim, the clauses in question were not clauses concerned with the measure of compensation for breach: the contract provided that if the seller breached certain restrictive covenants, money otherwise due would not be payable (a withholding clause) and the seller could be forced to transfer his remaining shares at a discounted price (a forced transfer of shares clause). Neither clause was held to be penal.

The judgment recognised that "In a negotiated contract between properly advised parties of comparable bargaining strengths, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach".

The majority of the Supreme Court held that when accepting that a clause operating on breach may properly be justified by some consideration other than the desire to recover compensation for breach, its legitimacy is not to be judged solely by reference to the damages which the Court might have awarded for breach. It was held that the real question is "whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation".

As regards the scope of the penalty rule, the judgment confirms that the identification of a clause as a primary or secondary obligation will be crucial. When considering whether a clause is a penal clause, the Courts do not review the fairness of the bargain between the parties - the penalty rule only regulates the remedies available for breach of a party’s primary obligations, not the primary obligations themselves. If a contract contains an obligation on a party to perform an act, and provides that, if he does not perform it, he will be required to pay a specified sum of money - the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty. If the contract does not impose, whether 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.

In relation to the application of the penalty rule to secondary obligations, the Court did not provide detailed guidance, but it is now clear that the fact that a clause is not a pre-estimate of loss will not, without more, mean that it is penal. The judgment recognises that a party may have a legitimate interest in the enforcement of a contract which extends beyond the recovery of compensation for breach, in which case the clause will be upheld unless it is out of all proportion to that interest. In order to determine the validity of a clause providing for the consequences of a breach of contract, the first step is to consider what legitimate business interest is served and protected by the clause and whether the provision made for that interest is extravagant, exorbitant or unconscionable.

It is too early to know how the Courts will apply the test but a number of drafting points arise from the judgment:

Primary obligations are not penal - it is crucial that parties clearly identify the legitimate commercial interests that underpin an agreement. Where appropriate, a clause may be expressed as a primary obligation thus avoiding the application of the doctrine. However, it is important to note that the classification of an obligation will depend on the substance rather than form.

The commercial significance of a clause / the legitimate interest being protected should be highlighted specifically in the agreement, either in the clause itself or another appropriate section of the agreement, such as the recitals. This will highlight their importance to the bargain.

To the extent that the parties are of equal bargaining strength and have received full legal advice during the drafting of the agreement, parties should consider making explicit reference to that in the agreement.